A Beginner’s Guide to Token Standards and Collateral Assets

A Beginner’s Guide to Token Standards and Collateral Assets

The world of decentralized finance is built on digital tokens and the collateral that backs them. If you are new to this ecosystem, the concepts of token standards and collateral assets can seem intimidating. This guide breaks them down into clear, digestible pieces so you can understand how they work together to create trustless, automated financial services.

Token Standards: The Building Blocks of Digital Assets

Token standards are protocols that define how tokens behave on a blockchain. They ensure that developers, users, and applications can interact with tokens consistently, regardless of who issued them. Learn more about token standards in the Foundations of DeFi Token Standards and Asset Basics.

The most common standards on Ethereum and other EVM‑compatible chains are ERC‑20, ERC‑721, and ERC‑1155. Each serves a distinct purpose, and their differences influence how collateral can be used in lending, borrowing, and synthetic asset creation. For a deeper dive into how token standards affect collateral listings, see the Understanding DeFi Assets From Token Standards to Collateral Listings.

ERC‑20: The Universal Currency

ERC‑20 tokens are fungible, meaning every unit is identical and interchangeable with any other unit of the same token. This universality makes ERC‑20 the standard for cryptocurrencies, stablecoins, and many utility tokens.

Key functions of an ERC‑20 contract include:

• totalSupply – returns the number of tokens in circulation.
• balanceOf(address) – shows how many tokens a particular address owns.
• transfer(to, amount) – moves tokens from one address to another.
• approve(spender, amount) and transferFrom – allow third‑party contracts to move tokens on your behalf.

Because these functions are standardized, wallets, exchanges, and DeFi protocols can reliably read and write ERC‑20 balances without custom logic.

ERC‑721: Non‑Fungible Tokens (NFTs)

ERC‑721 tokens are unique. Each token has its own identity, represented by a distinct token ID. NFTs are used for collectibles, digital art, and any asset where uniqueness matters. The standard includes:

• ownerOf(tokenId) – returns the owner of a specific NFT.
• transferFrom(from, to, tokenId) – moves a specific NFT.
• tokenURI(tokenId) – provides a link to metadata describing the asset.

Because NFTs carry individuality, they cannot be aggregated into a single “pool” like ERC‑20 tokens. This distinction is crucial when you consider using NFTs as collateral.

ERC‑1155: Multi‑Token Standard

ERC‑1155 blends ERC‑20 and ERC‑721 into a single contract that can hold both fungible and non‑fungible tokens. It allows batching of transfers, reducing gas costs when moving many tokens simultaneously. This flexibility makes it attractive for gaming, where a single contract might hold in‑game currencies and unique items.

Collateral Assets: The Backbone of DeFi Lending

Collateral is the asset that borrowers lock up to secure a loan. The value of the collateral must exceed the value of the loan to protect lenders against price volatility. For guidance on listing collateral assets, read the Mastering Collateral Asset Listing in DeFi Libraries.

What Makes a Good Collateral Asset?

1. Liquidity – The asset must be easy to trade in markets. High liquidity reduces slippage when the collateral is liquidated.
2. Price Stability – Assets with predictable prices help maintain healthy collateralization ratios.
3. Simplicity of Valuation – The asset should have a clear, unambiguous market price, often from a trusted price oracle.

Common Collateral Types

• ERC‑20 Tokens – Popular choices include ETH, WBTC, USDC, and DAI.
• Stablecoins – Tokens pegged to fiat currencies provide price stability, making them ideal collateral.
• Wrapped Tokens – Wraps of non‑EVM assets (e.g., WBTC) allow them to be used in DeFi ecosystems.
• NFTs – In emerging markets, unique digital items can serve as collateral, though their valuation is more subjective.

Stablecoins as Collateral: Why They Are Favored

Stablecoins are a subset of ERC‑20 tokens that aim to maintain a 1:1 value with a fiat currency, usually the US dollar. This primary advantage is price predictability, which directly addresses the core risk in collateralization: price volatility. Learn how stablecoins fit into DeFi in the Understanding DeFi Assets From Token Standards to Collateral Listings.

How Do Stablecoins Work?

1. Reserve‑Backed – The issuer holds an equivalent amount of fiat or other assets to back each stablecoin in circulation.
2. Algorithmic – Some stablecoins adjust supply automatically through smart contracts to maintain price stability.
3. Collateralized – Many are backed by over‑collateralized reserves on a blockchain.

Because the value of stablecoins is tightly regulated, lenders can set lower liquidation thresholds, improving borrowing efficiency for users.

Popular Stablecoins

• USDC – Fully backed by fiat reserves, audited monthly.
• DAI – Collateralized by other cryptocurrencies, managed by the MakerDAO protocol.
• USDT – Widely used but with less transparency compared to USDC.

Selecting Collateral Assets: A Step‑by‑Step Approach

Choosing the right collateral involves assessing risk, liquidity, and platform compatibility. Follow these steps to make an informed decision:

1. Identify the Lending Protocol

Each DeFi protocol has its own list of accepted collateral. For instance, Compound, Aave, and MakerDAO each support a unique set of assets. Reviewing the protocol’s documentation or on‑chain data will tell you what you can lock up.

2. Evaluate Liquidity

Use on‑chain analytics to check trading volume on decentralized exchanges like Uniswap or Sushiswap. A high 24‑hour volume indicates that the asset can be liquidated quickly without a large price impact.

