Less than two months after March 12's "Black Thursday" price crash, both Bitcoin and Ethereum have largely recovered. The same is not true for decentralized finance — better known as "DeFi" — which is still suffering from the effects of the crash.
The crash particularly highlighted the vulnerability of MakerDAO and its stablecoin, DAI, as well as MakerDao’s outsized importance in the DeFi economy. Defipulse.com indicates that 54% of the value in DeFi applications is locked in MakerDAO, and the DAI stablecoin is integrated into almost every DeFi application in existence.
The Anatomy of DAI's "Black Thursday" Crash
Due to volatile market conditions, the March 12-13 crypto market crash saw demand for stablecoins — cryptocurrencies tied to a "stable" asset such as the U.S. dollar — experience a sharp rise. As a result, stablecoins traded well above their pegs. DAI, especially, saw a surge in market prices, something that threatens the health of the DeFi ecosystem.
According to data from TradingView.com from March 12, the value of Tether's USDT rose as high as $1.05 on Kraken and Paxos Dollar (PAX) hit $1.02 on Bittrex. Because cryptocurrencies were falling so fast, investors were taking measures to secure their wealth, even if that meant paying a premium that would result in capital loss.
But no dollar-stablecoin deviated as much from the value of $1.00 as DAI. DAI is a decentralized stablecoin that isn't backed by cash reserves, but whose value is controlled by DeFi protocol MakerDAO.
As can be seen in the chart below, the day the crash transpired, the DAI/USDC trading pair on Coinbase Pro hit $1.06 — 6% above the one-to-one ratio that is normally seen — while buy-side volume spiked. On an intra-day perspective, the trading pair briefly touched $1.12, according to a report from an Ethereum data scientist citing Coinbase data.
On Kraken, DAI hit $1.10. The trend was even more dramatic on decentralized exchanges, which lack the liquidity of centralized exchanges, with the value of DAI trading much higher than $1.12. I personally observed DAI trade on a decentralized exchange at a 22% premium on the day of the crash.
This can be corroborated by data from CoinGecko, which indicates that the aggregate value (price weighted by volume) of DAI briefly hit $1.20 on March 12, meaning that on some exchanges the cryptocurrency was trading above $1.20 during that day.
As with USDC, USDT, and other stablecoins, investors were buying DAI as a hedge against downside in the crypto market. But the stablecoin also saw an influx of demand for another reason: investors needed DAI to close their loans created through MakerDAO, also called collateralized debt positions (CDPs) or vaults.
CDPs are decentralized loans that require the debtor to deposit Ethereum and other tokens worth more than 150% (or 125% if your loan is backed by USDC) of the loan size, to which the system loans out the amount of DAI requested by the user. If the collateral value falls below 150% of the loan size, a process begins that liquidates the collateral for DAI, which is subsequently burned by the system. This liquidation process theoretically costs the holder of a CDP 13% of the deposited tokens.
As LongHash previously reported, on March 12 CDPs started to automatically liquidate as Ethereum fell at a record clip. The problem is that some owners of liquidated loan positions received none of their Ethereum back, according tofirst-hand accounts posted to MakerDAO's subreddit.
Again, the CDP liquidation process is supposed to cost approximately 13% of the collateral, not 100%. The 0% return in CDP collateral was a shortcoming caused by a combination of two things — 1) the deviation between ETH's value as interpreted by the oracles and the actual market price, and 2) network congestion. This resulted in liquidators of loans (known as "Keepers") failing to properly sell collateral.
As many DeFi users lost millions of dollars worth of their holdings, the CDP holders that were on the brink of being liquidated rushed to exchanges. They did so to purchase DAI to close their CDPs, despite the high premiums. Getting 83% (assuming DAI was then trading at $1.20) of their collateral back, as opposed to 0%, was the obvious choice.
The effect that this increase in DAI demand had on prices was compounded by a decrease in the amount of the cryptocurrency on the market, caused by investors wanting to hold onto their stablecoins as Bitcoin and Ethereum were especially volatile.
The Premium Has Persisted
Even though this initial shock has passed, DAI has been trading at a premium of around 1% to 4% over the dollar in the seven weeks since the crash, as indicated in the chart presented earlier.
The premium has been so noticeable that Cyrus Younessi, a part of the risk team at MakerDAO, commented the "Dai price is too high imo" on May 1, referencing a comment made by Elon Musk regarding the stock of Tesla.
