Using CDP loans on a DeFi lending platform to double your ETH

I read an article by @edicted in which he discussed using reversed Dai-ETH CDP mechanics in a collateralize CDP loan. I thought it was a fascinating subject for those of us who love DeFi math and also the strategy is interesting for those who like making money. The problem is in breaking it down, so everyone or most of us can understand.

So I thought it was worth the laborious process of breaking it down and mapping the strategy with words and numbers, so that our community could benefit from learning abut it. And the more adventuresome in our community would actually try it out. So this is part one of a two part series. I hope this stimulates more discussion on it.

After writing it and now doing the editing I have learned things and now have a better grasp of what @edicted was writing about. Part 2 should be very interesting also.

Part One: Using CDP loans to double your ETH

This is done on Makerdao, a lending application on Ethereum. Using ETH and the stable coin Dai, which is pegged to the dollar 1:1 more or less. You can also do this on Venus, the DeFi lending platform on Binance Smart Chain.

First, some terms

CDP collateralized debt product, basically means you deposit some ETH, for simplicity let's say 10 ETH worth 100$ each or 1000$ worth of capital, deposited in a Vault.

Vault: basically a secure account, which is part of the DEFI lending platform smart contract.

Collateralized Loan: You deposit the ETH in the vault, and then you borrow Dai, a stable coin in a ration usually less then 2:1, or one half the value of your collateral.

Note Collateralization ration is the opposite of LTV or loan to value. When you borrow money to buy real estate, the most common scenario for collateralized loans in the Legacy financial system you use loan to value ratios of 60-95% depending on the lender. In crypto or DeFi we turn that on its head or upside down and its value to loan, but it's called collateralization ratio.

Second, borrow

So we deposit capitol worth 1000$
The Collateralization ratio is 2:1 or less
or for deposited value of ETH of 1000$ our max loan is 1000/2 or 500$ in Dai.

Third, reinvest

We take our loan $500 in Dai, the stable coin and buy $500 worth of ETH or 5 ETH.

Fourth, deposit purchased ETH in CDP

We deposit additional capital in our CDP vault.
Now we have 1000 plus 500 or $1500 as 15 ETH in our vault.

Rinse and Repeat

Borrow

We have $1500 or 15 ETH
We can borrow up to 1500/2 or $750
We have a loan for $500
We can borrow $750-500 or $250, so we borrow $250 in Dai.

Reinvest

We take the $250 in Dai and buy ETH
We deposit this additional ETH in ourCDP vault
We now have 1500 plus 250 or $1750 dollars or 17.5 ETH
We now have $750 in outstanding CDP loan

Borrow

We can borrow 1750/2 or 875
We have 750 outstanding
We borrow 875-750 or $125 in Dai

Reinvest

We take the borrow 125 Dai and now buy $125 more of ETH or 1.25 ETH
We deposit this additional ETH into our CDP loan vault
We now have 1750 plus 125 or $1875 in our CDP loan vault
We have $875 in outstanding loans

Borrow

We now have $1875 in our vault
We can borrow 1875/2 or 937.5
We have $875 in outstanding loans
We can borrow $937.5-875 or $62.5
We borrow 62.5 Dai

Reinvest

We use the 62.5 Dai to buy $62.5 worth of ETH
We then deposit $62.5 worth of ETH in our CDP vault
We now have 1875 plus 62.5 or $1937.5 in out vault or 19.375 ETH
We have a CDP loan for $937.5

Borrow

We have $1937.75
We have a CDP loan for 937.5
We can borrow 1937.5/2 or $968.75
Now we can borrow 968.75-937.5 or $31.25 dollars,
We borrow 31.25 Dai

Reinvest

We have a CDP with $1937.75 dollars worth of ETH or 19.3775 ETH
We borrowed 31.25 Dai, and we buy $31.25 dollars worth of ETH.
We deposit this additional ETH into our CDP.
We now have $1937.75 plus $31.25 or $1969.00 or 19.69 ETH in our CDP.

Summary:

We started with $1000 in capitol and bought 10 ETH for $100 each or $1000.
We deposited it in a CDP and using the principles of fractional banking we learned from the Legacy Banking system, we increased our ETH holdings to 19.69 or $19,69 dollars in value with no additional capitol.
We have effectively doubled from 10 to 19.69 ETH and from 1000 to 1969 just using the CDP process.

Cautions/Risks:

Note we are borrowing at the near maximum collateralization ratio.
Our last deposit put us at a CDP of $968.75 and our maximum is 1969/2 or 989.5, so we are under the Collateralization cap of 2:1.

It should be assumed that this is high risk, but risk can be mitigated by vigilance. This isn't a set it and forget strategy.

Concerns

ETH dropping could put us above the 2:1 ratio and we would have to deposit additional monies or some of the ETH would be sold in our vault to pay down the CDP to a 2:1 ratio.

Monitor:

So we would monitor the price of ETH and know exactly what price it would have to drop to, to put our funds in danger.

We could also choose not to try and double, but borrow only 3:1 and our funds would still increase without additional capitol, but be less risky.

This strategy is good in a bull market, where the run up makes your capitol safe. If ETH doubled in value from 100o to 2000, your outstanding CDP would still only be the 968 Dai you borrowed, but your 19.69 ETH would be worth 19.69 x 2000 or over 38,000 and your Loan collateralization ration would be 38000/968 or 4:1, very safe.

What do you think?

I look forward to hearing from the bright minds here on Leofinance.
I hope I haven't made any math mistakes, but in general I think the math is sound, even if there are small errors.

I also think you understand from this how significant transaction fees are for DeFi to be used to it's fullest potential. High transaction fees on Ethereum based platforms like Makerdao for these transactions would severely reduce your ability to double your ETH and increase the risk of overshooting your 2:1 ratio.
But on the other hand, the low fees on Binance Smart Chain would make this quite doable.
@empoderat has first hand experience with Venus, so I am interested in his feedback.

Penned by my hand. @shortsegments

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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