DeFi's Collateralized Debt Protocols

In legacy financial systems, collateralized debt obligations (CDOs) are, somewhat, complex structured finance products, usually backed by a pool of loans or other assets. These underlying assets serve as collateral should the loan go into default. Though risky and not for all investors, CDOs are generally regarded as a legitimate tool for shifting risk and freeing up capital by financial participants in the traditional finance system. With the emergence of MakerDAO and other blockchain-based solutions, collateralized debt obligations can now be created without financial intermediaries.

Collateralized Debt Positions

Collateralized Debt Positions (CDPs) are smart contracts that users can leverage to lock their collateral assets (i.e., Ethereum’s ether) to generate another token - often a stablecoin such as DAI.

CDPs can be thought of as vaults for storing collateral. To account for the volatility of a collateralized digital asset, DAI is usually over-collateralized, meaning that the deposit amount required is typically higher than the value of DAI. For example, users must lock $20,000 worth of ether (ETH) in order to receive $10,000 DAI, which is meant to account for the potential decrease in the value of the collateral. As a result, even if ether depreciates by 30%, the $10,000 in DAI are still fully collateralized by $14,000 in ether. In order to recover the pledged ether, the user has to return the DAI plus pay a ‘stability fee’.

Currently there are more than forty collateralized debt protocols with a combined locked total value of over $8.9 billion. The lion share comprises the oldest CDP MakerDAO with more than $7.6 billion in assets. However, newer entrants - such as Qi Dao (QI) are starting to gain more traction by making its solutions available across a number of different blockchains and Layer Two solutions such as Fantom, Polygon, Avalanche, Solana, and other chains (see table below).

However, solutions that deploy CDPs across more than one chain have to make use of ‘bridges’, often on a mint and burn system. The user - or the protocol - deposits a token into the bridge and it mints the version of that token on the other side of the bridge. Several bridges in the past were hacked, and user funds were drained. As such, investors into CDPs should be aware of the heightened risk these particular solutions might carry.

Blockchain-based collateralized debt positions are a promising tool for the adoption by legacy financial system to provide greater visibility into the underlying assets securing the loan. The opacity of the latter has been identified by many analysts as one of the main reasons for the 2008 financial crises, where many institutions were (or claimed to be) unaware of the risks associated to the collateral.

The missing link - as of today - however, are solutions that reliably turn ownership documentation (i.e. land titles) into digital assets, suitable to be committed into a smart-contract which can reliably serve as collateral which accessible to satisfy the outstanding principal. The latter might first emerge in developing nation without existing digital ownership instruments - i.e. countries still relying on paper-based ownership record. As with the adoption of smart phones, these regions may leapfrog financialized markets.