Dai is now 60% backed by centralized assets, what does that mean?

Crypto Twitter has been buzzing about Maker’s collateral status for the past few days.

Some users pointed out that 40% of all Maker collateral is now IOUs – meaning that instead of digital commodities like ether (ETH), which are no one’s debt – they rely on a central custodian for compliance .

Some of the assets discussed that are growing in popularity are USDC ($387 million), WBTC ($162 million), TUSD ($50 million) and PAX ($31 million). These IOUs issued on ethereum represent either Bank of America’s U.S. dollars or Bitcoin in custody at BitGo.

However, this figure underestimates the seriousness of the situation. While centralized collateral makes up 40% of collateral, not all collateral has the same collateral ratio. The ratio determines how much Dai borrowers can receive per $1 of collateral. They need $150 in ETH or WBTC to generate 100 Dai, but they only need $101 in stablecoins to generate the same 100 Dai.

Therefore, 61% of Dai is backed by these centralized assets, and 52% of Dai is only from centralized stablecoins.

Snapshot: September 25, 2020, 21:00 UTC

Let’s start with the obvious: this development makes Dai’s support somewhat dependent on the actions of centralized actors. For example, Circle could freeze all USDC in Maker (rather than a single CDP2), in which case the system would print more MKR to make up the difference. In this post, we explain why allowing stablecoins still makes sense, and why it is almost certainly temporary in nature.

MakerDAO is a permissionless credit facility that allows users to generate the debt token DAI against various forms of collateral. It also manages this tokenized debt to be worth $1.00, a task that has proven difficult over the past few months.

Like other assets, the price of Dai is determined by supply and demand. When trading above $1.00, the demand to hold tokens (long Dai) is greater than the demand to create tokens from a CDP and sell tokens (short Dai).

There are two reasons for the surge in demand: one is the use of Dai in yield farming, and the other is the general need for stable assets during times of global economic uncertainty.

It’s this ongoing divergence from the peg that has forced Maker into a bind. At a high level, there are three mechanisms for stabilizing currencies:

1. Interest rate policy

2. Open market operations

3. Collateral Policy

We analyzed all three options in more detail in a previous article4.

The gist is that Maker has reached a limit imposed by itself when it comes to interest rate policy (they are not willing to drop interest rates below zero, which amounts to longs paying shorts). They are also reluctant to conduct any open market operations, presumably due to regulatory concerns.

So the only tool they have left is a collateral policy. In order to increase the supply of Dai, Maker must strike a balance between increasing the collateral for the security of the system and the collateral that users wish to borrow against. They are actively adding more forms of trustless collateral,

But prior to the recent growth of decentralized finance, there were already very few good collateral assets (LCR, COMP, and LINK5 are about to be added).

So, in the absence of faster due process and more trustless collateral types on Ethereum, the only way to satisfy the exploding demand for Dai is to allow centralized assets, especially stablecoins, into the system.

Their addition creates excellent arbitrage opportunities for traders. For example, you can make 100,000 Dai from 101,000 USDC because the collateral ratio is 101%. If Dai is trading at $1.02, you can sell 100,000 Dai for $102,000, an instant arbitrage cycle. (Su and I previously criticized its lack in a 2019 article6)

Here, not only did you immediately make $1,000 on the trade, but you also retained the option to buy back $101,000 of USDC in the CDP for a profit if Dai trades below $1.01. For example, when it’s trading at $1.00, you can pay $100,000 in Dai to buy back $101,000 in USDC for another $1,000 in profit7.

There are three main points:

1. This arbitrage alone explains the rise of stablecoins within Maker.

2. As long as the collateral ratio of the stablecoin is 101%, Dai will never exceed $1.01 again. As long as the price is above this level, arbitrageurs will mint more Dai and immediately sell it, causing the price to fall back.

3. When Dai returns to the peg, stablecoins will naturally disappear from the system.

This last point may require some analysis. When Dai returns to $1.00, arbitrageurs have a dual incentive to unwind their stablecoin positions. First, they still have a negative profitability due to the stability fee (currently 4%) charged to the stablecoin vault. Second, they should exercise the option to buy back the collateral with now cheaper Dai.

Dai can go back to $1.00 because the demand to hold it has dropped, and the supply will naturally follow. Remember, Dai is a tokenized debt, generated by CDPs. Therefore, when arbitrageurs close their positions, Dai is bound to be destroyed in the process. Alternatively, the demand to mint Dai could be increased, creating more natural supply to meet market demand.

1. Link to the original text:

https://twitter.com/ProficieNtOCE/status/1309082477005336580?s=20

3. coinmetrics.io：http://coinmetrics.io/

4. Previous article:

https://insights.deribit.com/%e5%b8%82%e5%9c%ba%e7%a0%94%e7%a9%b6/%e7%9b%b8%e6%9c%ba%e6%8a%89%e6%8b%a9%e8%b4%a7%e5%b8%81%e6%94%bf%e7%ad%96%e6%88%96%e5%b0%86%e5%9c%a8%e6%9c%aa%e6%9d%a5%e5%be%97%e5%88%b0%e6%99%ae%e5%8f%8a/?lang=zh-hans

5. LCR, COMP and LINK:

https://forum.makerdao.com/t/collateral-status-index/2231

6. An article from 2019:

https://medium.com/@hasufly/maker-dai-stable-but-not-scalable-3107ba730484

7. $1000 profit:

Additionally, liquidations of regulated stablecoins are currently halted. Their $1.00 value is basically hardcoded into oracle.