Why I care about decentralized Finance?
I have been researching Decentralized Finance and the MakerDao Credit Facility because I want to understand why the MakerDao is doing close to 2 billion dollars in transactions per month in the first quarter of 2020, a multiple of over 10 times the volume of previous quarters. If you are interested understand what these entities are, how they work, and in reading definitions of their terms in plain language you should read the rest of this post.
When I first started reading about Decentralized Finance I didn’t understand why it was important, and more importantly I couldn’t learn much about it from reading the articles written on it because I didn’t understand any of the terms.
Decentralized Finance terms and concepts
This area of finance is new, it’s where finance and technology meet, a space called Fin-Tech and this space is filled with what I call Techno-babble. When a baby first starts to talk it makes sounds or noises that it thinks are words, but to everyone else it’s just noise. We call those noises babble. The purpose of this post is to hopefully change that noise into words, so you can understand Decentralized Finance.
First let’s look at common economic terms. When people purchase things they pay cash or credit. Cash is fiat or currency like Dollars, Euros, Yen. Credit is of course the use of credit cards and for larger purchases you get a loan. The loans have terms which include length and a fee for borrowing money called interest. There can also be fees or charges for making the loan called origination fees or loan fees. The loans like car loans or home loans are made by a bank. A bank provides you credit in the form of credit card use, which is a loan, specifically an unsecured loan. A bank is essentially a Credit Facility , it provides Credit which allows commerce, buying goods like cars and homes, plus consumer goods. The bank makes money by loaning money and charging fees.
Security or Collateral
A bank provides you “credit” in the form of credit card use, which is an unsecured loan. A credit card is secured by your “promise to pay” but not secured or backed up by any asset.
This is different from a secured loan like your car or home loan. Your car loan or home loan is secured by the car or the home. The car or loan are the “security” the bank needs to make the loan. You promise to give them the car or home, if you can’t pay back the money you borrowed to buy the car or loan. The other word for security is collateral.
A Contract
The loan is a contract between you and the bank. The bank agrees to loan you money, you agree to pay it back, you agree to provide security to the bank for this loan by agreeing that the bank can seize and sell your home or car if you can’t pay the loan back.
Security, secure loan or collateralized loan
In the above paragraph the home or car is called security, so the loan is called a secure loan. The home or car is also called collateral, so the loan is also called collateralized. The loan you get from the bank is also called a debt.
Let's look at what we have reviewed so far.
So far we have defined the terms credit, credit facility, loan, security, collateral, secured loan and collateralized loan come from. And now you know what they mean.
Stability Fees & Collateralized Debt Products
Let’s take this process a few steps forward and explain stability fees and collateralized debt products.
A car factory makes cars, a bakery makes bread and a bank makes loans.
In other words the the product of the car company is cars, the product of the bakery is bread and the product of a bank is loans.
We have learned above that a bank makes secured and unsecured loans.
We also learned that the loan is secured when it is backed by a promise to turn over the car, home or other asset to the bank if the borrower of the loan can’t pay the loan. We also learned that asset which secured the loan through the loan contract is also called collateral.
We also learned that the loan secured by collateral is referred to as a secured loan, but also as a collateralized loan.
CDP
Now take a deep breathe.
First, remember above when we said a loan you have for your house or car was called a debt?
Yes it’s a contract which says you owe money to the bank every month until you pay back the money you borrowed to buy the car or house.
It’s called a Debt.
Remember above when we said the product of a bakery was bread and the product of a bank was loans?
Well now you understand loans are considered secured, and secured loans are also called collateralized loans.
Well let’s put all that together:
Bakeries make Bread. Bread is the product of Bakeries.
Banks make loans.
Loans are a product of Banks.
Loans can be called Debt.
Loans can be called Debt Products.
Loans are secured or Collateralized.
Now lets combine all three terms by which loans can be called into one term.
Loans can be called Collateralized Loan Products.
Now lets abbreviate the words collateralized, debt and product by the first letter of the word.
Collateralized Debt Products are called CDPs.
Congratulations to those who read this far.
