MakerDAO is an immediate and non-custodial line of credit. By using Maker, users can open a CDP (Collateralized Debt Position) and borrow a stablecoin called DAI by depositing ETH as collateral. The most common reason for opening a CDP and borrowing DAI is purchasing ETH (source, source, source). If the price of ETH increases more than the cost of the stability fee, users profit.
However, there are risks to borrowing against yourself. If the price of ETH falls and the CDP becomes under-collateralized, Maker automatically sells the collateral to repay the debt.
This post shows how to lower the risk of a CDP liquidation by over 40%.
When does liquidation happen?
Liquidation is when the Maker automatically sells your ETH collateral to repay the DAI debt. Liquidation happens when the value of the ETH collateral is less than 150% of the DAI borrowed.
Let’s walk through an example:
- Opening a CDP — Alice opens a CDP with 1 ETH and borrows $75 worth of DAI.
- Initial price — The price of ETH is $150 and Alice is 200% collateralized (USD value of ETH collateral / DAI borrowed).
- Liquidation conditions — If the price of ETH falls to $112.5, the CDP will be liquidated and the ETH sold to repay Alice’s $75 DAI debt.
Reduce the liquidation risk by increasing collateral
Increasing the collateral value of CDPs by adding ETH is usually discussed in the context of getting access to more leverage and purchasing additional ETH (link). The overlooked benefit of adding collateral to your CDP with purchased ETH is lowering the liquidation price and making the CDP more resilient to drops in ETH prices.
Options A and B both allow users to borrow $100 worth of DAI. Option B allows users to borrow the same amount of DAI but lowers the liquidation risk without additional cost.
Walking through a detailed example, here’s how Alice could have made her CDP safer by re-collateralizing:
- Opening a CDP — Alice opens a CDP with 1 ETH as collateral. The price of ETH is $150 and Alice’s collateral is worth $150.
- Withdrawing DAI — Using her ETH as collateral, Alice decides to withdraw the maximum amount of 100 DAI. Alice is in a dangerous situation. If ETH prices drop by just $1, Alice’s collateral will be liquidated.
- Purchasing ETH — Alice is an ETH HODL’er and uses the $100 DAI to purchase 0.66 ETH
- Reducing liquidation risk by adding collateral — Alice can reduce her liquidation risk by adding the 0.66 ETH she just purchased back into her CDP as collateral. Alice’s CDP is now backed by 1.66 ETH.
- Reduced liquidation price — The CDP now has 1.66 ETH to repay the same $100 DAI debt. Since there is more collateral backing the $100 loan, Alice has lowered her liquidation price from $150 to just $90.
The benefit of re-locking the ETH in the CDP grows as more DAI is borrowed.
What are the downsides?
Even though adding collateral lowers your liquidation risk in Maker, there is no free lunch. The downsides of this approach are:
- Liquidation is still a risk — Adding collateral reduces the liquidation price. However, if ETH prices collapse quickly, you could lose more collateral.
- Great exposure to Maker systemic risk — In the event Maker has bugs in the smart contract and gets hacked, you would lose more ETH.
- Higher gas fees — Adding the collateral back into the CDP costs gas. This transaction can be expensive if the network is congested.
The safest bet is to purchase crypto and hold without additional leverage. However, if you plan to borrow from Maker, adding that newly purchased ETH back into the CDP is one of the best ways to lower your risk.
Pro users on MakerDao always add collateral into their CDPs
Re-collateralizing CDPs is a smart move already made by many high-value CDPs. Our team analyzed hundreds of CDPs on MakerScan and found a common pattern: every DRAW is followed by a LOCK. A DRAW withdraws DAI and increases debt. A LOCK adds ETH collateral and increases the collateral ratio.
Taking a look at CDP #1162 below, the user starts by locking ETH to draw DAI. The user then takes this DAI to purchase ETH. This action follows a LOCK where the user adds the newly purchased ETH back into the same CDP.
How do I create a safer CDP?
If you are borrowing DAI to go long on ETH, adding the purchased ETH back into the CDP is a free way to lower risk. By adding additional collateral into the CDP, you lower the liquidation price and protect the CDP against drops in the price of ETH.
DISCLAIMER: This is not financial advice. It is intended only as an educational resource meant to aid the community. Always do your own research.