How to manage risk
The main principle to keep in mind here is the collateralised debt position (CDP). This is calculated by dividing the amount you are borrowing or debt over the collateral you are using. Your debt is how much USDP you received in return, while your collateral is the token you have deposited to secure the USDP loan.
The initial CDP is called Initial Collateral Ratio (ICR). This tells you how much collateral you need to add given the current prices at the time of the transaction.
Here's an example where ETH is deposited to borrow USDP.
In this example, the ICR is 77%, which means that the user can borrow $770 for every $1000 value in ETH in deposit. The risk to the user can be seen in two main points, one is the liquidation ratio, and second is Ether’s real time fluctuation in price. Once the initial transaction goes through and the user has borrowed $770 worth of USDP, the lower the price of ETH goes, the higher the risk of reaching the liquidation rate of 78%.
Crypto prices fluctuate, quite dramatically at times, meaning that the ICR that the users start with will fluctuate up and down. In this example, the price of ETH is currently $1,861.60, but in a few hours will decrease by $100. If we do some simple math, we can see that the lower the denominator on debt / collateral gets, the higher the percentage representing the CDP is. The result of increasing a CDP is that it increases your risk of liquidation depending on how close you are to the liquidation rate.
Let's use ETH as an example again to explain CDP risk. A user deposits $1000 worth of ETH and borrows $770 worth of USDP making their CDP ($770/ $1000) at 77% then they will be just 1% away from the liquidation rate of 78%. If ETH's value were to decline by 5%, which is not uncommon, it would reduce the value of the collateral $950, raising the CDP to 78.1%, and triggering the liquidation process. A more realistic approach would be to not borrow the fully allowed amount of 77% but to give yourself a reasonable buffer for regular price fluctuations. A safer CDP might be a 50% CDP by borrowing $500 USDP against $1000 ETH collateral ($500/$1000 = 50%). So, if the similar scenario of a 5% drop in ETH value occurs, then the CDP will be safe at 52%. This would mean the CDP would be protected from a lot of the regular ETH price fluctuations, only leaving them exposed in more extreme situations.
Applying the principles above to our initial borrowing process, the user wants to deposit 1 ETH as collateral and borrow USDP against it. Unit Protocol offers a simple slider to choose the desired level of risk associated with the USDP borrowed. To ensure that the deposited capital is unlikely to get liquidated, it is best to stay quite far away from the CDP ratio. In this example, 50% is sufficient. This allows users to retain their ETH, take out a USDP loan to invest or use while remaining relatively assured that their deposit is safe from risk of liquidation.
A risky CDP where the maximum amount is borrowed and risk of liquidation is high
A more reasonable CDP where 50% of the maximum amount is borrowed risk of liquidation is less likely
After you've borrowed USDP, you can either pay it back in full or partially to reduce the overall CDP risk.
As we've seen, it's important to consider the liquidation rate of the asset you're collateralising when you set up the CDP.
To reiterate, when the asset was deposited ETHs liquidation rate is 78% and as a result the user should consider collateralising well below this percentage. This will safeguard your deposit from liquidation during price fluctuations. If a situation arises where your initially conservative collateralisation rate becomes more risky due to extreme price fluctuation and your deposit is at risk of liquidation you can take action to prevent this from happening.
Consider a scenario where the user has collateralised ETH at 65% ($650 debt/$1000 collateral) to borrow some USDP. Then, a sudden ETH price drop of 15% reduces their collateral to $850 and therefore the CDP to 76%. This is now just 2% away from the liquidation rate. To reduce this risk the user can simply pay back some of the debt to reduce my CDP rate by:
- 1.Scroll down to the 'Repay USDP & Withdraw collateral' section.
- 2.Enter the amount of USDP you wish to repay and click Execute. In this case, the user will repay $100 worth of USDP and click 'Execute'. Thus, they have managed to reduce my CDP rate to 64.7% ( $550 debt/ $850 collateral) which is well below ETHs liquidation rate of 78%.
If the user wanted to repay the entire amount instead, they could scroll down to the 'Repay USDP & Withdraw collateral' section and select the full USDP amount that they borrowed initially and click 'Execute' to pay it back.
Alternatively, the user could also choose to take on more risk by borrowing more USDP against the existing collateral if they are not at the maximum CDP allowed. The basic idea is that users have complete freedom in borrowing, de-risking, or paying debt back. It's up to the user to decide on the best course of action given risk profile, market fluctuations, and your investment preferences.