Over the past few months, decentralized finance — best known as "DeFi" — has looked like Ethereum’s killer use case.
The amount of value locked in DeFi applications surpassed $1 billion earlier this year while smart contracts facilitating Ethereum-based finance saw a strong uptick in activity. Much of this growth had to do with the tantalizing high interest rates these protocols offer.
After injecting $2 million worth of liquidity into protocols Compound and dYdX, Coinbase branded DeFi "an essential part of an open financial system, [for it is] censorship-resistant, unbiased, programmable, and available to anyone with a smartphone."
Last week’s market crash has seemingly thrown a wrench in that narrative — with a 50% drop in the price of Ethereum throwing DeFi into disarray. There is no better illustration of this than MakerDAO, DeFi’s top protocol, which discussed an emergency shutdown as it struggled to handle ETH's rapid decline.
It's hard to talk about DeFi without mentioning MakerDAO — a DeFi protocol that allows users to get loans at algorithm-driven interest rates in the form of DAI, a stablecoin pegged to the value of $1. Loanees deposit ETH or Basic Attention Token worth more than 150% (at minimum) of the loan's value as collateral. If any Maker loan (these loans are also called CDPs) falls under the 150% collateralization threshold, it is liquidated, with the collateral auctioned off to keep the system stable.
The protocol has received so much attention that the crypto arm of Andreessen Horowitz, a legendary venture capital firm, invested $15 million into MKR, the governance token of the protocol, in 2018. This represented an acquisition of 6% of the total token supply at the time.
Yet despite the mandatory 150% collateralization of Maker loans of DAI, last week's market crisis quickly exposed holes in MakerDAO — holes that some analysts say may threaten the viability of DeFi.
What Happened to DeFi Last Week?
After hitting $9,200 on March 7, Bitcoin began a steep decline, in tandem with the S&P 500 and most other indices and assets, that ended with BTC hitting $3,800 as a result of high leverage on margin-enabled exchanges.
Unsurprisingly, altcoins followed Bitcoin down, and Ether was no exception. At the lows, ETH traded at $90 — 64% lower than the highs of the week prior to this move, per data from TradingView.
Due to the severity of the drop — ETH's worst daily price performance ever according to CoinMetrics' Nic Carter — MakerDAO found itself embroiled in crisis.
As can be seen in the chart above, once the value of Ethereum started to see extreme volatility, Maker loans were quick to be liquidated. (Note: Above is a chart of the liquidation of loans of Single Collateral Dai, which is a minority variant of the DAI stablecoin. There were millions more worth of loans of Multi Collateral Dai, the majority variant, also liquidated.)
Although liquidations of loans are normal, there was an issue: the loans were not liquidated in the manner defined in MakerDAO's whitepaper.
More specifically, owners of liquidated loan positions received none of their Ethereum back, according to first-hand accounts posted to MakerDAO's subreddit, despite the theoretical liquidation fee amounting to a purported 13%.
Analysis by decentralized finance data provider DefiPulse, which was echoed by Ethereum developer and proponent Marc Zeller, indicated that due to the simultaneous crash in ETH and a dramatic influx of transactions, the price oracles feeding data to the DeFi ecosystem crashed. As DeFiPulse wrote:
"The dramatic increase in gas prices caused Maker’s price feed oracle to remain stuck at ~$166 despite the market dipping almost 15% lower at times."
A combination of two things — 1) the deviation between ETH's value as interpreted by the oracles and the actual market price, and 2) the network congestion — resulted in liquidators of loans (known as "Keepers") failing to properly sell collateral, Zeller wrote.
For example, due to the network clog, one Keeper managed to bid zero DAI for a purported $4.5 million worth of liquidated ETH. This zero DAI bid — which normally would have been contested in the ten-minute auction timeout period — went uncontested due to other Keepers failing to get a bid registered on the blockchain.
This Keeper won the auctions, which allowed them to secure millions worth of Ethereum literally free, resulting in millions of undercollateralized DAI tokens.
Since the cluster of liquidations, MakerDAO has entered uncharted waters. Never has the protocol seen such a deficit, and never has the crypto market (at least in its current "mature" state) seen such a large amount of pain in such a short period of time. Also, the value of DAI, which is supposed to trend towards $1.00, has started to deviate dramatically, reaching levels as high as $1.20 on some exchanges.
