Using Stable coins in CDPs to reduce volatility risk

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(Edited)

Using stable coins in CDPs (collateralized debt products) to reduce volatility risk on DeFi lending platforms.

Cryptocurrencies like Bitcoin or Ethereum are by their very nature volatile, as in they experience huge swings in price, in U.S. Dollars from day to day. This volatility is a major source of risk when you use Bitcoin or Ethereum as collateral for loans. One of the first DeFi platforms in cryptocurrency was the lending platform MakerDao on the Ethereum blockchain.The lending platform there uses ETH as collateral for loans, which provide investors Dai for their deposited ETH. If you are unfamiliar with this ETH-Dai Loan process please read this [post] and then follow the link at the bottom of that post back here. Stable coins by definition are stable stores of value, pegged to the U.S. Dollar.

ETH-Dai CDP Loans

These loans are initiated by depositing ETH and borrowing Dai.
The risks here are based on the volatility of ETH. You can borrow half the value of your ETH in Dai, but if the price of ETH falls, then the loan will become greater in value then 50%, as the value of ETH falls. This results in a monetary penalty and the liquidation of your deposited ETH to pay back the borrowed Dai and the penalty fee, along with transaction fees on Makerdao on Ethereum. Note there is a similar process on Venus, involving BTC or BNB, and the stable coin Vai.

Dai-ETH CDP loans

I first read about Dai-ETH CDP loans in a post by @edicted and I felt this should be discussed further, and perhaps it would be useful to explain it in detail. Now this is my current understanding, and one of the main reasons I write is to share and to learn myself. Certainly trying to explain something to another is a test of your understanding and puts your thoughts on paper or on computer screen as the case may be, where all can see them, so they must stand on their own feet under scrutiny.

If Makerdao allowed us to deposit Dai as collateral and borrow ETH it would be a fascinating possibility, because it would reduce the risk of volatility greatly, as stable coins have very little volatility by nature. One could even say these loans could be described as zero volatility loans.

Stable coins by definition are stable stores of value, pegged to the U.S. Dollar. For example ETH may fluctuate from 950 to 1050 with a trading day, a range of 100$. While Dai would fluctuate from 0.95 to 1.05, a range often cents. We know that these ranges occur and we know that these ranges are exploited for arbitrage trades. These arbitrage trades are one of the chief reason behind the large volumes of stable coins that trade each day. But back to our subject.

Deposit

If you deposit 1000 Dai, which is around $1000.00 in a CDP, your balance is 1000 Dai, the value is $1000 dollars.
For the purposes of this example assume ETH is 1 dollar.

Borrow 50% of your Dai value in ETH.

If you borrow 500 ETH at 1 dollar each, that 500 ETH, the ratio between your deposited Dai $1000 dollars and the loan for the ETH $500 will be 2:1.

Invest

If you sell the ETH for Dai, and deposit this new Dai into this same account, you now have $1500 worth of Dai (1500 Dai) and you owe the lender 500 ETH.

Rinse and Repeat

Borrow

Using this larger CDP loan balance of 1500, you can borrow additional ETH.
1500 Dai divided by two is 750 ETH using 2:1 ratio. You can borrow 750 ETH minus the existing 500 ETH loan or 250 ETH.
750-500 equals 250 ETH.

Invest

You sell the 250 ETH for 250 Dai.
You deposit the new Dai in to your CDP.
You now have 1750 Dai and a 750 ETH Loan.

Borrow

You now have 1750 Dai.
You can borrow 1750/2 or 875 ETH, minus the 750 ETH CDP.
875-750 equals 125 ETH.

Invest

You sell the 125 ETH for 125 Dai.
You deposit the 125 Dai in your CDP.
You now have 1875 Dai in your CDP.
You have a 850 ETH CDP loan.

Borrow

You have 1875 Dai in your CDP.
You have a 850 ETH CDP loan.
You can borrow 1875/2 or 937.5 ETH.
You can borrow 937.5 minus 850 or 87.5 ETH
You borrow 87.5 ETH.

Invest

You use your 87.5 ETH, to buy 87.5 Dai.
You deposit your 87.5 Dai.
You now have 1952.5 Dai in your CDP vault.
You have a 937.5 ETH CDP loan.

Summary:
You have used the CDP loan process to double the amount of Dai in your vault, going from 1000 Dai to 1952.5 Dai without adding additional capitol. You have incurred a debt of 937.5 ETH to be paid in the future.

Note also that your loan is based on a stable coin. So the volatility risk associated with Eth-Dai CDP is almost non-existent in a Dai-ETH CDP. However your debt is in ETH. If the market price of ETH falls below one dollar, you will be able to buy back ETH later and pay off that ETH debt and keep your excess Dai as a profit.

If however, the price of ETH rises above two dollars, you will not have enough Dai in your vault to buy it back, and you will lose money.

This we see that this CDP process is most profitable in a bear market. And will result in losses in a bull market.

The other thing we realize is that this illustrates how you lose money when you short a stock. You only win if you can buy the stock cheaper later, for less then you sold it for, or if it goes up, you incur losses.

Questions?

Note if you only use this CDP process once you have an entirely different outcome.

So if you only use the CDP to buy the 500 ETH, and don't sell the ETH to buy Dai, instead you hold the ETH. Your outcome is completely different in a bull market.

This allows worry free investment in ETH, along with preservation of 100% of your Dai capitol. Your Dai coin is a stable coin. If ETH doubles in price you can pay off your CDP by selling half of it and now your CDP loan is paid, your capitol is freed up and you are the proud owner of ETH free and clear.

Math:

Deposit

You deposit 1000 Dai in a CDP. Its value in dollars is 1000.

Borrow

You borrow 500$ worth of ETH.

Invest

You sell the ETH for $500 worth of Dai.
You deposit the day into your CDP.
Your CDP now holds 1500 Dai.

Rinse and Repeat

Borrow 50% of your Dai value in ETH

Sell

Your ETH goes up 10% to $550
You sell the ETH for 550 Dai.

Invest

You deposit the 550 Dai in your CDP, now you have a balance of 1550 Dai.

Borrow

You borrow 50% of your Dai or 750Hodl or Hold ETH
You hold your ETH

ETH doubles in value

Your 5 ETH goes from 100$ per ETH to 200$ per ETH and its value goes from $5000 to $1000.

Sell ETH pay back CDP

You sell 2.5 ETH for $500 and pay off your CDP.

Result

You have 1000 Dai (original capitol) and $500 dollars 2.5 ETH free and clear, unencumbered by a loan.

Summary:

You used the CDP to obtain ETH at 100$ using a loan against your deposited Dai.

You used the maximum allowed borrowing.

You didn't worry about volatility in cryptocurrency price triggering a CDP loan ratio default and liquidation of your loan, because your collateral is a stable coin.

Other thoughts

You could hold the collateral indefinitely.
You could sell the ETH once it doubles, for Dai, deposit the Dai and borrow 50% again to buy more ETH.

That was a math nerd exercise for sure, but it was fun, for some of us...

Penned by my hand. @shortsegments

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Shortsegments is a writer focused on cryptocurrency, the blockchain, non-fungible digital tokens or NFTs, and decentralized finance, where finance meets technology.

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