Collateralized Debt Position (CDP) Farming

A primary risk in CDP farming is the potential for liquidation cascades. High leverage across interconnected protocols can lead to:

• A market downturn triggering mass liquidations.
• Liquidation penalties eroding user equity.
• Downward price pressure on collateral assets, potentially causing further liquidations in a reflexive spiral. This systemic risk is a key consideration for any CDP farming strategy.

CDP farming often follows a cyclical pattern of increasing leverage:

• Deposit Collateral: User locks asset A in Protocol X.
• Mint Stablecoin: Borrow stablecoin S against the collateral.
• Recycle & Farm: Swap S for more of asset A, deposit it as new collateral, and repeat to increase exposure. The borrowed S is then deployed into a yield farm. This cycle amplifies both potential returns and risks.

The primary risk is the forced sale of collateral if its value falls below the required collateralization ratio. This is exacerbated by:

• Oracle price manipulation: Inaccurate price feeds can trigger unwarranted liquidations.
• Volatility spikes: Rapid market moves can cause cascading liquidations before users can react.
• Liquidation penalties: Fees incurred during liquidation can significantly erode the user's capital position.

CDP farming inherits all underlying risks from the lending and yield-generating protocols involved.

• Smart contract bugs: Vulnerabilities in the lending protocol (e.g., MakerDAO, Aave) or the farm can lead to direct fund loss.
• Governance attacks: Malicious governance proposals could alter critical parameters like stability fees or collateral factors.
• Integration risk: Failures in the complex interactions between the lending protocol and the yield farm can create unexpected states.

The debt position is not static and can become unsustainable.

• Accruing stability fees: The debt (e.g., DAI) continuously incurs interest, increasing the liquidation threshold over time.
• Variable borrowing rates: In non-fixed-rate systems, rising APRs on borrowed assets can outpace farming yields, making the position unprofitable.
• Negative carry: The core risk where the cost of borrowing exceeds the yield generated by the farmed assets.

The sustainability of the farming rewards is critical to the strategy's profitability.

• Inflation and dumping: High emission rates for farm tokens can lead to rapid price depreciation.
• Impermanent loss: If providing liquidity with the borrowed assets, LP position value can diverge from simply holding.
• Reward rug pulls: The underlying farm could be malicious or its token could have a malicious vesting schedule for developers.

CDP farms are vulnerable to broader market failures and interconnected protocols.

• Collateral de-pegging: If the collateral asset (e.g., a stablecoin) loses its peg, it can trigger mass liquidations.
• Protocol insolvency: A failure in a major lending protocol could freeze collateral or debt positions.
• Network congestion: High gas fees during market stress can prevent users from managing their position, leading to avoidable liquidation.

The complexity of managing leveraged positions introduces significant non-technical risks.

• Health factor monitoring: Failure to actively monitor the collateralization ratio and market conditions.
• Transaction ordering: Inability to execute top-ups or repayments quickly enough during volatility.
• Approval risks: Overly permissive token approvals to smart contracts can increase exploit surface area.

The automated process of selling a borrower's locked collateral to repay their debt when their collateralization ratio falls below a predefined liquidation threshold. This is a critical risk in CDP farming.

• Trigger: Caused by a drop in collateral value or a rise in debt value.
• Process: Often involves liquidation bots and auctions.
• Consequence: The borrower loses their collateral, often with an additional liquidation penalty paid to the liquidator.

The practice of automatically moving capital between different DeFi protocols (like AMMs, lending markets) to maximize returns on the assets generated from a CDP. This is the "farming" component.

• Automation: Often managed by vault strategies on platforms like Yearn Finance.
• Goal: Generate yield (in ETH, tokens, or LP fees) that exceeds the stability fee (borrowing cost) of the CDP.
• Risk: Adds smart contract risk and strategy risk on top of the underlying CDP risks.

A protocol-level parameter that limits the total amount of a specific debt asset (like DAI) that can be minted against a particular type of collateral. It is a risk management tool for the CDP protocol.

• Purpose: Prevents over-exposure to any single collateral asset.
• Governance: Typically set and adjusted by protocol governance (token holders).
• Impact on Farming: Can constrain the scalability of farming strategies using popular collateral types.

Programs where protocols distribute their native governance tokens as rewards to users who provide liquidity or take specific actions like opening CDPs. This often supercharges CDP farming APYs.

• Mechanism: Users earn extra tokens (e.g., MKR, LQTY, SPELL) on top of base yield.
• Purpose: Protocols use this to bootstrap usage and decentralize governance.
• Consideration: These incentive tokens are often volatile and may be a significant part of the farming profit calculation.