Understanding Core DeFi Primitives, Collateralized Debt Positions, and Oracle Risks

When I first saw a friend’s phone buzzing with alerts about a “decentralised loan” going into liquidation, I felt a flash of that old corporate anxiety—was this a scam, or was it a new kind of risk we didn’t yet understand? That moment is the kind of slice of life that turns a cold, abstract idea into something people can feel.

Let’s zoom out a bit. The world of decentralised finance, or DeFi, is built on a handful of primitives that look simple on paper but, in practice, create a network of interlocking risks. The three we’ll explore today are: the basic building blocks of DeFi, collateralised debt positions (CDPs), and the oracles that keep them afloat. By the end, I hope you’ll have a clearer picture of how these pieces fit together—and a practical way to keep your own crypto portfolio from getting caught in a sudden liquidation.

DeFi Primitives: The “If‑You‑Build‑It” Ingredients

When I was a portfolio manager, every investment had a “why” and a “how.” In DeFi, the primitives are the “how.” They’re the simple, reusable contracts that developers stitch together to create everything from lending protocols to synthetic assets. Think of them as the modular parts of a kitchen: cabinets, countertops, and appliances. If you understand the parts, you can start imagining the whole.

• Smart contracts – The heart of any DeFi protocol. They are self‑executing agreements written in code that run on a blockchain. Once deployed, they cannot be changed unless they have an upgrade mechanism.

• Tokens – Units of value that can represent anything from a share in a DAO to a stablecoin pegged to the U.S. dollar.

• Governance – The process by which token holders vote on changes to the protocol. This is where decentralisation can become messy if a single holder accumulates too much voting power.

• Oracles – External data feeds that let smart contracts read prices or other off‑chain information. Without oracles, a contract could not know the value of collateral or the price of a token.

• Collateralised debt positions – The mechanism that lets users lock up assets to borrow another. This is where the rubber meets the road.

When you piece those primitives together, you get the building blocks of a whole ecosystem: lending platforms, insurance pools, and even prediction markets. Each block has its own risks, and that’s where the story becomes interesting.

Collateralised Debt Positions (CDPs): The “Borrow from a Friend” Analogy

A CDP is essentially a loan secured by an over‑collateralised asset. Imagine you go to a friend and say, “I’ll give you my guitar, and you’ll give me a dollar.” Your friend would want a safety net in case the dollar is suddenly worth less than your guitar’s worth. In the DeFi world, the safety net is a high collateralisation ratio.

How a CDP Works in Practice

1. Deposit collateral – You lock up a certain amount of a token (say ETH) in a smart contract. The contract records the amount and the time of the deposit.

2. Borrow – You draw a certain amount of a stablecoin or other token against that collateral. The protocol sets a collateralisation ratio (for example, 150 %). This means you can only borrow up to 2/3 of the collateral’s value if the price of ETH is stable.

3. Maintain – As the market moves, your collateral value changes. If the price of ETH drops, your collateralisation ratio falls. The protocol will send a margin call or automatically liquidate your collateral once the ratio falls below a threshold.

4. Repay – You can pay back the debt (plus any interest) and withdraw your collateral.

The elegance is that the entire process is automated. There’s no need to call a broker or check a bank statement. But automation is a double‑edge sword. If the price data is wrong, the contract will act on that wrong data.

Real‑World Example: MakerDAO

MakerDAO is the classic example. Users lock up ETH or other approved assets and generate DAI, a stablecoin pegged to the U.S. dollar. The protocol imposes a minimum collateralisation ratio (currently around 150 %). When the ratio falls, the system triggers a liquidation process that sells the collateral to cover the debt.

In 2020, MakerDAO faced a serious risk when a front‑end attacker fed a faulty price feed into the system, temporarily lowering the price of ETH in the oracle. The protocol liquidated a huge amount of collateral, and the attacker profited from the price discrepancy. The incident highlighted that the oracle is a single point of failure.

What Makes CDPs Risky?

• Price volatility – If your collateral is a volatile asset (like ETH or BTC), a sudden price drop can trigger liquidation even if you’re not at fault.

• Interest rates – Some protocols adjust interest rates dynamically. A spike can push the debt cost beyond what you can handle.

• Gas fees – Executing a liquidation requires a transaction fee. In congested networks, that fee can be a large fraction of the value being liquidated.

• Oracle slippage – If the price feed is delayed or manipulated, you might be liquidated on a price that is not reflective of the real market.

Knowing these risks is the first step in mitigating them. Let’s talk about the oracle, because it sits at the heart of the whole operation.

Oracles: The Eyes of the Contract

An oracle is a service that delivers real‑world data to a blockchain. Think of it like a trusted journalist: the contract asks for a piece of information, and the oracle replies. In DeFi, the most common data is price. A simple price oracle might ask: “What’s the price of ETH in USD?” The answer comes from a market aggregator.

