A Collateralized Debt Position (CDP) is a decentralized financial (DeFi) instrument that allows users to borrow cryptocurrencies against collateral. It’s like a loan where you use your cryptocurrency assets as security to obtain funds. CDPs are a key feature of DeFi protocols like MakerDAO, which issues the stablecoin DAI.
How do CDPs work?
- Deposit collateral: Users deposit cryptocurrency assets into a CDP smart contract.
- Mint DAI: Users mint DAI, a stablecoin pegged to the US dollar, in exchange for the deposited collateral.
- Maintain collateralization ratio: Users must maintain a minimum collateralization ratio (CRR), which is the percentage of DAI value covered by collateral.
- Repay DAI and redeem collateral: To repay the loan and reclaim their collateral, users must repay the DAI borrowed plus any accrued interest.
Benefits of CDPs
- Access liquidity: CDPs allow users to access liquidity without selling their cryptocurrency holdings.
- Earn interest: Users can earn interest on their deposited collateral while their CDP is open.
- Avoid capital gains taxes: By borrowing instead of selling, users can avoid paying capital gains taxes on their cryptocurrency holdings.
Risks of CDPs
- Liquidation risk: If the collateral value drops below the CRR, the CDP may be liquidated, resulting in the user’s collateral loss.
- Price volatility: The value of the borrowed DAI and the deposited collateral can fluctuate significantly, affecting the CRR and liquidation risk.
Examples of CDPs in DeFi
- MakerDAO: MakerDAO is a decentralized stablecoin protocol that uses CDPs as the primary mechanism for issuing DAI.
- Liquidity: Liquidity is another DeFi protocol offering CDPs unique features, such as zero-interest loans and support for multiple collateral types.
- Goldfinch: Goldfinch is a DeFi protocol that facilitates peer-to-peer lending using CDPs, focusing on real-world asset-backed loans.