Collateralized Debt Position (CDP)

The critical subsystem that ensures CDP solvency. Different protocols employ distinct models:

• Collateral Auctions (Maker): Liquidated collateral is sold via auctions to the highest bidder.
• Stability Pool (Liquity): A pool of LUSD acts as the first line of defense, automatically absorbing debt in exchange for discounted collateral.
• Fixed Discount (Some Forks): Liquidators purchase collateral at a fixed, protocol-defined discount.

Failure of this mechanism is the primary systemic risk for any CDP protocol.

The primary financial risk in a CDP. If the value of the locked collateral falls below a predefined collateralization ratio (e.g., 150%), the position becomes eligible for liquidation. A liquidation event triggers an auction where the collateral is sold, often at a discount, to repay the debt, potentially leaving the user with a loss.

• Example: Locking 10 ETH ($30,000) to mint $15,000 DAI creates a 200% ratio. If ETH drops to $2,000, the collateral value is $20,000, and the ratio falls to ~133%, triggering liquidation.

CDPs rely on oracles to determine the real-time market price of collateral assets. If an oracle is compromised or provides stale data, it can cause:

• False liquidations if the price feed inaccurately reports a lower price.
• Undercollateralized positions if the feed reports an inaccurately high price, allowing unsafe borrowing.

This makes oracle security and decentralization a critical attack vector for the entire protocol.

The CDP's logic is encoded in immutable smart contracts. Risks include:

• Bugs or vulnerabilities in the contract code that could be exploited to drain funds.
• Governance attacks where malicious actors take control of protocol parameters (like fees or collateral types).
• Upgrade risks in upgradeable contracts, where a new implementation could introduce flaws.

Users are trusting the code and the governance process absolutely.

The stability fee is a variable interest rate (often in the native governance token) charged on the borrowed stablecoin. This creates ongoing cost risk:

• Fees can be changed via governance, increasing borrowing costs unexpectedly.
• If not managed, accumulating fees can increase the debt over time, pushing the position closer to its liquidation threshold.
• Users must actively monitor and manage their position's health.

The inherent volatility of crypto assets amplifies CDP risks. Using a single, highly volatile asset as collateral (e.g., a low-cap token) requires a much higher safety margin.

• Concentration risk: A sharp, correlated market downturn can trigger mass liquidations across the protocol.
• Liquidity risk: During market stress, there may be insufficient buyers in liquidation auctions, leading to deeper discounts and bad debt for the protocol.

The design of the liquidation process itself carries risks. Key components include:

• Liquidation penalty: A fee (e.g., 13%) added to the debt, taken from the collateral sale proceeds.
• Auction design: Inefficient auctions can result in collateral being sold below market price, worsening user losses.
• Keeper reliance: The system depends on external actors (keepers) to trigger liquidations. If keeper incentives fail, undercollateralized positions may persist.

The forced closure of a CDP when its collateralization ratio falls below the liquidation threshold. This process protects lenders by selling the collateral, often at a discount, to cover the outstanding debt. Key aspects include:

• Liquidation Price: The asset price at which a position becomes undercollateralized.
• Liquidation Penalty: An additional fee charged to the borrower.
• Liquidators: Network participants incentivized to trigger liquidations for a reward.

The recurring cost, typically expressed as an annual percentage rate (APR), charged by a protocol for borrowing against a CDP. This fee accrues on the debt and is usually paid in the protocol's governance token or the borrowed stablecoin. It is a primary mechanism for:

• Regulating demand for the minted stablecoin.
• Generating revenue for the protocol treasury.
• Compensating governance token stakers.

Critical risk metrics for any CDP.

• Liquidation Ratio (Minimum Collateralization Ratio): The minimum value of collateral required relative to the debt, set by the protocol (e.g., 150%).
• Health Factor: A real-time metric representing the safety of a position. A value below 1.0 triggers liquidation. It is calculated as (Collateral Value * Liquidation Threshold) / Debt. Monitoring this is essential for position management.

The fundamental security principle of most CDPs, where the value of the locked collateral exceeds the value of the minted debt. This overcollateralization creates a buffer that:

• Absorbs market volatility in the collateral asset's price.
• Protects lenders (or the protocol) from losses.
• Enables the creation of trustless, decentralized stablecoins without relying on a central issuer.

A protocol-level risk parameter that limits the total amount of debt (e.g., DAI) that can be minted against a specific type of collateral. It serves to:

• Limit Systemic Risk: Prevent over-exposure to any single asset.
• Manage Protocol Capacity: Control the growth and composition of the collateral portfolio.
• Require Governance Action: Changes to debt ceilings are typically voted on by token holders.