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A Primer on Collateralized Debt Positions
In the decentralized finance (DeFi) world, a key mechanism that has gained substantial traction is the Collateralized Debt Position (CDP). Essentially, a CDP is an open loan backed by collateral such as a cryptocurrency. Originating from conventional financial systems, CDPs have found their footing in the DeFi landscape, where users lock up crypto assets to borrow against them.
MakerDAO was one of the first platforms to leverage this concept in the DeFi space, particularly for the issuance of their DAI stablecoin. For a user to mint DAI, they need to deposit cryptocurrencies worth more than the DAI amount they wish to mint.
CDP Example: Maker Vaults and DAI
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.
In order 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 are able to 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.
The Maker Vaults, which backs Dai, has been in development since 2014 by the MakerDAO project and were originally called Collateralized Debt Positions (CDP). With a CDP, users deposit an asset (ETH, USDC, BAT) into a smart contract as collateral for a loan. Once in the CDP, the user can then generate ~60% of the USD value in Dai that they wish to borrow. Users cannot borrow 100% against their collateral due to liquidation risk and price volatility in the underlying assets. However, with the new funds they do have from the loan, users can then spend their Dai like any other cryptocurrency, even to buy more ETH. The originally deposited assets inside the CDP can be retrieved once the user has paid back the same amount of Dai they initially borrowed plus any interest accrued during the loan.
The Allure of CDPs in DeFi
CDPs are instrumental in DeFi for a number of reasons. The first and foremost is decentralization. CDPs are entirely governed by smart contracts, eradicating the necessity for a central authority to manage debt or liquidity.
Next, CDPs provide scalability and flexibility. This is because they accept a wide array of assets as collateral, thus expanding users' choices. Finally, due to a healthy volume of borrowers and lenders, the total value locked (TVL) in CDPs is used effectively, leading to optimal capital utilization.
Notably, DeFi employs CDPs primarily in lending protocols and stablecoin systems. The key difference between the two lies in their operation. In lending systems, users deposit collateral to borrow assets from a shared pool. On the other hand, in stablecoin systems, users create new tokens by locking in collateral, which then backs the minted stablecoins.
Inside the Mechanics of CDPs
Understanding CDPs requires us to examine the typical user interactions with CDP protocols.
Scenario 1: Pledging Collateral
One major difference between DeFi and traditional finance is the requirement for collateral. In DeFi, a user must provide collateral, a deposit whose value is higher than that of the funds they wish to borrow. This is done to ensure financial balance within the protocol, even if the value of the collateral decreases. The collateral-to-debt value ratio is referred to as the Collateral Ratio (CR).
Scenario 2: Position Closure
When a user chooses to close their position, they must return the borrowed assets. Over the borrowing period, however, the debt accrues interest. This interest rate could be either fixed or variable, contingent on the protocol. The collected interest is subsequently distributed among the pool's creditors.
Scenario 3: Collateral Liquidation
If the collateral's value drops below a predefined threshold, it could face liquidation, a significant risk in DeFi systems. Several types of liquidations exist:
- Instant Liquidation: Here, the collateral is instantly sold at market value. This is common in protocols where collateral and debt values are identical.
- Auction Liquidation: This method involves selling the collateral through an auction. It's typically used in protocols where collateral and debt values differ.
- Partial Liquidation: This approach involves selling a portion of the collateral to cover the debt. It's employed when the collateral's value surpasses the debt's value.
These liquidation strategies aim to mitigate the protocol's risk and ensure repayment to lenders, even if the collateral's value decreases.
Scenario 4: Liquidity Provision
Users can also contribute liquidity to CDP protocols by depositing their assets into a shared pool. They receive an interest rate on their deposits in return. This interest rate is often variable and is calculated using an algorithm considering the utilization ratio (the ratio of borrowed assets to available assets).
Distinguishing Features of CDP Protocols
DeFi CDP protocols come in various shapes and sizes, each with unique features:
Collateral Type:
- ERC20 Tokens: These fungible tokens such as ETH, WBTC, and USDT are commonly used due to their ample liquidity and large trading volumes.
- ERC721 Tokens: Also known as non-fungible tokens (NFTs), these can be used as collateral in platforms such as NFTfi.
- LP Tokens: Tokens provided by liquidity providers in decentralized exchanges are also accepted as collateral in some platforms.
Borrowable Assets:
- Stablecoins: These are favored due to their low volatility.
- ERC20 Tokens: Some protocols allow borrowing of popular tokens.
- LP Tokens: A handful of protocols offer the option to borrow LP tokens.
Practical Applications of CDPs
CDPs have several practical uses that have seen significant growth in DeFi. Let's explore a few.
- Leveraged Trading: One primary use case is to enable leveraged trading, allowing users to multiply their potential profits, and unfortunately, their potential losses. Essentially, a trader can lock their assets in a CDP, borrow against them, and use the borrowed assets to purchase additional crypto assets. This increases their potential earnings if the market moves in their favor, but it also amplifies losses if the market moves against them.
- Yield Farming: CDPs are integral in yield farming strategies, where users lock their assets into a protocol to earn yield. They deposit crypto into a CDP, mint stablecoins against their collateral, and then deposit these stablecoins in another DeFi protocol to earn interest or governance tokens.
- Paying Off Debts: For users with high-interest debts in traditional finance, they could lock their crypto assets into a CDP, mint stablecoins, and then sell those stablecoins for fiat to pay off their debts. This allows them to retain their exposure to their crypto assets, assuming they can pay back the debt in the CDP, and avoid potential capital gains taxes from selling their crypto.
The Future of CDPs
The future of CDPs in DeFi is bright. As the sector continues to mature, we can anticipate more sophisticated CDP models, broader asset acceptance as collateral, and greater interoperability between different DeFi protocols.
Moreover, the advent of scalable layer 2 solutions, as well as the development of decentralized identity solutions, could introduce new types of CDPs that aren't solely overcollateralized, thus expanding the realm of possibilities in DeFi lending and borrowing.
In Conclusion
Collateralized Debt Positions form a pivotal cornerstone in the DeFi landscape. By enabling individuals to leverage their crypto assets, they have unlocked immense liquidity and opportunities in the blockchain world. Nevertheless, the field also presents an array of risks, from volatile market conditions to smart contract vulnerabilities, which users must navigate carefully.
As the DeFi sector continues to innovate and evolve, the role of CDPs will be critical in shaping its future. Despite their complexities, CDPs exemplify the revolutionary potential of DeFi to democratize finance, making it more accessible and inclusive for all.
