Unconfirmed Ep.66 - Why Has MakerDAO’s Dai Struggled to Keep Its Dollar Peg?

Transcript

Hi everyone. Welcome to Unconfirmed, the podcast that reveals how the marquee names in crypto are reacting to the week's top headlines and gets the inside scoop on what they see on the horizon. I'm your host, Laura Shin. Last week I did a live podcast recording in front of an audience with Vitalik Buterin, the creator of Ethereum, for the first Unchained Live, sponsored by Coin Stamp. We had a technical mishap that prevented a live stream from appearing for 25 minutes. However, earlier this week we released the full video on YouTube and Facebook and the full audio on Unchained. If you missed them, I highly recommend you check them out since, in my opinion, the first 25 minutes was the best part.

Are you ready for global cryptocurrency money laundering regulations? CipherTrace secures the crypto economy with powerful AML tools for exchanges, crypto businesses, and regulators. Today's guests are Ryan Todd and Matteo Leibowitz, research analysts at The Block. Welcome Ryan and Matteo. Thank you. Thanks for having us, Laura. Thanks for having us, Laura. Let's start with Matteo. Dai, the stable coin of the Maker DAO system, recently lost its dollar peg. What value had the stable coin been trading at and why?

Sure. So, uh since about January of this year, Dai has been trading below its uh targeted dollar peg. Really, this is a factor of an imbalance between supply and demand in the system. There are the predominant reason uh there are actually two predominant reasons for this imbalance. The first is being uh the Sorry, the first is that as of January, the uh interest rate that the Maker system was charging for these Dai loans uh was incredibly low. It was set at 0.5% APR. Um so, anybody who wished to open a CDP could do so at a

very low cost. Uh, the second factor is that there was a change in sentiment in the crypto markets. So, the ETH market bottomed out in, uh, early December and is since up about, uh, 50 60%. So, there was a lot of demand to, uh, leave a long ether. And so, you had a lot of people opening these CDPs, uh, drawing DAI, and then selling DAI on the market in order to purchase ETH.

And unfortunately, there wasn't enough natural demand to satisfy this, um, glut in supply. And so, what What is the mechanism by which the price of DAI rises or falls? Uh, again, it's really just a factor of supply and demand. So, you need there to be enough demand in the market, enough natural demand in the market to counterbalance this this um you know, increasing supply that is continuing to come into the market. So, one way that the Maker system can try and adjust these supply and demand dynamics is through the stability fee.

And so, essentially, the stability fee is what people have to pay when they sort of like return the DAI. So, it's like if you're taking out a loan and you pay interest on that, that's kind of the cost of the time value of that money. Is that sort of how that works? Exactly. The stability fee is really just a synonym for an interest rate. So, in this case, it was very very low, and then what happened? Sure. So, the reason it was so low, actually, is because throughout 2018, as the price of ETH was falling, there wasn't sufficient demand.

There wasn't sufficient demand to open these CDPs and actually increase the total outstanding supply of die. So, Maker's stakeholders lowered the stability fee to uh 0.5% and that led to an increase in demand for for CDPs and an increase in uh outstanding die supply. So, once die started trading below this dollar peg, uh make Maker's stakeholders decided to the stability fee. So, on February 9th, they increased it from 0.5% to 1%. Then, on the 23rd of February, from 1% to 1.5% and then in March, uh so far there have been two further stability fee hikes. So, the

initial one was from uh 1.5% to 3.5% and then uh just last week, the uh stability fee was increased another 4% uh to 7.5%. And Ryan, can you explain who decides what the stability fee is? Sure. So, it's actually pretty interesting process. Um but it's it it involves uh people essentially getting on a on a phone call and uh walking through data that's not very robust yet since the system hasn't been around too long. But, talking over which factors would uh necessitate a need to bump the rates up.

Stability fee being the interest rate that you pay on these loans. So, currently the the governance process has I don't know, roughly 20 to 50 people on these calls at any given time. And these people can participate however they see fit. And that's that's currently how it's been set. Yeah, so I'd I'd Sorry, I was just going to add to that. So, so really you can um that there are almost four distinct steps to the governance process. So, as Ryan mentioned, you have this governance call which takes place every Thursday. Uh so, the next one will be at at uh noon Eastern Time today.

So, that on these governance calls, you have these various participants. The call is actually led by the Maker Foundation's risk management team. Then, uh you know, there's discussion and debate as to what the latest uh supply and demand dynamics are. And suggestions as to how uh the stability fee monetary policy monetary policy should be adjusted. Then, the conversation moves on to social media forums like Reddit. Uh after that, if uh there there is a decision uh kind of a rough consensus to adjust the stability fee, uh the process moves to polling, whereby uh MKR holders signal their intent as to whether the stability

fee should be uh adjusted or kept at the status quo. And then, if uh that proposal passes through the polling process, which is just a simple majority, it then moves to the executive vote, um which is a continuous voting process and the final vote in the system. Well, that is that is pretty complex um or at least, you know, it it it feels a kind of like cautious and inclusive, and yet I don't think that the process is very decentralized. Or or you tell me, how decentralized do you think the voting process is so far?

Uh that's very interesting. So, if you if you look at the uh voter turnout in the in the last couple votes, it might seem that uh you know, it's it's not particularly decentralized. You don't have too many participants involved. Uh so, for the March 9th executive vote, I think there were just uh 37 addresses out of uh over 9,600 MKR holding addresses have participated in the executive vote. And another factor to consider is that just one single address contributed 57% of uh stake in favor of the hike.

