When MakerDAO created the DAI stablecoin, they introduced the term “CDP” to describe how it worked. I wish they hadn’t because it’s confusing.
First of all, what is a CDP? A CDP is when you put collateral into a vault in return for another asset, typically a stablecoin. The CDP represents the idea that you have to return the assets you received in order to get your collateral back. MakerDAO compared this to taking a loan and incurring a debt — hence the “D” in CDP.
But the transaction really isn’t very much like taking a loan. One of the key functions of a bank is something called liquidity transformation. As described here, liquidity transformation means taking illiquid assets (e.g., a mortgage on a house) and providing liquid assets in return (e.g., cash or deposits).
The problem with the CDP terminology is that there isn’t really much liquidity transformation going on. The “collateral” being deposited (e.g., ETH or some other crypto asset) is just as liquid as the asset being withdrawn.
So if not liquidity transformation, what is going on? Setting aside pure arbitrage, the main role of a stablecoin vault is volatility transformation as I have described here, here and here.
Perhaps it is no great sin to use slightly inaccurate terminology, but the analogy to taking loans obscures the fundamental role of stablecoins in the crypto ecosystem. Decentralized computation provides some very interesting tools for volatility transformation, and the CDP concept was an important achievement in this regard. But it is still very much uncertain whether crypto has any meaningful role to play liquidity transformation.
The problem is that crypto by itself does not do a great job of enforcing ownership rights for illiquid assets. Think about it. What kinds of assets are illiquid? There are two main categories: physical assets and future assets (i.e., assets that don’t exist yet).
Physical assets can be represented on the blockchain, but they don’t exist on the blockchain natively. Contracts for enforcing the ownership of these assets must necessarily rely on some kind of physical enforcement. In other words, when it comes to physical assets, code is not law.
Future assets are a bit more complicated. In some cases (e.g., credit cards) people can get uncollateralized loans that are backed by nothing more than a promise to pay. There are, of course, special cases where promises are enforceable entirely on the block chain. Flash loans are one example, but they have obvious limitations. It is possible that viable crypto-native systems of credit will be developed, but this isn’t really how crypto “loans” currently operate.
If we want to talk about how CDPs currently operate, the closest analogy is probably a margin account. In other words, crypto loans are mainly used to increase leverage. Ironically, stablecoins are usually used as an intermediary for increasing volatility.
Admittedly, margin accounts also use the “loan” terminology. But then again, the securities purchased in margin accounts are typically less liquid than the cash being borrowed. Crypto is unique in that crypto assets are often both volatile and liquid. So we can borrow terminology from traditional finance industry, but it tends to obscure what is really going on.
