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Collateralized Debt Positions (CDPs)

Collateralized Debt Positions (CDPs) are innovative financial mechanisms in Decentralized Finance (DeFi) that allow users to lock up cryptocurrency as collateral to borrow other assets. Originating from traditional financial concepts, CDPs have become a cornerstone in DeFi, offering a secured loan framework where users can leverage their crypto holdings. MakerDAO pioneered this concept within DeFi, using CDPs to issue its DAI stablecoin. By depositing crypto assets as collateral in a CDP, users can mint DAI, showcasing a practical application of CDPs in stabilizing and expanding the utility of DeFi platforms.

Key Features of CDPs

Key Features of CDPs in DeFi underscore their revolutionary impact on financial protocols:

• Decentralization: CDPs are managed by smart contracts, eliminating the need for central authorities to oversee debt or liquidity. This automation ensures transparency and efficiency, decentralizing financial interactions and empowering users with control over their transactions.

• Scalability and Flexibility: The acceptance of a diverse array of assets as collateral enhances the scalability and flexibility of DeFi platforms. Users benefit from a broadened choice spectrum, enabling them to utilize various crypto assets for borrowing, thereby optimizing capital utilization and accommodating a wider range of financial strategies.

• Operation Differences: CDPs function differently in lending protocols compared to stablecoin systems. In lending protocols, users deposit collateral to borrow from a shared liquidity pool, facilitating a dynamic borrowing environment. 

Conversely, stablecoin systems use CDPs to lock in collateral for minting new tokens, primarily stablecoins, which are backed by the deposited assets. This distinction highlights the versatility of CDPs in supporting various DeFi applications, from enhancing liquidity to creating stable digital currencies.

Overall, CDPs serve several practical purposes in DeFi, with notable growth in areas such as:

• Leveraged Trading: Users can amplify their potential gains (or losses) by locking assets in a CDP, borrowing against them, and then using the borrowed assets to acquire more crypto assets.
• Yield Farming: Involves depositing crypto into a CDP, minting stablecoins against the collateral, and then using these stablecoins in other DeFi protocols to earn interest or governance tokens.
• Paying Off Debts: Users with high-interest debts in traditional finance can use CDPs to mint stablecoins by locking their crypto assets. They can then sell these assets for fiat to settle their debts. This method allows them to maintain exposure to their crypto assets while potentially avoiding capital gains taxes.

Example of CDPs on MakerDAO

MKR is an ERC-20 token on Ethereum and thus cannot be mined. Instead, it is created (and destroyed) in response to Dai price fluctuations to keep the Dai price around $1. MKR is used to pay transaction fees on the Maker system, and it collateralizes the system. It stabilizes the value of Dai through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors. 

To take out a loan or “vault” within the Maker system, users must deposit any of the several accepted crypto-tokens into the Maker vault and then borrow Dai against the value of those tokens. Typically, the collateral must be at least 150% of the value of the loan. The protocol then charges borrowers a stability fee for borrowing Dai. This fee is variable and subject to the discretion of Maker governance. Ultimately, the stability fees collected by all the Dai loans are used to buy MKR from the open market and then burn it. This stability fee/burning mechanism is the primary source of value accrual for MKR.

Over-collateralization

CDPs often rely on over-collateralization to promote stability in the system, just as MakerDAO does. Over-collateralized loans are vital for maintaining a lending protocol's financial stability. Over-collateralization is crucial for maintaining financial equilibrium within the protocol, particularly in scenarios where the collateral's value might decrease. The ratio of the collateral's value to the debt value, known as the Collateral Ratio (CR), is a critical measure in this context.

Upon deciding to close their position, users must return the borrowed assets. Importantly, the debt accumulates interest over the period of borrowing. This interest rate could be either fixed or variable, depending on the specific terms of the protocol. The accrued interest is then distributed among the creditors of the pool, ensuring that lenders receive their due returns.

When the collateral's value falls below a predetermined threshold, it becomes susceptible to liquidation, a notable risk in DeFi protocols. There are several liquidation methods:

• Instant Liquidation involves the immediate sale of the collateral at market value. It is typically used when the collateral and debt values are equal.
• Auction Liquidation, where the collateral is sold through an auction process, is common in situations where the collateral and debt values vary.
• Partial Liquidation entails selling a part of the collateral to settle the debt and is utilized when the value of the collateral is higher than the debt.

These strategies are designed to mitigate the protocol's risk and ensure lenders are repaid, even when the collateral's value diminishes. Users also have the opportunity to contribute liquidity to CDP protocols by depositing their assets into a shared pool. In return, they receive an interest rate on their deposits. This rate is often variable and calculated algorithmically, taking into account the utilization ratio, which is the ratio of borrowed assets to available assets in the pool.

Consider the situation where the value of the collateral provided suddenly falls below the value of the assets borrowed from the protocol and they are NOT liquidated. In this case, the borrower's incentive to repay the loan diminishes, as the collateral they would recover upon repaying the loan is worth less than the repayment amount. Consequently, the loan becomes insolvent. This is why protocol must have efficient liquidation strategies (discussed in more detail in later sections).

Insolvent loans are detrimental to DeFi protocols. The debt generated by insolvent loans introduces uncertainty into the system, as lenders cannot reclaim the full value of their assets from the protocol. To illustrate the severity of this issue, consider a scenario akin to a traditional finance "bank run" on a DeFi protocol. In such an event, the last users attempting to withdraw their assets would be unable to do so, as the protocol would not have sufficient funds to cover the withdrawals.

DeFi protocols with significant levels of bad debt are less attractive to users, as the inherent financial instability poses considerable risks. Therefore, it is essential for lending protocols to enforce over-collateralization to mitigate the occurrence of insolvent loans and maintain the overall confidence and stability of the DeFi ecosystem.

There are many different ways in which DeFi protocols attempt to mitigate bad debt and secure their protocol from risks surrounding cascading liquidations - a negative feedback loop in which trader positions are forcefully liquidated and closed by exchanges or applications due to falling values in the underlying collateral. This can leave protocols without a safety net in trouble, and with a lack of central authority, there are no organized bailouts for these protocols. 

So, some protocols like Aave also implement security stopgaps, such as the Aave Safety Module, where users can stake the AAVE token in exchange for token emissions. If there is a significant liquidation event, stakers could have up to 30% of their staked positions slashed to cover debt deficits. This ensures Aave can cover its debt obligations effectively.