Disclaimer: This article will assume that you are reasonably familiar with stablecoins and the relationship between Maker and Dai. If you are looking for an introduction to what stablecoins are, please read more here. If you are looking for a quick recap of Dai, please reference this explainer video. For a deep dive on the project, read the full MakerDAO whitepaper here.
It’s no surprise that the Maker Foundation has been gaining significant attention for the substantial amount of Dai (currently over 87M and counting) being minted through new Collateralized Debt Positions (CDPs). As of February 25th, 2019, Maker’s Global CDP collateralization sits at 334% with an estimate of 2.1M of Pooled Ether (PETH) or ~2% of total circulating supply, currently being locked in escrow by Dai CDP owners. With 8,360 CDPs currently opened, the average CDP has just over 251 ETH collateralized, or $35,140 in USD (ETH @ $140).
The growth of the Maker system has been extremely interesting to watch over the past few months. Namely, Dai is one of the few stablecoins that maintains its peg without legal tender being used as the primary collateral source (think USDT, TUSD, USDC, GUSD). With this in mind, the governance decisions determining how to effectively maintain a 1:1 peg has become increasingly complex.
What’s the Issue?
From a high level, the average community member might have trouble understanding why there’s a “problem” with the current peg price. As community member Ben Sparango pointed out, CoinMarketCap currently lists Dai at a rate of $1.01 (slightly above the intended peg). Behind the curtain, numerous data sets have shown that CoinMarketCap is not a sufficient indicator for the actual price of Dai. As of the time of writing, it’s largely agreed that Dai is trading closer to $0.98 despite a recent increase of a 50 bps stability fee increase (setting the new stability fee rate at 1.5%).
For those readers unfamiliar with why a stablecoin actively trading its peg is a big deal, the long-term success of the MakerDAO is entirely reliant on Dai actively trading at an exact 1:1 peg. As such, a lower peg price directly correlates to mistrust in the project and adds additional sell pressure from current Dai holders speculating that the Maker Foundation is not able to effectively govern and regulate the target peg price of their stablecoin.
Before we dive into the governance debate, one of the most significant factors surrounding the conversation is identifying where demand for Dai is stemming from. In today’s governance call, it was made apparent that in order for the Debt Ceiling to be revisited, the DEMAND for Dai must reach the current level of $100M. It’s important to note as there is a large gap between the outstanding supply of Dai and the actual demand from CDP owners. For this reason, it was concluded that utilizing the debt ceiling to drive upward price action would not be sufficient for understanding how to stabilize the long-term peg.
How is Dai Being Used?
Generally speaking, users are opting to spend Dai somewhere in the larger cryptocurrency ecosystem within a week of creating the CDP. This goes against the traditional notion of stablecoins being held as a hedge against market volatility. This is important to note as one of the primary use cases for opening a CDP is to benefit from an abstracted version of margin trading. Once the user receives Dai, they can sell it on the open market for additional ETH or other digital assets in which they are long. In this instance, if the price of Ether increases, the user can sell a lower amount of their holdings for an equivalent amount of Dai and retrieve their CDP collateral by paying off the debt plus the stability fee (more on this later).
In addition to margin trading, decentralized finance (DeFi) platforms have begun offering intriguing opportunities for investors to earn risk-free interest on their holdings, namely through applications such as Compound Finance.Specifically, Compound offers Dai holders a fixed return (2.45% at the time of writing) for lending out their stablecoin through the platform. While 2.45% might not seem too attractive to the average crypto investor, back in December and January these interests rates were much higher, generally around 5–10%. With this in mind, the high risk-free return for investors through lending Dai was likely the driving factor in the surge of open CDPs within the Maker system back in January.
As a result of this arbitrage opportunity, a large amount of new Dai being created was effectively being removed from the open market and primarily being used as a floating-rate debt instrument rather than as the defacto stablecoin hedge that it was originally intended to be.
During the governance call on February 21st, the core team emphasized the importance of understanding Dai demand functions being critical for the success of the project. Although DeFi lending might not have been the intended function for Dai from the start, it’s critical that Maker understands and accounts for these use-cases when pricing stability fees to remain competitive.
Explaining the Stability Fee
The Maker system has multiple mechanisms implemented in order to balance the supply and demand for Dai currently for single collateral lending and in the future for multi-collateral lending opportunities. In the current single-collateral implementation, users who create a CDP are subject to a stability fee (currently 1.5%/year) which continuously accrues on the debt over time. When a user wishes to retrieve their collateral, they must pay down the debt in the CDP along with the stability fee. It’s important to note that stability fees can only be paid in MKR which is automatically burned in the process. In essence, the stability fee is used in order to disincentivize users from opening unnecessary CDPs due to a smaller opportunity for arbitrage.
