Earlier this month it was an honor to share this post as a guest on Ryan Sean Adam’s Bankless - go-to newsletter to help you level up your open finance game. View original here. Special thank you to Petru Catana from Maker for his continuous feedback and support. We will release a follow-up tutorial on Multi-Collateral Dai once it goes live on November 18th.
See how you can get access to an instant loan by opening a collateralized debt position (CDP) on MakerDAO. We’re going to learn how CDPs work, risks involved and whether you should consider opening one.
Goal: Learn how to open and manage a CDP to get an instant loan and avoid risks.
Effort: 1-2 hours
ROI: Positive ROI if value from loan > loan interest
What is a CDP?
A CDP is a MakerDAO is a smart contract system that locks up collateral (currently ETH) and generates stablecoins (DAI). The value of the locked-up collateral (locked ETH X current ETH price) must always be more than 150% of the amount of DAI that you generated (but it's recommended to have around 350% due to ETH price volatility). Otherwise locked up ETH gets sold on market (liquidated) to pay back:
Your generated DAI amount
Accrued stability fees - aka interest (currently set to 10.5% per year)
Liquidation penalty (currently 13%)
The DAI you generate is effectively a loan backed by the collateral value of your ETH. In order to get back your ETH, you need to pay back the DAI at some point in the future.
Generated DAI could be used anywhere it is accepted, similar to USD. It can even be traded for USD or other tokens on exchanges. Each generated DAI is backed by ETH locked in MakerDAO CDPs. There is around 80M DAI in circulation right now with over 1.5M ETH locked up in CDPs.
Think of MakerDAO as an open-source Federal Reserve built on top of Ethereum. MakerDAO (MKR) token holders govern the system by voting on development changes which determine things like collateral requirements, stabilities, and liquidation penalties.
All credit data such as how many loans were originated, how much ETH is locked up and DAI generated, is always available for anyone to view and verify anytime on-chain. Maker team created an awesome front-end to help us analyze this data at Mkr.tools.
Should you open a CDP?
The primary benefit of opening up a CDP at this time is getting instant liquidity without selling your ETH. But you have to be willing to accept liquidation risks and also believe that returns from staying invested in ETH (or returns generated from utilizing borrowed liquidity) will outpace liquidity borrowing costs.
Here’s how I would approach this:
Look up current CDP stability fee which is the annual interest rate—currently its 10.5% per year. Now, use historical data to project future stability fees. (RSA note: remember—this a variable rate loan that changes wkly—2.5% to 20.5% in the past).
Estimate how long you will need to borrow DAI for.
Decide if you think staying invested in ETH and the ROI generated from borrowed resources will beat accrued stability fees.
For example, if you want to borrow 1,000 DAI for 3 months, take the current annual stability fee of 10.5%, project the average stability fee for the next 3 months (say 14.5% avg) and divide by 4 to get 3.625% which is interest you’d pay for the 3 month loan. On 1,000 DAI for 3 months that’s an interest payment of $36.25. If you think the profit from utilizing the DAI loan will increase by more than $36.25 within 3 months, it could make sense to consider opening up a CDP.
Two things to watch out for:
If the stability fee increases above what you projected then the interest payments could be higher than you expect (RSA note: variable rate loan!)
If your collateral value (locked ETH x Current ETH price) drops below 150% of your borrowed DAI amount anytime during those 3 months, your locked ETH will be liquidated (RSA note: do not underestimate how far ETH could drop).
It is important to keep a close eye on your collateralization level after you initiate a loan and ‘top up’ your locked ETH balance if it gets close to liquidation.
Here are tools I like for you to easily open and manage CDPs to avoid liquidations:
MakerDAO CDP Portal
MakerDAO team itself created the first user interface to help end-users open CDPs. To open a CDP:
Visit MakerDAO CDP Portal and connect with a Metamask, a hardware wallet, or a Coinbase Wallet which contains ETH you want to collateralize for your loan.
Click OPEN CDP and enter how much ETH you want to lock up and how much DAI you want to generate against that ETH. You will notice your liquidation price gets higher as you increase your DAI to be generated. Typically, anything below 200% collateralization ratio is considered at risk so make sure you pay close attention to your liquidation price here and collateralize enough ETH.