You now have been introduced to loans, contracts, debts, security, collateral, products, loan products, debt products, secure loans, collateralized loans, collateralized debts and finally collateralized debt products or CDPs. If your brain works like mine, now that the derivation of the term has been explained you understand and your ready to learn more.
Loan to Value Ratio, Collateralization Ratio and Liquidation
Loan to Value or LTV
Traditionally, a bank doesn’t loan you $10,000 USD on a new car selling for $10,000.
They only loan you a percentage of what the car is selling for and you pay the rest.
For example the bank rules may state that the highest amount they can give you is 80% of the purchase price or 80% of the value of the car.
When the bank loans you 80% of the cars value, the bank uses a term called loan to value, which means the percentage of the car's value the loan represents.
And in this case the loan to value is 80%.
So the loan to value is often abbreviated by the first letter of the words as LTV
Collateralization Ratio
Collateralization Ratio
Decentralized finance was created by young people, and all parents know that young people like to invent new terms to describe old things 😊 Ha Ha
We learned above that In decentralized finance their are no banks, but there are Credit Debt Facilities.
These credit facilities make loans called CDPs or collateralized debt products.
In this world of new words, they don’t use the words loan to value ratio, but instead they use something called a Collateralization Ratio.
Additionally, in collateralization rations you don't put the loan on top and the value on the bottom in the formula, instead you do the opposite.
In a loan to value ratio you create a fraction with the loan value on top (numerator) and asset value on bottom. (Denominator).
In a collateralization ratio the value of the asset is on top, and the loan is on the bottom.
The top is a the value of the asset in fiat, like dollars and the bottom is the value of the loan.
Note: unlike a loan to value ratio, which is always less than one, in a collateralization ration the value is always greater than one.
For example in the MakerDao it’s the collateralization ration must be greater than 1.5, this is in contrast to the loan to value ratio we talked about above, which was 80%. This fraction commonly referred to as a percentage and currently it is usually 150%.
So this means the value of your collateral in a Collateralized Debt Product must be 150% of your loan.
For Example:
So if your loan is for $100 your collateral must be worth $150. That’s a 150% collateralization ratio. Next we shall tackle liquidation.
Liquidation
Liquidation
The final thing we need to understand in decentralized finance is called liquidation.
Now as we saw above, in the collateralization ratio of decentralized finance, the credit debt facility like the MakerDao or in the future Just on Tron, loaned you around $ 100.00 on an asset worth $150.00 and the collateralization ration was 150/100 or 1.5.
You have a contract or loan, called a collateralized debt product in decentralized finance, which is different from the usual loan contract, which normally states the bank can seize your asset and sell it. But in decentralized finance you have an account containing cryptocurrency, which is the collateral for the collateralized debt product and the credit debt facility can sell off your coins if the collateralization ration falls below 1.5, but only enough coins to pay off your loan or CDP, plus any penalties. The rest is left in your account your loan amount back to the 1.5 level. if the collateralization ration falls below 1.5.
[Source] (https://community-development.makerdao.com/makerdao-scd-faqs/scd-faqs/liquidation)
https://community-development.makerdao.com/makerdao-scd-faqs/scd-faqs/liquidation
The derivation of the term Liquidity, or where does the term liquidity come from?
The bank loaned you cash. Cash has a property called liquidity; which means amongst other things you can buy anything with it. Your asset like your cryptocurrency is valuable, but it isn’t liquid. You can’t take your cryptocurrency to the store to buy food and you can’t send your landlord cryptocurrency to pay your rent. (Maybe in the future)
So now you know the terms and how they were derived.
Equality of access
The decentralized finance platform credit debt facility doesn’t care about your race, religion, sex or country of origin. There are no financial qualifications other than having cryptocurrency. This is permission-less, as in you don’t need anyone’s permission to do this. It is also trust-less by design as the smart contract locks up your cryptocurrency when you enter the agreement and releases your cryptocurrency when you repay the loan.
This is why I am excited about decentralized finance, so we need to learn how to use it to our advantage.
✍️written by Shortsegments.