3. Check Price Oracle Reliability

Protocols rely on price oracles to determine collateral value. Verify that the oracle feeds are reputable (e.g., Chainlink, Band Protocol) and that the asset is not subject to oracle manipulation.

4. Understand Collateralization Ratios

Protocols specify a maximum loan‑to‑value (LTV) ratio. For example, if the LTV is 70 %, you can borrow 70 % of the value of your collateral. Knowing the ratio helps you calculate how much you can safely borrow.

5. Assess Volatility

Even if an asset is liquid, a sudden drop in price can trigger liquidation. Use volatility metrics such as the standard deviation of daily price changes to gauge risk.

Risk Factors in Collateralized Lending

All collateral carries inherent risks. Understanding them helps you protect your capital.

Market Risk

If the collateral’s market price falls, your loan may become under‑collateralized, leading to automatic liquidation. This risk is mitigated by maintaining a healthy buffer above the minimum LTV.

Oracle Risk

Oracles may fail, become inaccurate, or be manipulated. A false price can trigger unjustified liquidations. Protocols often use multiple oracle sources to reduce this risk.

Smart Contract Risk

Bugs in the lending contract can lead to loss of funds. Audits and community vetting are essential before depositing collateral.

Liquidity Risk

If an asset has low trading volume, liquidation could occur at a price far below market value, increasing losses for lenders.

Listing Collateral on DeFi Platforms: The Process

When a new asset is proposed as collateral, the community and protocol developers evaluate it through several stages:

1. Proposal Creation – A proposal is submitted, outlining the asset’s characteristics and potential risks.
2. Community Discussion – Stakeholders debate the proposal, suggesting modifications or raising concerns.
3. Testing – The asset is added to a testnet environment to observe behavior under various conditions.
4. Audit – Independent auditors review the smart contract code and collateral integration.
5. Governance Vote – Token holders vote on whether to activate the asset as collateral.

For best practices on collateral asset listing, see the Mastering Collateral Asset Listing in DeFi Libraries. Once approved, the asset appears on the platform’s collateral list, and users can begin borrowing against it.

Practical Example: Borrowing Against ETH on Aave

Let’s walk through a typical borrowing scenario to illustrate how token standards and collateral interact.

Step One: Acquire ETH

You purchase 1 ETH on a centralized exchange and transfer it to your wallet. The ETH is represented on the Ethereum blockchain as a native asset, not an ERC‑20 token. For borrowing, you need its wrapped version, WETH, which is an ERC‑20 token. Convert ETH to WETH via a swap on Uniswap.

Step Two: Deposit WETH as Collateral

Open the Aave app, connect your wallet, and deposit 1 WETH. Aave records this as your collateral and updates your collateralization ratio.

Step Three: Choose a Loan Token

Aave allows you to borrow a variety of ERC‑20 tokens, such as DAI or USDC. Select the token you need and specify the amount.

Step Four: Check LTV and Health Factor

Aave displays your Loan‑to‑Value (LTV) ratio and Health Factor. The Health Factor indicates how close you are to liquidation. Maintain a Health Factor above 1.0 to avoid being liquidated.

Step Five: Receive Loan and Repay Later

After approval, the borrowed token is transferred to your wallet. When you repay, you can use the same token or any other asset that the protocol accepts. Once the loan is fully repaid, you withdraw your WETH collateral.

Advanced Collateral: Using NFTs

While rare, some platforms allow NFTs to serve as collateral. Because each NFT has a unique value, protocols use special oracles that appraise NFT prices. The process involves:

• Minting the NFT – Ensure it conforms to ERC‑721 or ERC‑1155.
• Appraisal – The protocol queries an oracle or uses an internal marketplace to estimate value.
• Collateralization – The NFT is locked in a smart contract, and a loan is issued based on its appraised value.
• Liquidation – If the NFT’s price falls, the protocol can auction it to cover the debt.

This area is still evolving, and risk management is more complex than with fungible tokens.

Future Trends in Token Standards and Collateral

The DeFi ecosystem continues to innovate. Anticipate the following developments:

• Layer‑2 Tokenization – Tokens on roll‑ups like Optimism and Arbitrum will offer lower fees, increasing collateral usage.
• Interoperability Standards – Protocols like Cosmos and Polkadot are working on cross‑chain token standards, allowing collateral to move freely across ecosystems.
• Dynamic Collateral Models – Smart contracts that adjust collateralization ratios in real time based on market conditions could reduce liquidation events.
• Decentralized Oracles – Advances in oracle networks will improve price accuracy, enhancing collateral safety.

Conclusion

Token standards form the foundation of how digital assets behave, while collateral assets provide the security layer that underpins lending, borrowing, and synthetic markets. By understanding the roles of ERC‑20, ERC‑721, and ERC‑1155 tokens, you can navigate which assets can be used as collateral and why stablecoins are often preferred. Evaluating liquidity, oracle reliability, and volatility will help you choose safe collateral and manage risk effectively.

Armed with this knowledge, you can confidently participate in DeFi protocols, leveraging the power of blockchain to create new financial opportunities. Whether you are a casual investor or a professional developer, mastering token standards and collateral fundamentals is essential for thriving in the evolving world of decentralized finance.