Types of Oracles

In practice, many protocols use a combination. MakerDAO, for instance, relies on a set of oracle nodes that feed price data into a time‑weighted average price (TWAP) calculation.

The 2020 MakerDAO Oracle Attack

To recap, the attack involved a user sending a fake price feed that temporarily dropped ETH’s price to $700. The MakerDAO smart contract, trusting that feed, liquidated the user’s collateral. The attacker then bought the liquidated ETH at a discounted price and sold it back at the true market price, pocketing the difference.

This incident was a wake‑up call: if the oracle is compromised, the whole protocol can be hurt. It’s not just about CDPs; it affects swaps, yield farming, and any protocol that relies on price feeds.

Flash Loan Attacks and Oracles

Flash loans allow you to borrow a large amount of capital for a single transaction, with no collateral, provided you repay it within the same block. Attackers have used flash loans to manipulate oracles: by temporarily pushing the price of a token down, they trigger liquidations, then buy the discounted collateral. After the transaction, they restore the price, and the oracle is left with a corrupted snapshot.

These attacks show that oracles must not only provide accurate data but also be resilient to manipulation.

Mitigating Oracle Risks: Practical Steps

1. Use Multiple Oracles
   If a protocol aggregates data from several independent sources, the attack surface is lower. Even if one oracle is compromised, the final price is still anchored by the others. Think of it like getting two independent news reports before making a decision.

2. Time‑Weighted Average Prices (TWAP)
   Instead of relying on a single price point, calculate an average over a period (e.g., 24 hours). This dampens the effect of a sudden price spike or dip. MakerDAO uses TWAP to mitigate flash loan attacks.

3. Set Conservative Collateralisation Ratios
   If you’re borrowing against a volatile asset, keep a higher buffer. A 200 % collateralisation ratio is safer than 150 % during turbulent markets. Remember: it’s less about timing, more about time.

4. Monitor Liquidation Thresholds
   Many protocols allow you to see the exact collateralisation ratio in real time. Keep an eye on the “red line” before it hits the liquidation point. Some wallets even send alerts when you’re close to the margin call.

5. Diversify Collateral
   Don’t put all your eggs in one basket. Some protocols allow multi‑asset collateral, which can help balance out volatility.

6. Use On‑Chain Oracles Where Possible
   On‑chain oracles like those built on Uniswap or SushiSwap use liquidity pools as price feeds. While they can be manipulated by large trades, they’re immune to off‑chain manipulation.

7. Stay Informed About Protocol Governance
   If a protocol’s governance decides to lower the collateralisation ratio or change the oracle sources, you need to know. Governance updates can happen quickly, and the impact can be profound.

A Human Perspective: How to Keep Your Portfolio Calm

I’ve seen people get rattled when their position gets liquidated. The panic is understandable: a drop in the market feels personal. But the same fear can push you to make hasty decisions—like dumping all your holdings in a panic. That’s where a steady, grounded approach matters.

• Start with the basics – Understand exactly what you’re borrowing, against which collateral, and at what ratio.

• Set up notifications – Use a service that alerts you when your collateralisation ratio hits 110 % of the minimum. That gives you a cushion.

• Think about your “what if” scenarios – If the price of your collateral drops by 20 %, will you still be above the liquidation threshold? If not, prepare a plan: reduce the debt, add more collateral, or switch to a less volatile asset.

• Avoid emotional reactions – Markets will swing. It’s the same as a storm; you’re not the weather. You can decide to ride it out or change course, but you can’t control the storm.

• Keep a buffer – If you’re borrowing a large amount, consider putting an extra 10 % or 20 % of your collateral in reserve. That’s a safety net for unforeseen price dips.

The Bottom Line: What You Can Do Right Now

1. Audit your CDPs – Check each position’s collateralisation ratio, the oracle sources, and the interest rate. Make a list of any that are close to the liquidation line.

2. Check the protocol’s governance status – Is there a recent proposal that might lower collateralisation ratios or change oracle feeds? If so, act.

3. Consider diversifying – If all your borrowed tokens are backed by a single asset, spread the risk across multiple collaterals.

4. Stay updated on oracle news – Follow the protocol’s community channels. Oracles can be updated or patched without you noticing.

5. Prepare an exit strategy – Decide in advance what you’ll do if the market starts to move against you: will you repay, add collateral, or close the position?

By keeping an eye on these points, you’ll have a clearer sense of when a CDP is healthy and when it’s at risk. And you’ll be less likely to be caught off guard by a sudden price feed glitch.

In the end, DeFi is a tool, not a toy. If you treat it like any other investment—understand the mechanics, keep a safety buffer, and avoid knee‑jerk reactions—you’ll use it to build real, sustainable financial freedom. Remember, it’s less about timing, more about time. And the markets test patience before rewarding it. So take a breath, check those ratios, and let the rest roll on the blockchain like it always does.