Collateral Swap

The multi-step nature of a swap creates a temporary window where a user's collateral ratio may fall below the liquidation threshold. Key factors include:

• Price volatility between the initiation and finalization of the swap.
• Transaction ordering (MEV): Searchers may front-run the final deposit step to trigger a liquidation.
• Slippage on the decentralized exchange (DEX) used for the asset conversion, resulting in less new collateral than expected.

Collateral swaps rely heavily on price oracles to determine the value of both the outgoing and incoming assets. Risks include:

• Using a single-point oracle vulnerable to flash loan attacks.
• Time-lag or staleness in price feeds during high volatility.
• The swap contract using a different oracle than the lending protocol, creating valuation mismatches that can be exploited.

The safety of a swap depends on the health and governance of the underlying protocols. This encompasses:

• Upgradable contracts: Admin keys or governance could upgrade contracts maliciously or with bugs.
• Protocol insolvency: If the lending platform suffers a major hack, collateral may be lost.
• Parameter changes: Governance may alter collateral factors, liquidation penalties, or supported assets, impacting swap viability.

For cross-chain collateral swaps, the security of the bridge becomes the primary risk layer. This includes:

• Bridge compromise: A hacked bridge can result in total loss of bridged assets.
• Validation fraud: In optimistic or light-client bridges, fraudulent state proofs.
• Wrapped asset depegging: If the bridged representation of the asset (e.g., wBTC) loses its peg to the native asset.

The technical complexity of swaps introduces significant user-driven risk:

• Slippage tolerance set too high, allowing unfavorable trades.
• Incorrect asset selection, leading to unsupported collateral.
• Gas estimation errors causing transaction failure mid-swap, potentially leaving funds in a vulnerable state.
• Misunderstanding the net health factor impact after the swap.

A Collateralized Debt Position (CDP) is the fundamental structure that enables collateral swaps. It is a smart contract vault where a user locks collateral to mint a loan in a stablecoin or other debt asset. Swaps involve modifying the collateral composition of an existing CDP.

• Core Mechanism: The foundation for protocols like MakerDAO.
• Purpose: Allows users to change collateral types without closing and reopening their position, saving on gas and avoiding liquidation triggers.

Debt refinancing is the broader financial strategy of which collateral swaps are a key tool. It involves adjusting the terms of an existing loan to achieve better rates, terms, or risk exposure.

• In DeFi: This can mean swapping to a collateral asset with a lower liquidation risk, a higher loan-to-value (LTV) ratio, or one that earns yield (e.g., staked ETH).
• Goal: Optimize the health and cost-effectiveness of a leveraged position.

Cross-margin or cross-collateralization is a feature where multiple asset types within a single protocol can be used as collective collateral for a debt position. This setup is a prerequisite for efficient collateral swaps.

• How it works: Protocols like Aave V3 allow users to supply a basket of assets (e.g., ETH, wBTC, LINK) as collateral for a single borrowed amount.
• Swap Implication: Users can rebalance this basket, swapping out one asset for another, to dynamically manage their portfolio risk and borrowing power.

A flash loan is an uncollateralized loan that must be borrowed and repaid within a single blockchain transaction. It is a powerful primitive often used to execute complex collateral swap strategies atomically.

• Common Use Case: A user takes a flash loan to pay off their existing debt on one protocol, withdraw their original collateral, swap it for a new asset on a DEX, and deposit the new asset as collateral to re-borrow the flash loan amount—all in one step.
• Benefit: Enables swaps without any upfront capital beyond transaction fees.

Liquidation risk is the probability that a collateral asset's value falls below the required threshold, triggering a forced sale to repay the debt. Managing this risk is a primary motive for collateral swaps.

• Volatility Management: Swapping a highly volatile asset for a more stable one (e.g., swapping altcoins for ETH or stablecoins) reduces liquidation risk.
• Health Factor: Swaps directly impact a position's health factor or collateral ratio, which is a key metric for liquidation thresholds in protocols like Aave and Compound.

An Automated Market Maker (AMM) is a decentralized exchange protocol that provides the liquidity pool necessary to execute the actual asset exchange in a collateral swap. Most swaps involve routing through an AMM like Uniswap or Curve.

• Execution Layer: The swap leg of the transaction (e.g., converting WBTC to stETH) occurs via an AMM's liquidity pools.
• Slippage: A key consideration is swap slippage, which affects the final amount of new collateral received and thus the health of the resulting position.