While in theory increased stability fees *should* reduce unnecessary supply, there is little evidence on the exact effects of increases (and decreases) of the stability fee and residual effects to any adjustments. In the single-collateral Dai system, we have seen proposals for increases to the stability fee to range from 0.5% to 2.5% with new proposals discussed on a weekly basis. As of last week, the Maker community passed a vote to increase the stability fee by 0.5% from 1% to 1.5% due to high inventory levels and the persisting below $1 peg value of the Dai.
Despite the recent implementation, the Maker Foundation again concluded that the 50 bps increase had no real effect on increasing the price of Dai. Marker makers supported this claim by suggesting that their capital was not sufficient to close the entirety of the spread between DAI/USDC trading pairs on Coinbase with iceberg orders further proliferating this issue.
As a result, all signs indicate that the stability fee will now be increased by a minimum of around 100–200 bps (conservatively speaking) on a biweekly basis.
Higher Stability Fees
As explained above, it’s widely agreed that the outstanding supply of Dai does not correlate with outstanding demand. Due to the arbitrage and margin trading opportunities that exist at the height of a prolonged bear market, the Maker Foundation is undergoing an incredibly difficult experiment of trying to determine how much the stability fee needs to be increased to have a tangible effect on reducing unnecessary new CDPs from being opened. Furthermore, the current theory is that higher stability fees should disincentivize people to open CDPs due to smaller arbitrage opportunities.
Rune Christenson, the founder and CEO of MakerDAO, has continually noted that 0.5% stability fee increases have no noticeable effect rebalancing the peg. The governance calls continue to discuss how often stability fees should be adjusted (the current consensus landing around one governance poll followed by an executive poll every other week) and what the precedence for increasing the stability fee should be moving forward.
While Fitzner Blockchain realizes there are arguments to be made for and against adjusting the stability fee on such a short time period and who should be responsible for the ultimate decisions, for the sake of this article, we are going to move onto why this issue has become so controversial.
Who benefits from these decisions?
As described above, the stability fee affects the amount of interest accrued on CDPs over the course of a year. Once the CDP owner pays off the debt in full and closes the position, the stability fee is paid in MKR and automatically burned. Therefore when the stability fee increases, the scarcity for MKR tokens increases. Theoretically, as the platform continues to expand and the system transitions into multi-collateral Dai (MCD), this will result in the exponential growth of the price of MKR. With this in mind, it’s easy to see that MKR token holders may have a conflict of interest when voting on stability fee increases as they have an inherent incentive to always vote yes.
On the flip side of this mindset, the Maker Foundation is entirely responsible for ensuring that Dai holds its peg. After participating in multiple governance calls, it’s incredibly clear that increasing stability fees is not driven by greed in the slightest regard. Increased stability fees currently seem to be the only effective mechanism for allowing Dai to actively hold its peg as people will instinctively close their CDPs once they realize arbitrage loopholes are no longer as economically viable.
It’s clear that actors opening CDPs and actively using Dai (thus increasing the adoption of the project as a whole) will be upset from their respective losses that come with increased stability fees. Until more use-cases emerge where Dai is being used as base trading pairs across larger exchanges (think BTC/DAI, ETH/DAI, etc.) or integrated into more platforms such as Meridio, the only unique value for DAI over other stablecoins such as PAX or TUSD (for someone who isn’t long on MKR) is to continue to exploit arbitrage opportunities.
As of the time of writing this, it seems that MakerDAO is currently entering uncharted territories. To summarize the team’s sentiment, the true issue at hand is ensuring that demand is organic and relatively controlled. It’s clear that these are the early days of the project and as one community member pointed out, these changes are far easier to implement now relative to where the project hopes to be in 3–5 years.
The Maker system poses an entirely new economic model when it comes to the decentralized issuance of debt. Now that we’ve clearly seen there’s an interest in this model, the focus must now shift towards the long-term maintenance and stability of the project.
There’s no doubt that the Maker Foundation team has been regarded as one of the most innovative and experienced groups of individuals to enter the blockchain ecosystem. Unfortunately, the question now shifts to whether or not a DAO is truly effective in maintaining and acting on a desirable long-term vision of the project.
Many have pointed out that the current system surrounding MKR burns might not be synonymous with traditional dividends or buybacks which leads to an increasing conflict of interest as the system continues to grow. On the other hand, this system proposes an opportunity for every early actor to benefit from their support and understanding of MakerDAO’s value by acting as a keeper and participating in governance decisions as the platform scales.
While MakerDAO might be entering a period of turbulence, it’s safe to say that the discussions surrounding the short-term monetary policies have easily been some of the most exciting and promising discussion surrounding cryptocurrencies to date. We look forward to staying up to date with governance calls moving forward and to providing further reports on how the development of the MakerDAO evolves with time. For those interested in staying engaged with real-time updates, be on the lookout for renewed interest and activity on the Maker Governance subreddit.
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