(RSA note: have enough collateral for ETH to drop well below $80—seriously)
Click COLLATERALIZE & GENERATE DAI, confirm your loan details and FINALIZE to send the transaction. Once it’s confirmed on Ethereum, you will see your ETH locked in CDP, and DAI appear in your wallet balance just like any other ERC20 token.
Monitor price of ETH and its effects on your collateralization ratio. Lower your liquidation risk by locking up more ETH in your CDP.
👉Visit cdp.makerdao.com to get started.
Instadapp provides an even better user experience for opening and managing your CDPs. For example, if you use CDP Portal above, you’ll need to have MKR (or DAI) tokens to pay stability fees when you repay and close your CDP. But a big advantage of Instadapp is that you can repay stability fees in ETH (the ETH is automatically swapped with MKR via Kyber Network in the background). This removes friction and creates better experience for end-users.
Instadapp also has a popular bridge function which allows you to seamlessly migrate your CDP back and forth from Maker to Compound to take advantage of better rates.
(RSA note: a CDP on instadapp increases contract hack risk vs using the CDP portal though instadapp has passed security audits without major issues)
👉Visit instadapp.io to get started.
In addition to easily opening and managing your CDP, similar to Instadapp, DeFi Saver has a feature that allows you to automatically manage your CDP collateralization ratio. You just indicate which ratio you would like to maintain and DeFi Saver will automatically adjust if it ever falls below.
You should always try to monitor your CDP in addition to any automatic protections you set up in place. When the price crashes too fast, as we saw it happen on September 24, DeFi Saver Automatic CDP protection might not adjust your ratio fast enough and you could end up getting liquidated. 2 CDPs from Automatic CDP protection were liquidated as a result of this recent flash crash. But what I liked is how transparent the DeFi Saver team was about this situation, made quick changes, and even offered to compensate those 2 CDP owners for their liquidation losses. You can read more about what happened here.
(RSA note: while DeFiSaver uses the standard Maker proxy wallet and maintains compatibility with the Maker CDP portal, which is a plus, their smart contracts have not been externally audited and so features such as Boost/Repay can be considered as additional exposure to risk)
👉Visit defisaver.com to get started.
Uses Cases for these Loans
So what are these CDPs being used for?
Margin-long on ETH. Looking at the history of CDP originations, there’s a clear correlation between ETH’s price rebounce from mid-December 2018 lows and # of CDPs being originated. Most believed the price of ETH wouldn’t go lower so most of the generated DAI from opened CDPs was used to buy more ETH, effectively placing a margin trade.
Leverage for ICOs. Another popular use-case: I’ve noticed some projects lock up ETH raised from ICOs to generate DAI for employee salaries and business expenses.
In the long-run, I expect many more use-cases for CDPs as DAI adoption increases, stability fees decrease and additional layers measuring your ‘DeFi credit score’ emerge. This would enable borrowings that fund more use-cases with real economic outputs:
Small business loans
Student loans with income share agreements
A CDP gives you an instant loan using ETH as collateral. Don’t open one unless you know what you’re doing and have seriously weighed the risks. The primary risks are liquidation risk due to falling price of ETH and the risk of higher than projected stability fee increases. As with any money protocol, there’s also the potential you could lose your collateral in the event of a catastrophic smart-contract hack.
There’s an emerging class of third-party tools like Instadapp and DeFiSaver that improve the user experience in opening and management of a CDP. These will continue to improve and you can try them out now.
Today, the primary use case for a Maker loan is speculative—going margin-long on ETH. But as the open finance lending market matures CDPs will underpin a far wider assortment of economic activity. You’ll want to get some experience with them now.
Open a CDP with a small amount to try it out (tutorial on Coinbase Earn)
Consider: are you comfortable with the CDP risks to use it as a short-term loan?
Simulate your CDP with DeFi Strategies app before playing with real money. If you left your information to get early access but have not received your invitation yet, keep an eye out for an email from us next week. I partnered with a few smart contract developers and we have been heads-down building out some awesome tools for open finance. Can’t wait to share more next week 🙊
⚡️UPDATE ⚡️1/ Incredibly proud to share our Kyber hackathon project: DeFiZap.com - allocate your capital across and others, in a single transaction. Zap is a smart contract that auto-spreads incoming deposits based on pre-set allocations 👇F