Collateralized Debt Position (CDP) stablecoin

Bel2433

"The mechanism behind Collateralized Debt Positions (CDPs) for stablecoins is as follows: Users deposit collateral into a smart contract and, in return, receive a certain quantity of stablecoins equal to the value of the collateral (although many projects use over-collateralization). This is similar to how commercial banks create money through fractional reserve lending.

However, unlike traditional bank loans, most CDP stablecoins use full collateralization or over-collateralization because assets used as collateral, such as Ethereum and Bitcoin, can potentially depreciate rapidly at any time. Hacks, regulatory actions, and other unforeseen or unexplained events can significantly reduce the value of the assets in a CDP.

The interest paid by CDP holders is typically referred to as a ""stability fee."" Most CDP systems are built on the Ethereum blockchain.

For example: MakerDAO
Collateralization Ratio: 150%
Collateral: ETH, etc.
Pegged Currency: USD
The MakerDAO system also has two tokens:
1. Maker (MKR): Protocol and governance token representing ownership and control with a variable price.
2. Dai: A stablecoin pegged 1:1 to the USD.

The collateral-to-debt ratio in MakerDAO is 150%. When the collateral-to-debt ratio falls below the liquidation ratio, the smart contract liquidates the position.

Price Stability Mechanism:
When the price of Dai falls below $1, CDPs sell collateral to buy Dai, pushing the price of Dai back to $1. When there is under-collateralization in CDPs, MKR tokens are minted to buy Dai. The process is not solely reliant on selling collateral to increase the price of Dai back to $1; it can work the other way around as well.

It's important to note that when there is under-collateralization, and the value of Dai falls below $1, minting MKR tokens to increase supply will decrease the value of MKR, effectively ""punishing"" MKR holders for making poor governance decisions.

Stability Fee:
A stability fee is charged each time Dai is returned to users in exchange for collateral. The stability fee is paid in MKR, and over time, it increases the value of MKR through burning. In addition to the stability fee, borrowers may also pay penalties if the collateral-to-debt ratio falls to the liquidation point when closing a CDP position.

Savings Rate:
MakerDAO recently introduced another price stability mechanism called the Dai Savings Rate (DSR), which allows Dai holders to earn a 3% annual interest rate by simply holding Dai. The DSR aims to increase demand for Dai, similar to how savings rates for Nubits increase demand for Nubits.

The DSR will be one of the new features included in Multi-Collateral Dai. Dai holders can lock or unlock Dai into the DSR contract at any time, and the locked Dai generates interest. However, since Dai operates on the Ethereum blockchain, blockchain users have to pay Ethereum gas fees every time they lock or unlock Dai from the DSR contract. DSR interest is funded by stability fee revenue. For instance, if the stability fee is 3%, MKR token holders may choose to set the DSR at 2%.

MKR token holders also have other tools for managing the DSR, such as the Rates Policy Oracle, which allows adjustments to the DSR interest as Dai's price changes. In extreme cases, the governance team can choose to shut down the DSR mechanism.

The DSR mechanism works in coordination with the stability fee's balancing mechanism, deploying both the DSR and the stability fee as needed to maximize the effectiveness of its price stability policy.

Weaknesses:
The risks associated with collateral-backed stablecoins like CDPs are much smaller than those of algorithmic stablecoins. The latter can face under-collateralization at any time, while CDPs may lead to inefficient collateral usage. As the leverage ratio decreases during the process of repeated pledging, the yield also decreases.

For example, when the collateral-to-debt ratio reaches 150% for MKR holders, borrowers can deposit $150 worth of ETH in exchange for $100 worth of Dai. They can then use this $100 Dai to purchase $66 worth of ETH. At this point, the borrower will have $166 worth of ETH. They can then deposit $66 worth of ETH in exchange for $44 worth of Dai, continuing the leverage.

MakerDAO's current design not only makes it more costly for traders to profit from decentralized leverage but also makes it harder for them to profit from arbitrage opportunities. Like any other financial asset, the price of DAI can differ across exchanges at any given time, presenting arbitrage opportunities between different exchanges. However, the system's design only allows them to profit from returning borrowed Dai before the price of ETH changes. Otherwise, the price differential between DAI across exchanges may have disappeared when they close their CDP, resulting in a lost arbitrage opportunity, or the price of ETH may have dropped, causing financial losses.

MakerDAO's 150% collateralization ratio forces arbitrageurs to incur a 33% capital cost when opening a CDP, i.e., $1.5 worth of ETH only receives $1 worth of Dai. In other words, they have to pay a 33% capital cost every time they borrow $0.66 worth of Dai. To profit from arbitrage without repaying the CDP, the price differential of Dai between exchanges must exceed 50%, which is highly unlikely.

Later on, we will see that collateral-backed stablecoins like Reserve allow traders to profit from arbitrage when trading Tether or other centralized stablecoins with a 100% collateralization ratio.

Stablecoins with a 1:1 collateralization ratio have greater scalability."