What is a CDP and How Does it Benefit Crypto Traders?
MakerDAO’s Collateralized Debt Position (CDP) is one of the more popular products in the decentralized finance space today.
How does a CDP work and how does it benefit investors?
What Is a CDP?
MakerDAO is a company specializing in delivering decentralized finance (DeFi) products and services. One of its products is the CDP, which allows users to lock cryptoassets as collateral to generate Dai, a stablecoin based on Ethereum’s ERC-20 protocol. The generated Dai can be used for anything, including buying more crypto or trading it for fiat.
Users can generate up to two-thirds of the value of their collateral. However, this incurs debt in the user’s CDP account. This debt can be repaid in full or on a pro-rata basis to recoup the collateral. Failing to do so will result in the CDP being liquidated. Any collateral leftover from repaying the debt is then returned to the user with a minor liquidation fee.
How Does It Work to Generate Additional Stablecoins?
A CDP works like a loan. Users put up collateral in the form of ETH (or any assets the company accepts in the future) to generate Dai, which comes from the pool of funds in MakerDAO’s token, MKR. This is achieved through Ethereum smart contracts so there’s no way for borrowers to game or manipulate the system.
To own a CDP, an individual must deposit the amount of ETH they want to put up as collateral. The formula for the maximum amount of Dai generated is the total value of your collateral divided by 1.50, a number derived from a CDP’s minimum collateralization ratio of 150%:
Total Collateral Value / 1.50 = Maximum Dai Generated
For example, if ETH’s value is $100 and you deposit 1 ETH, you can generate up to 66 Dai. If ETH rises to $200, you can generate an additional 66 Dai due to the appreciation in value, but your debt would also increase at the same time. In the case of a bear market, borrowers would have to pay their debts to maintain the 150% collateralization ratio to avoid liquidation.
CDP holders pay a stability fee for generating Dai and closing their accounts. The fee is determined by MKR token holders through a voting system. Funds generated from stability fees are then used to buyback MKR from the market and burned. This stops the overinflation of Dai through limiting supply — also known as a deflationary policy.
An Example of Profit-Taking and Liquidation in CDPs
Let’s assume the value of ETH is $100. You open a CDP by depositing 10 ETH as collateral. The total value of your collateral is $1,000 and from the formula mentioned above, you can generate a maximum of 666 Dai.
You decide to generate 600 Dai and use that to buy 6 more ETH. You now have 16 ETH — 10 from your initial collateral and 6 more from the loan — which leaves you with a debt of 600 Dai. After some time, the price of ETH rises to $300. You sell the 6 ETH you bought earlier for 1,800 Dai. You use your earnings to repay the 600 Dai debt, leaving you with 1,200 Dai in profit.
That is the best-case scenario of ETH experiencing a bull run. What if prices crash instead?
In a bear market, you need to repay your debt before it drops below the 150% collateralization ratio. If it drops below that, Maker will automatically liquidate your account to cover the debt. Lower ETH prices will also limit the amount of Dai you can generate due to lower liquidity in Maker.
To maintain or increase the ratio to over 150%, you need to deposit more ETH to increase your collateral value or repay your Dai debt. To be safe, keep collateralization ratios above 250% to allow more leeway in avoiding liquidation. It’s also wise to not generate the maximum amount of Dai, as even a $0.01 decrease in ETH’s value will liquidate your CDP.
What Can Users Do With the Generated Dai?
1. Buy More Cryptoassets
A popular strategy is to buy ETH with the generated Dai and depositing it back to the CDP as collateral. This positive feedback loop boosts the collateral value and can be done continuously as long as the value of ETH rises. There is, however, a huge risk if ETH crashes, as users will suffer a greater loss of collateral. Of course, users can also use Dai to invest in other cryptoassets instead of boosting their CDP.
2. Earn Interest by Saving or Lending
Maker’s own Dai Savings Rate (DSR) tool, as well as other lending platforms (e.g. Compound, Fulcrum), allow users to save Dai and earn interest from stability fee payments. Interest rates in DeFi are extremely attractive, with some platforms offering close to 10% APR for lenders.
3. Use It as a Currency
Dai can also be used as a currency just like any other stablecoin. Users who need an injection of funds can rely on Dai as long as ETH doesn’t suffer a flash crash. Individuals can pay their rent or purchase goods and services with Dai, for example, without selling their ETH since there are no deadlines for debts to be repaid in CDPs.
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