The Toned-Down Vernacular Crypto Spectacular Collateral Loan Explainer

MyEtherWallet
Jun 28 · 6 min read

It’s official — stablecoins are the new exciting thing in crypto, fueling DeFi (decentralized finance) growth and offering beginners a less risky option for their first crypto investment.

The DAI stablecoin specifically is seeing exponential growth at roughly 20% per month, showcasing the pronounced demand for stability within the DeFi ecosystem.

However, with traditional banking loans already such a staple in many parts of the world, why should anyone bother with collateralized crypto-loans?

One word: Decentralization

We have previously addressed the differences between fiat-collateralized and crypto-collateralized stablecoins, and here is the heart of the matter: decentralization. How does this relate to loans?

  • Traditional bank loans = Centralized fiat lending with high trust and low ownership. The bank gathers a great deal of client information, has the power to approve or deny the loan without making the procedure transparent, dictates the rules, and has full control over the distribution of funds.
  • Fiat-collateralized stablecoin = Centralized cryptocoin with a value backed by ‘real’ money somewhere in the physical world with a high need for trust and low levels of ownership, referring to ‘ownership’ as being in complete control of one’s funds, which requires sole management. Users can own these stablecoins, but the real reserves they are tied to are still managed by a centralized group. While this may remove some hurdles of approval that a traditional bank has, ownership of the funds and governance are highly centralized, taking control away from the user.
  • Crypto-collateralized stablecoin = Decentralized coin with a value kept stable through smart-contract balancing technology that manages reserves of cryptocurrency while maintaining COMPLETE user ownership. No trust needed!

Why should you care?

Understanding and participating in decentralized finance and governance is becoming more important than ever. As the internet expands and governments tighten their regulations, almost no one can say they completely ‘own’ their assets. Banks tack fees upon fees and shut down accounts on their own terms, and creditors offer interest rates that encourage debt feedback loops. The true appeal of decentralization is total ownership and the elimination of a need for trust in unknown, intransparent third parties.

Another attractive feature of decentralization is the accountability that comes with it. All transactions made through decentralized blockchain technology are anonymous, yet completely public for anyone to see. If you know someone’s address, you can see exactly what they’re doing with their funds. This permanently recorded, publicly available ledger hold all actors in the investment space to a higher standard of accountability.

How does the CDP work?

There are no credit checks, no extra fees, and no denials of loan. The CDP protocol is streamlined with the user in mind. Anyone with ETH can open a CDP and interact with the DeFi ecosystem, regardless of history, status, or location.

Stake ETH

Through MakerDAO, you can open a Collateralized Debt Position (CDP) by staking ETH. The ETH you stake is stored in a smart contract, which creates DAI tokens in return (these tokens maintain a value of 1 DAI = $1 USD). The MakerDAO protocol will charge you a 16.499% stability fee per year in MKR. That’s right, per year. While traditional loans charge interest monthly, MakerDAO spreads that interest over the course of the entire year, slowly generating a balance. This MKR interest is paid to the remote regulators of the network, as a fee for their maintenance services.

It’s important to make the distinction between a MKR regulator and centralized governance. MKR regulators keep the entire system secure through checks and balances, as well as community-wide voted agreements for any changes that may need to occur to keep the ecosystem safe and efficient. They can not access your DAI or MKR or ETH. They do not have control over your assets. They are only there for maintenance and upkeep.

ETH in CDP

The only way your ETH in the CDP can be affected without your direct participation is when the price of ETH drops too drastically to maintain the CDP. That’s why, when you open a CDP for DAI, it’s recommended to leave overhead room to account for the shifting markets.

For example, if you are investing $300 worth of ETH, you would likely only want to take out $150 of DAI, which equates to a collateralization ratio of around 200%. If you took out $300 worth of DAI (a 100% collateralization ratio) but then the value of your ETH dropped to $290, MakerDAO’s smart contract technology would automatically close your CDP and auction off the ETH you staked for DAI, to keep everything balanced. This process is in place to make sure there is enough capital locked against the amounts of assets being moved out. To prevent this from happening, MakerDAO has set a minimum collateralization ratio of 150%. However, this ratio is also considered risky and leaves little room for shifting markets. Remember, full ownership also means keeping track of what’s happening with your investments.

Closing the CDP

When you’re ready to close out that CDP, you must pay back the DAI plus any extra interest in MKR you have accrued to get back the ETH staked in the beginning.

What can I do with a CDP loan?

With the DAI received from a CDP, you can do anything that you would do with a traditional loan, provided the service accepts crypto. The stability of DAI encourages its use in any situation. Pay off your house mortgage or car payments, buy products, pay your employees or contractors, go back to school, or even start your own business!

Refinancing debt is another attractive option, since most fiat credit unions charge high monthly interest rates that can result in infinite debt feedback loops, while DAI only charges a minimal stability fee per year. As long as you pay back your DAI, your ETH will remain in waiting.

Traders have been finding an interesting use for the loans as well. Let’s say $100 worth of ETH is staked in a CDP for $40 worth of DAI, and more ETH is purchased with that DAI. As the price of ETH rises, the return on the investment becomes higher than if they kept the amount of ETH they started with initially. They can then purchase more DAI with the profit they made and sell it back to MakerDAO to close out their CDP, causing an overall gain in their investment. This is a clever use for DAI that allows greater investments with less cost.

This method can also be applied to investing outside of crypto. If you stake 2 ETH at a relatively low value (let’s say $300 per ETH, for a total of $600) and receive 300 DAI ($300), you could then use your DAI as a stable investment tool. Let’s say you invest all $300 DAI in a stock A, but stock A drops down a bit to where you only have $100 worth of DAI left. That’s fine, since your ETH is untouched. You just have to buy $200 worth of DAI, close your CDP, and retrieve your 2 ETH. Perhaps ETH value has been rising this whole time to $500 per coin, so while you lost ~$200 in stocks you’ve gained $400 in ETH’s value! This is a best-case-scenario, but it does speak to the way crypto-collateralized loans can benefit users.

Looking Forward

As time goes on, more features will be added to the MakerDAO CDP protocol. It may begin offering positive interest rates for ‘saving-account’ services or expand their support for staking other cryptocurrencies beyond just ETH. The crypto-community is growing rapidly, and MakerDAO intends to stay a major player in the expanding DeFi ecosystem. This technology has the potential to change the entire landscape of how we interact with our finances, encouraging a more open and honest economy.

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MEW Publications

MyEtherWallet (MEW) is a free, open-source, client-side interface for interacting with the Ethereum blockchain.

MyEtherWallet

Written by

https://www.myetherwallet.com

MEW Publications

MyEtherWallet (MEW) is a free, open-source, client-side interface for interacting with the Ethereum blockchain.

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