Collateralized Debt Position is a system created by MakerDAO which locks up collateral in a smart contract in exchange for stablecoins, a decentralized stablecoin known as DAI. CDP, as it is often called, is a position characterized by a smart contract, a collateral and an issued collateral-backed stablecoin.
MakerDAO is an ethereum-based blockchain protocol that issues the stablecoin DAI, which is pegged to the dollar (USD) without a centralized authority. Since the advent of decentralized finance (DeFi) – which is simply traditional finance implemented using blockchain solutions – MakerDAO has championed the cause in the blockchain industry over the years.
How does Maker CDP work?
A stablecoin (such as USDT, USDC, and PAX) is essentially a collateral-backed cryptocurrency. In a way, they are cryptocurrencies collateralized by a major fiat currency (usually USD). This means that you offer a fiat currency such as USD in exchange for a digital asset of closely approximate equivalence (the issuing party keeps small charges as fees for transactions carried out on the network). It is expected that each issued token is backed by a dollar held by the issuing party, and they can provide the same value once the issued token is returned.
MakerDAO created the CPD system to allow the issuing of stablecoins without the need for an issuing party and using crypto assets as collateral instead of a fiat currency. The terms of issuing the DAI token is written into the smart contract and only executed when the DAI loan is returned. Ether (ETH) used to be the only underlying asset supported as collateral for funding a collateralized debt position and mint the DAI token; however, other cryptocurrencies such as ZRX, TUSD, USDC etc., are now supported.
In a bid to hedge against the ever-fluctuating prices of cryptocurrencies, the collateral locked in the position must be 1.5x the value of the DAI that is issued. This way, the position is still covered even if the price of the collateralized asset dips. However, if the value of the collateral falls below 150% (i.e. 1.5x), the position becomes uncollateralized, incurring a 13% liquidation penalty and an accompanied stability fee.