The consistent premium suggests that there is still a shortage of DAI’s supply relative to the demand for the cryptocurrency. Many would welcome excessive demand for an asset like Bitcoin, as that would mean the coin would trade higher, but for stablecoins, too much demand is dangerous. Their entire premise is to trade very close to a fixed price, meaning there should be parity between stablecoin supply and demand at $1.00.
A premium is more dangerous for the decentralized DAI than it is for USDC, USDT, or other centralized stablecoins. Centralized stablecoins more easily trend towards $1.00 because they can be minted by arbitrageurs who can deposit dollars, receive stablecoins, then sell them on the market for a premium, driving down the premium. With DAI, there is a higher barrier to entry for arbitrageurs because of collateralization requirements.
As DAI has no dollar reserve to back it, it is inherently more volatile than reserve-backed stablecoins. Yet DAI trading well above $1.00 for long periods of time can be dangerous. And as DAI is the cornerstone of the DeFi economy, what’s bad for DAI is bad for DeFi as a whole.
Think of it this way: is a new user looking to purchase a DeFi-enabled stablecoin going to purchase USDT, which barely deviates from a dollar, or DAI, which is currently at a premium? Most likely, they would choose USDT, as purchasing a stablecoin above its peg means there is almost a certainty your investment will lose value due to the premium decaying.
The persistence of the premium comes in spite of emergency efforts from holders of the cryptocurrency Maker (MKR), who make decisions for MakerDAO, to spur growth in the supply of the stablecoin to match demand by dropping the stability fee of CDP collateral types towards 0%.
Returning to the $1.00 Peg
With the peg still in jeopardy, holders of the MKR governance token have begun to discuss methods to push DAI back towards the $1.00 peg.
Discussion about fixing the peg is currently taking place on MakerDAO's forums, with Parafi Capital, a blockchain fund focusing on decentralized finance, leading the debate.
Parafi's partners wrote that with the stability fee effectively at 0%, "MKR holders have no more effective monetary policy levers to increase DAI supply given where rates stand."
They proposed three solutions to combat the premium:
First, the expedition of the addition of new collateral types to the MakerDAO system, which will allow users to fund their CDPs using other cryptocurrencies than just Ethereum, Basic Attention Token, and USD Coin. This should spur additional demand for CDPs, increasing the liquidity of DAI, thus dropping prices. Parafi Capital specifically supported Chainlink's LINK.
Second, the fund suggested that MKR holders have the ability to lower the stability of fees of Ethereum and USDC to 0%. Though, Parafi cautioned that this "alone may not be effective enough" to drive liquidity.
Lastly, the creation of a new CDP type was proposed that could drive demand to open CDPs valued at a "few million DAI" by users of DeFi applications such as Compound and dYdX.
More recently, on May 2, Matt Luongo — founder of crypto startup Thesis — proposed the addition of tBTC as a collateral type for MakerDAO. tBTC is a tokenized version of Bitcoin on Ethereum that is almost entirely decentralized, and as a result, it may act as an on-ramp for many BTC holders into the DeFi space. Like with the proposed addition of LINK, Luongo and his proponents believe that this will bring additional collateral to MakerDAO.
There's also been a discussion of a negative interest rate for DAI, which ironically is similar to what many central banks are imposing on their respective fiat currencies. JP Koning, a columnist for CoinDesk, wrote on April 20 that "in theory, the next step [to reduce DAI's premium] would be to reduce interest rates into the negative territory."
Prominent crypto researcher "Hasu" echoed this sentiment, writing that fixing DAI's peg issues is as simple as lowering the stability fee, the interest rate, even below zero "if necessary." The analyst even suggested that a negative stability fee would make adding new collateral types not mandatory to fix peg issues.
As it stands though, there are technological limitations to the addition of negative rates, as you cannot currently take DAI away from someone because of the decentralized nature of private keys.
Since Parafi's post on the jeopardized peg, MakerDAO governance has sprung into action to implement solutions.
On May 2, MakerDAO started to support Wrapped Bitcoin (WBTC) — a tokenized representation of custodied Bitcoin on Ethereum. Also, the protocol dropped the CDP stability fee for USDC deposits to 0%, according to a tweet from "Maker DAI Bot."
These solutions have seen some success thus far, with cryptocurrency investor Spencer Noon noting that the number of MakerDAO CDPs has "returned to pre-Black Friday levels," while liquidity is starting to return to the DAI markets. Data from Daistats.com also indicates that users have started to mint DAI with WBTC, locking 39 coins into the DeFi protocol.
