Debt Position

The Collateralization Ratio (CR) is the primary health metric of a debt position, calculated as (Value of Collateral / Value of Debt) × 100%. It determines liquidation risk.

• Safe CR: A high ratio (e.g., 150%+) provides a buffer against price volatility.
• Liquidation Threshold: If the CR falls below a protocol-defined minimum (e.g., 110%), the position is eligible for liquidation.
• Maintenance: Users must monitor and often top up collateral to maintain a safe CR.

A liquidation is the forced closure of an undercollateralized debt position to protect the protocol from bad debt. Key elements:

• Trigger: Occurs when the Collateralization Ratio falls below the liquidation threshold.
• Process: A liquidator repays part or all of the debt in exchange for the collateral at a discounted rate (the liquidation penalty).
• Purpose: Ensures the borrowed assets are always fully backed, preserving protocol solvency.

Protocols impose limits on borrowing to manage systemic risk.

• Global Debt Ceiling: The maximum total amount that can be borrowed against a specific collateral asset across the entire protocol.
• User Borrowing Capacity: The maximum debt an individual can take, determined by their collateral value and the Loan-to-Value (LTV) ratio. For example, a 66% LTV on $1000 of collateral allows a maximum borrow of $660.

The cost of maintaining an open debt position, typically expressed as an annual percentage rate (APR).

• Accrual: Interest (the stability fee) continuously accrues on the debt, increasing the outstanding balance.
• Variable Rates: Fees are often dynamically adjusted by governance based on market demand and protocol utilization.
• Impact: Accruing interest reduces the Collateralization Ratio over time if not actively managed.

Not all collateral is treated equally. Protocols assign specific risk parameters to each accepted asset.

• Volatility: Highly volatile assets (e.g., altcoins) require higher collateralization ratios and have lower LTVs.
• Liquidity: Less liquid assets may have stricter limits or higher liquidation penalties.
• Examples: Ethereum might have a 150% minimum CR, while a stablecoin might be allowed at 110%.

Users interact with their debt position through several core actions:

• Deposit Collateral: Adds more assets to increase the Collateralization Ratio.
• Generate Debt / Borrow: Draws new stablecoins or other assets against locked collateral.
• Repay Debt: Reduces the outstanding loan balance, improving the CR.
• Withdraw Collateral: Only possible if the CR remains above the minimum after withdrawal.

The primary risk of holding a debt position is liquidation, triggered when the collateralization ratio falls below a protocol-defined threshold (e.g., 110%). This occurs due to:

• Collateral value depreciation.
• Debt value appreciation (for volatile debt assets).
• A liquidation penalty is typically applied, and a portion of the collateral is auctioned to repay the debt, resulting in a loss for the position owner.

The debt position is governed by immutable or upgradeable smart contracts. Key risks include:

• Bugs or vulnerabilities in the contract logic (e.g., price oracle manipulation, reentrancy).
• Admin key risk for upgradeable contracts, where a malicious or compromised administrator could alter terms.
• Integration risk with external dependencies like oracles and liquidity pools.

The health of a debt position depends entirely on the accuracy of its price feed. Oracle failure or manipulation is a critical attack vector.

• Delay/Latency: Stale prices can cause false liquidations or prevent necessary ones.
• Manipulation: Flash loan attacks can be used to skew oracle prices on DEXs.
• Protocols mitigate this with time-weighted average prices (TWAPs) and multiple oracle sources.

The type of collateral asset introduces unique risks:

• Volatility: Highly volatile assets (e.g., altcoins) require higher collateral ratios.
• Illiquidity: If the collateral lacks deep markets, liquidations can cause severe slippage and bad debt.
• Censorship/Depegging: Wrapped assets (e.g., wBTC) carry bridging and custodial risk. Stablecoins can depeg.
• Interest-Bearing Tokens: Collateral like cTokens or staked assets add protocol dependency risk.

The debt position exists within a larger financial system. Broader failures can impact it:

• Contagion: Mass liquidations in one asset can cascade, crashing prices and causing more liquidations.
• Protocol Insolvency: If the liquidation engine fails to cover bad debt, the system may become undercollateralized, potentially impacting all users.
• Governance Attacks: Malicious governance proposals could alter risk parameters to harm users.

User-controlled settings and protocol parameters create operational risks:

• User Error: Setting collateralization too close to the liquidation threshold, forgetting to top up, or interacting with malicious frontends.
• Parameter Updates: Governance can change liquidation ratios, penalties, or stability fees, altering position risk profiles without user action.
• Gas Costs: Failure to have sufficient gas to perform critical actions (like adding collateral) during volatility can lead to avoidable liquidation.

Assets deposited into a protocol to secure a loan and open a debt position. The value of the collateral, relative to the borrowed amount, determines the health factor of the position. Common types include:

• Overcollateralized: Standard for most DeFi loans (e.g., deposit $150 of ETH to borrow $100 of USDC).
• Liquidatable: If the collateral value falls below a protocol's minimum threshold, the position can be liquidated to repay the debt.

A numerical metric representing the safety of a debt position. It is calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value. A health factor below 1.0 triggers liquidation. Key thresholds:

• Safe: > 1.5 (protocol-dependent).
• At Risk: Nearing 1.0, may require adding collateral or repaying debt.
• Liquidated: <= 1.0, where collateral is automatically sold to cover the loan.

The forced closure of an undercollateralized debt position to ensure protocol solvency. When the health factor falls below 1.0, a liquidator (often a bot) can repay part or all of the debt in exchange for the user's collateral at a discount. This process:

• Protects the protocol from bad debt.
• Results in a liquidation penalty for the borrower.
• Creates a profit opportunity for the liquidator via the liquidation bonus.

A protocol-level parameter that sets a maximum limit on the total amount of a specific asset that can be borrowed. It is a critical risk management tool to prevent overexposure to any single collateral type or market. For example, a MakerDAO vault for a specific collateral asset may have a debt ceiling of 100 million DAI, capping systemic risk.

In protocols like MakerDAO, major debt positions are used to mint decentralized stablecoins. Users lock collateral (e.g., ETH) to generate DAI, which is itself a debt obligation that must be repaid with a stability fee (interest) to reclaim the collateral. This positions the stablecoin as a collateralized debt position (CDP) on the protocol's balance sheet.

The use of borrowed funds (debt) to amplify exposure to an asset's price movement. A debt position is the primary tool for creating leverage in DeFi. For example, a user can:

1. Deposit ETH as collateral.
2. Borrow a stablecoin against it.
3. Swap the stablecoin for more ETH, and repeat. This creates a leveraged long position on ETH, where profits and losses are magnified, and liquidation risk is significantly higher.