collateralized debt position

A collateralized debt position is the mechanism that lets you mint a brand-new stablecoin into existence by locking up other crypto as collateral, most famously the vaults of MakerDAO that create DAI. Unlike borrowing from a lending pool, where you draw on assets other people deposited, a CDP creates the borrowed stablecoin from nothing the moment you take the loan and destroys it when you repay. You deposit, say, ETH worth far more than the DAI you want, the protocol lets you mint DAI against it, and your locked collateral is held hostage until you return and burn that DAI.

Because the minted stablecoin is meant to hold a stable peg, the position is heavily over-collateralized and governed by three key parameters. The liquidation ratio is the minimum collateral-to-debt ratio you must maintain (for instance 150%). The stability fee is an interest rate, accruing on your debt, that you pay when you close the position. And the debt ceiling caps how much stablecoin can be minted against a given collateral type, bounding the system's exposure to any one asset. If your collateral value falls and your ratio breaches the liquidation threshold, your collateral is auctioned to cover the debt plus a penalty.

The CDP was one of the foundational primitives of DeFi, predating the AMM boom, and it remains the template for decentralized, crypto-backed stablecoins. Its great strength is that the stablecoin's backing is transparent and on-chain rather than a trust-me promise of off-chain dollars; its great weakness is reflexivity. Because the collateral is itself volatile crypto, a sharp market crash can push many CDPs underwater at once, triggering mass liquidations that dump collateral and can, in the worst case (as on Black Thursday in March 2020), leave the system with bad debt that must be backstopped by minting and auctioning governance tokens.