What Is A Collateralized Debt Position?
The world of cryptocurrencies is shown to be flexible enough for fintechs and DeFis to design numerous ways of servicing the multitude to easily access financial markets. Where the limits of traditional banking rest in rigid and obsolete structures, blockchains and smart contracts allow for digital financial designs that can reach out to the vast majority across borders. One genius of a design is the collateralized debt position or CDP.
What is a CDP?
MakerDao creatively designed a financial variant in 2014 on the Ethereum blockchain wherein one can collateralize a debt while maximizing the volatility of the market by retaining the exposure of the collateral to market movements. In other words, a CDP requires users to deposit a cryptocurrency into a smart contract as collateral in order to qualify for a loan on the MakerDAO platform. After the deposit, the CDP takes hold of the asset and then allows the user to borrow DAI a value equivalent to the USD they would like to loan. Once they get hold of the DAI tokens, they can freely transact with them accordingly as they wish to while leaving their collateral locked but exposed to market volatility.
How does a CDP operate?
To avail, a collateralized debt position must first be created on the MakerDAO platform. After which, the user needs to deposit a certain amount of ETH as collateral that must always be 1.5 times higher than the amount to be loaned to avoid suffering liquidation or a 13% penalty. With the collateral, the CDP vault is activated to generate the loan in DAI stablecoin. An outstanding debt keeps the collateral locked and unavailable. But once the amount borrowed in DAI is paid together with the interest or stability fee paid in MKR, the CDP can again be accessed or left empty until the next loan.
As the CDP locks the user’s crypto assets in ETH, the amount to be loaned is 66% of DAI (that is, 1 DAI is equal to 1USD) against the total deposited amount. For example, if 10 ETH is locked up in the CDP where ETH is worth 400 USD, the locked up amount is 4,000 USD. The maximum amount that can be borrowed is 6 ETH worth of DAI stablecoin, which is equal to (2) 640 DAI, or (2) 640 USD. If the borrowed (2) 640 DAI is repaid, the deposit is back in ETH. But if the price of ETH goes up, say 900 USD, the borrowed (2) 640 DAI is still paid worth (2) 640 USD, but the 10 ETH deposited at 400 USD is now worth 9,000 USD. The good thing is that if the user still holds the borrowed DAI, it can be used to buy more ETH if wished to.
Advantages of a CDP
No Required Credit History
A CDP will not require a credit history which is good news for people who are locked in bad credit. With CDP, there is no exhaustive paperwork to be done. All that is needed is an Ethereum and all else follows.
In contrast with legacy lending, there are no time limits in a CDP including minimum payment schedules and shift-term-based rates. Users can add collateral anytime to draw additional DAI.
Charges are very low considering that on the blockchain, there are no third parties and very low overhead expenses.
Blockchains are decentralized and, therefore, users do not rely on counterparty entities for fund management. Records are transparent, secure, and immutable.
CDP is a good investment vehicle for people who take due diligence in learning how to maximize their potential using their crypto assets to reach their financial goals. Though, it is a personal responsibility that each one should take when getting involved in cryptocurrencies. With sound financial management, anyone can achieve their objectives using different financial technologies wisely and knowledgeably, including a collateralized debt position.
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