At one point on March 12, the MakerDAO Foundation and holders of MKR considered shutting down the protocol entirely for a short period of time to mitigate further risk. A shutdown sees the freezing of new loans, the finalization of debt auctions, and the redemption of DAI at a fixed price.
Fortunately for DAI holders, the protocol was never shut down. Instead, Maker has been left to grapple with the undercollateralized DAI in a different manner.
Thus far, a series of measures have been enacted to restabilize the system.
To account for the shortage of DAI, MakerDAO will auction a TBD sum of newly-printed MKR, increasing the circulating supply of the currency, on Wednesday the 18th. (Note: the auction was later delayed to March 19). This sale should pay back the debt, though will hurt the holders of the cryptocurrency as they will suffer from a debasement. The exact details of the auction can be found in this explainer from crypto data firm Messari.
As it stands, per data from Daistats, there is a $5.3 million DAI shortfall, meaning the MKR auction on Wednesday will inflate the asset's supply by approximately 2.6%, assuming MKR's market cap holds around $205 million.
Industry participants, including fiat-to-DeFi onramp Dharma and crypto-asset fund Paradigm, have announced their intent to participate in the auction to seemingly support the value of MKR and, as a result, the rest of the Maker ecosystem.
To account for the deviation of the value of DAI from dollar parity — a simple byproduct of recent excess demand in relation to supply as investors seek "safe" and "stable" assets amid Bitcoin's recent volatility — the stability fee (effectively the interest rate of Maker loans) has been temporarily decreased to 7.5%, which should theoretically increase the supply of DAI because loans are cheaper.
As mentioned earlier, there is also the issue of loan holders losing 100% of their collateral. It isn't clear that attempts are being made to make some borrowers whole, though there is sentiment that liquidated loan holders receiving zero Ethereum back is a function of the free market, not an issue on the end of Maker's governance.
As this article was being written, Maker community members continued to discuss measures that will hopefully amend the existing instability. A thread has appeared on the project’s forums that is discussing whether the protocol should support centralized dollar stablecoin, USD Coin, as a collateral type to "help to create Dai liquidity and push the Dai peg back towards $1."
So far, the majority of community members are leaning towards the emergency inclusion of USDC, though the measure is not finalized, as technical upgrades would need to occur to ensure this change (should it be agreed on) takes place smoothly.
Considering that DAI continues to trade 5% above its $1 peg (as of the time of this article's writing according to CoinMarketCap), there remain concerns about Maker's stability due to the remaining debt. It is entirely feasible that the Foundation and MKR holders continue to try and find new ways to amend the ongoing situation while also mitigating future risk.
Not Ready to Go Mainstream
Although the health of the DeFi ecosystem has started to recover since last week’s carnage, the effects on the psyche of investors, especially DeFi users, have been lasting.
Tushar Jain, partner at crypto and blockchain-centric investment fund Multicoin Capital, expressed his fears in an extended Twitter thread, writing:
"The entire DeFi ecosystem almost died today. Several large market participants went bust. [...] If we just all need to accept that crypto can drop by 60%+ in a day that *severely* limits the usefulness of this tech."
His skepticism surrounding DeFi's potential in response to the crypto market's volatility has been echoed by others in the space.
Bitcoiners specifically have championed this unfortunate debacle as proof that these de-facto decentralized banks are anything but decentralized and have no place in the revolution in finance. Lightning Labs lead team member Alex Bosworth wrote:
"Selling high-risk "decentralized" schemes to retail consumers to paint the tape on adoption numbers? Outcome six months on: losses mounting, bailouts requested."
The bottom line is that DeFi may not be ready to go mainstream. As Jon Jordan, Communications Director at DAppRadar, mentioned to LongHash in an interview that took place two days after this crisis:
"I don't think anyone thinks the current generation of DeFi is ready to be deployed to the mainstream. In total, there are probably less than 10,000 people using DeFi protocols — just compare that to Binance."
But despite the fears of systemic risk and the sentiment that DeFi remains immature, it appears alive and kicking. According to data from DAppRadar on March 16, DeFi apps still make up almost all of the top ten Ethereum applications by transaction volume.