Ongoing DAI Debacle Threatens DeFi
Although holders of MKR are deploying strategies to fix DAI, some of these may backfire.
In a Twitter thread outlining his thoughts on DAI, Adam Cochran, a partner at MetaCartel Ventures, a community fund investing in Ethereum DeFi apps, said that the ongoing move to add more collateral types to MakerDAO is just playing with fire.
"Peercoin, NXT, Mastercoin, Quark, Megacoin, Primecoin, and Feathercoin were all considered top brass projects in 2014. But, now, in hindsight, [they're worthless.] How would you feel about any of those coins being the backer for your digital dollar?"
His point is that the more coins MakerDAO needs to support to maintain a DAI peg, the more likely it is that the cryptocurrency will eventually fail. Cochran likened the basket of cryptocurrencies backing DAI to the "junk bond crash of 2008," which was catalyzed by the introduction of increasingly riskier assets into the basket of junk bonds.
This makes sense: the more cryptocurrencies a DeFi protocol supports, the bigger the attack surface is. Hypothetically, if DAI was backed by ten cryptocurrencies at 10% each, the collapse of one asset could easily send the MakerDAO system into disarray, forcing DAI off the peg.
One popular DeFi commentator with the handle "@DegenSpartan" added that with the current track MakerDAO is on, adding USDC and WBTC, the decentralized stablecoin is starting to become centralized, which is obviously antithetical to decentralized finance. USDC and WBTC are minted by a central authority, and can also be frozen by that same authority.
Maker's Popularity Wanes Among DeFi Users
With the recent issues surrounding DAI, it looks like the cryptocurrency and the protocol affiliated with it, MakerDAO, are not truly ready for primetime. Yes, Ethereum's crash and the subsequent effects were not the fault of the protocol, but commentators have said that the protocol has been slow to act.
The aforementioned commentator "@DegenSpartan" remarked:
"The persistent DAI off peg and the inability of the Maker system to scale up supply to meet demand is a really big problem that is causing them to lose a lot of users."
Ryan Berckmans, a senior engineer of Ethereum-based derivatives market Augur, shared this view. The DeFi engineer opined on April 29 that after "spending 20 hours studying Maker's response during and after Black Thursday," he will not use the protocol, citing the DAI premium as a clear sign "Maker [has] eroded" the public trust.
Parafi Capital corroborated the sentiment that the issues with the peg are actually causing firms and individuals they know to stop using DeFi, or at least DAI and MakerDAO. On the subject the venture capital firm wrote in its aforementioned post on the state of the peg:
"We believe this lack of stability and liquidity is translating into uncertainty around using DAI as a decentralized stablecoin in many DeFi protocols. Anecdotally, we have heard a handful of DeFi teams express frustration over DAI’s lack of liquidity/stability, with some opting to use USDC instead."
MakerDAO losing users further places the stability of DAI's value in jeopardy as the dollar peg is predicated on liquidity.
The Need for a MakerDAO Competitor
But there may be a silver lining: DAI's issues with the dollar peg could promote competition in the DeFi space. If members of the Ethereum community are truly losing faith in s MakerDAO it could be a good time for another platform to enter this market, creating competitors that will end up strengthening DeFi as a whole.
Thus far, MakerDAO's primacy in the decentralized stablecoin and loan space has been largely unquestioned — DAI is the only decentralized stablecoin in the top 100 cryptocurrencies. Its unique model of minting a stablecoin through a decentralized loan has yet to be copied by an entrenched project, though this is changing.
The Block reported on May 4 of the creation of a new stablecoin protocol on Ethereum named Liquity. According to the project's website, which indicates it is "coming soon," Liquity and its stablecoin LQTY promises to differ from MakerDAO in a number of ways:
1. Loans will always be zero interest, much unlike MakerDAO's CDPs, whose interest rate reached upwards of 19.5% at times
2. Borrowers of LQTY will only need to maintain a collateral ratio of 110%
3. There is no governance in Liquity; all monetary policy decisions are achieved through "protocol incentives and algorithmically adjusted redemption and loan issuance fees (0% by default)"
4. Thus, a governance token will be replaced by an incentive token
It is unclear if the Liquity team can live up to its promises, but it’s unlikely to be the only new player entering the space. Given DAI’s recent issues and the resulting disappointment among Ethereum users, it is clear that the DeFi market is ripe for competition.