CDP and Collateralized Stablecoins

What Is CDP

CDP (Collateralized Debt Position) is a structure where you deposit cryptocurrency as collateral and issue stablecoins. It's similar to lending, but the difference is that you "issue" stablecoins rather than "borrow" them.

Core of the CDP system:

• User deposits collateral → Issues stablecoins (minting)
• Repays stablecoins → Gets collateral back
• Insufficient collateral → Liquidation

MakerDAO's DAI is the first and largest CDP-based stablecoin.

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MakerDAO and DAI

System Overview

MakerDAO: Decentralized protocol that issues DAI DAI: Stablecoin pegged to $1 MKR: Governance token

DAI Issuance Process

1. Create Vault: Open a Vault at MakerDAO
2. Deposit Collateral: Deposit ETH, WBTC, stETH, etc.
3. Issue DAI: Mint DAI up to a portion of collateral value
4. Use DAI: Use freely anywhere
5. Repay DAI: Pay back DAI + stability fee
6. Retrieve Collateral: Full collateral returned

Collateral Ratios

Minimum collateral ratios vary by collateral type:

ETH-B: Lower collateral ratio = Higher leverage = Higher liquidation risk = Higher fee

Example

Issuing DAI with 1 ETH ($3,000) as collateral:

• Minimum collateral ratio: 145%
• Maximum DAI issuance: $3,000 / 1.45 = 2,069 DAI
• For safety margin, issue only 1,500 DAI (200% collateral ratio)

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Stability Fee

Concept

The stability fee is the interest on DAI issuance. It accumulates while the vault is maintained.

1,000 DAI issued, 5% annual fee, maintained for 1 year → 50 additional DAI required for repayment

Role

DAI Price Adjustment:

• DAI > $1: Lower fee → Encourage more issuance → Increase supply → Price drops
• DAI < $1: Raise fee → Encourage repayment → Decrease supply → Price rises

MKR Burning

DAI received as fees is used to buy MKR from the market and burn it. When the system is healthy, MKR supply decreases, increasing its value.

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Liquidation Mechanism

Liquidation Trigger

When collateral value drops and the collateral ratio falls below the minimum, the position becomes eligible for liquidation.

Example:

• 1 ETH ($3,000) collateral, 2,000 DAI issued
• Collateral ratio: 150%
• ETH drops to $2,700
• New collateral ratio: $2,700 / 2,000 = 135% < 145%
• Liquidation eligible!

Liquidation Process

1. Keeper: Discovers vault eligible for liquidation
2. Auction Starts: Collateral is put up for auction
3. Bidding: Keepers bid for collateral with DAI
4. Liquidation Complete: Debt repaid + liquidation penalty deducted
5. Remaining Collateral: Returned to vault owner (if any)

Liquidation Penalty

Additional amount deducted from collateral during liquidation.

• MakerDAO: ~13%
• This penalty serves as an incentive for liquidators

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Liquity and LUSD

Differences from MakerDAO

Liquity Features

Advantages:

• ETH only collateral → No centralized assets
• 0% interest (one-time fee only)
• Immutable contract → No governance attacks possible
• Low collateral ratio → Capital efficiency

Disadvantages:

• Large-scale liquidations during ETH price crashes
• Smaller scale than MakerDAO
• Limited liquidity

Recovery Mode

When the system's total collateral ratio falls below 150%, Recovery Mode is triggered:

• Vaults below 150% collateral ratio can be liquidated
• New vaults require 150%+ collateral ratio
• System stabilization takes priority

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CDP vs Lending

CDP (DAI Issuance)

• Issues stablecoins
• Protocol creates new tokens
• Collateral ratio follows protocol rules
• Auction-based liquidation

Lending (USDC Borrowing)

• Borrows existing stablecoins
• Borrows tokens deposited in pools
• Collateral ratio based on asset LTV
• Liquidators directly repay during liquidation

Selection Criteria

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DAI Peg Mechanism

Why Does DAI Maintain $1?

Arbitrage:

• DAI > $1: Issue new DAI and sell on market → Increase supply → Price drops
• DAI < $1: Buy DAI on market and repay debt → Decrease supply → Price rises

PSM (Peg Stability Module):

• Exchange USDC ↔ DAI at nearly 1:1
• Major contribution to price stability
• However, increases DAI's USDC dependency → Decentralization debate

DAI Savings Rate (DSR)

DAI holders can deposit in DSR to earn interest.

• DAI > $1: Lower DSR → Decrease DAI demand → Price drops
• DAI < $1: Raise DSR → Increase DAI demand → Price rises

MakerDAO governance adjusts DSR to manage the peg.

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Vault Strategies

Long Leverage

Deposit ETH as collateral, issue DAI → Buy more ETH with DAI → Loop

Same effect as DeFi leverage strategies.

Stablecoin Liquidity

When you need stablecoins without selling ETH:

• ETH collateral → Issue DAI → Use as needed
• If ETH rises: Collateral value increases, more comfortable position
• If ETH falls: Watch for liquidation

DSR Yield

If you issue DAI and deposit in DSR:

• Issuance cost (stability fee)
• Revenue (DSR interest)
• Arbitrage possible if DSR > stability fee

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Risk Summary

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Summary

CDP is a system for issuing stablecoins with cryptocurrency as collateral, with MakerDAO's DAI being the prime example. It operates in a cycle of deposit collateral → issue DAI → use → repay, with automatic liquidation when collateral is insufficient. Stability fees contribute to DAI price regulation and MKR value creation. Liquity's LUSD is more decentralized with ETH-only collateral, no governance, and immutable contracts. While similar in purpose to lending, the key difference is that CDP issues new tokens.

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