Crypto-Collateralized Stablecoins and CDPs

A dollar-backed stablecoin is simple in concept: a company holds a dollar in a bank account for every token it issues. A crypto-collateralized stablecoin takes a harder path — it backs its stable token with a volatile asset like ETH, held in a smart contract called a collateralized debt position (CDP). The trick that makes this work despite ETH's swings is over-collateralization: lock in far more value than you borrow out, so the collateral has room to fall before the debt is at risk.

Locking collateral, minting debt

A user deposits ETH into a CDP smart contract and, against it, mints a stablecoin (say, DAI) up to some fraction of the collateral's dollar value — never the full value. The collateralization ratio is the collateral's current value divided by the debt outstanding; the protocol requires this to stay above a minimum, commonly 150%, meaning you can borrow at most about two-thirds of what you deposited. The gap exists entirely to absorb price swings in the collateral without threatening the stablecoin's backing.

Worked example

A user deposits ETH worth $3,000 into a CDP and mints 2,000 DAI against it. Collateralization ratio: $3,000 / $2,000 = 150%, exactly at the minimum. If ETH's price falls 10%, the collateral is now worth $2,700, and the ratio drops to $2,700 / $2,000 = 135% — below the required minimum. The protocol's liquidation mechanism triggers: it seizes the collateral, auctions enough of it to repay the 2,000 DAI debt plus a penalty fee, and returns any leftover ETH to the user. Because the position was liquidated automatically and promptly, the 2,000 DAI in circulation stays fully backed even though the ETH behind it lost value — the loss was absorbed by the user's collateral cushion and a penalty, not by the stablecoin holders.

What this means in practice

Over-collateralization is the entire reason this design can survive volatility that would break a 1:1 cash-backed peg model if the "cash" were itself volatile. The system-wide safety depends on liquidations actually executing fast enough and at fair-enough prices during a crash — if ETH gaps down 30% in an hour and liquidation auctions can't clear at reasonable prices because buyers have vanished, the protocol can end up with bad debt, positions that were liquidated too late to fully cover the minted stablecoin. This is exactly what happened to MakerDAO during the March 2020 crash, prompting design changes to liquidation mechanics afterward.