And then in the latest executive vote, there were just 58 addresses that participated, which uh comes to about 0.58% of uh total MKR holding addresses. So, clearly um you know, voter turnout is is pretty low, and um you would think that that the higher the voter turnout, the better. In some way, these kind of critiques are are fairly misguided. So, you should actually think of the voting process as more of a technical process than a decision-making process. The decision-making actually takes place on these governance calls, in these social media forums, and then voting is essentially just an an oracle uh for

this uh soft governance. So, the most important governance mechanism within the Maker DAO system is actually this uh emergency shutdown mechanism. So, the problem with voting is that you don't necessarily know whether, you know, people have voted have voted correctly or have voted in a way that benefits the system. So, you can have very, very high turnout, but could be that these voters are voting uh in a way that actually uh is to the detriment of uh the system's stability.

So, if you have this emergency shutdown, and you have a relatively low uh requirement to to trigger this emergency shutdown, all you really need is for there to be enough kind of honest actors available to trigger emergency shutdown, and then the the the system should uh ultimately be okay. We're going to keep talking about the governance of Maker DAO, but first a quick word from our fabulous sponsors. Ready or not, the Financial Action Task Force anti-money laundering recommendations soon go into effect globally. If you handle cryptocurrencies, no matter where you do business, these new AML laws will apply to you. CipherTrace helps exchanges, ICOs, funds, brokerages, and regulators

understand and manage crypto asset and compliance risks. Learn how to reduce your exposure and prepare now for tough new regulations. CipherTrace is securing the crypto economy. Learn more at cyphertrace.com/unconfirmed. Back to my conversation with Ryan and Matteo of The Block. So, Matteo, just I want to understand something you said that you feel like even though participation is below 1% that it's still decentralized because of the emergency shutdown function. So, what why is that so important and why is that you seem to imply that you think that that's the key to decentralization?

So, it's a, uh, just to clarify, I I don't think, you know, having this emergency shutdown mechanism necessarily means that, uh, voting today has taken place in a decentralized fashion. I just think that emphasis should be kind of taken off the voting process itself, just because, as I mentioned already, voting is more of a technical process than a decision-making itself. So, uh, it's it's not actually, uh, a hugely significant event within within the the Maker DAO system.

So, yeah. So, the idea of the emergency shutdown is that emergency shutdown can be triggered, and anyone holding DAI can be made whole. Uh, so, as long as the system is over-collateralized at the time, so there's more collateral than there is outstanding debt. Anybody holding die can be will be given at least $1 worth of ether. And at this moment, how much weight do the Maker Foundation and A16Z have? Sure. So, I think the Maker Foundation has roughly 20% of MKR MKR tokens. I I I might be incorrect, but I I think that's

roughly correct. A16Z has about 15%, but should definitely note that they haven't kind of set up the technical support that would allow them to participate in governance just yet. So, they haven't participated in in the voting process. Obviously, if you if you look at voter turnout today, with their 15% of supply, they they should be able to carry any vote in in the direction that they would like, but they are yet to come online, as it were. And Ryan, what do you think is the importance of Maker in the overall Ethereum ecosystem? As we know, there's I think 2% of all ether is locked up in

in Maker CDPs, and and it seems to be central to the DeFi movement. So, where how do you see its significance in the overall system? Absolutely. You know, Maker I wrote a piece on this actually recently, but Maker is systematically important to DeFi. It's It's proven what DeFi is capable of. You know, DeFi doesn't take off without Maker. I don't know if I made I lost count of the various explorers. DeFi Pulse is the one that came out that we really like. But Maker has roughly $300 million worth of collateral posted within the protocol.

And you know, that's that's roughly 90% of the USD value uh locked within DeFi. And that's across DEXs, money platforms, and other use cases. So, yeah, it is systematically important to DFI. And if the dollar or sorry, if the peg is not staying at a dollar, then how does that affect the whole system? That's kind of interesting when you think about it. Yes, it hasn't stayed exactly at a dollar, uh but when you look at the standard deviation or the variability to the dollar, it's actually pretty tight.

Uh the last by last count that we ran, I think the standard deviation was roughly maybe a penny, penny and a quarter. Um over the past year. And obviously that outperforms any other crypto asset, even even other stablecoins, centralized or not, um let alone G7 currencies and then and FX rates. So, while the peg has broken down, I mean, it's done its job. It's it's It's held It's held relatively steady.

And during that time Ether was falling in price. So, in that respect you would expect that actually there would be kind of more pressure on the system and and that would be a true test of of its performance. And it So, how do you feel it has performed during that time? Well, results speak for themselves. The peg's held relatively, again, steady. Uh I mean, but but just to be clear, there there was a time at least when it did drop as low as 94 cents, which you know, it's not it's not like huge, but but also it does indicate that, you know, it's not it's not always staying very close to a dollar, either.

Right, that's fair. And I actually I think the more interesting question is what's going to happen if ETH was to run back up to 1,200. Currently there's a a smaller demand to lever long ETH in an environment that's more bearish. And it's already seen upwards of 90 million dollars worth of outstanding originations. Obviously, that's come in now that they've bumped rates up to 7.5, which is another interesting trend to follow. Um Yeah, I I was just going to add to that. So, if anything, I think it was uh easier for for Dai to maintain its peg during uh the the bear market, um you know, the market of 2018, just because there was always this looming threat of CDP liquidation.

And so, you you had a lot of uh natural buy demand from CDP holders for Dai so that they could either uh wipe their debt or or close uh their CDPs entirely. As As Rune said, now we're starting to see the ETH market recover slightly, and um you can actually do kind of a uh simple sensitivity analysis for CDP holders, and kind of work out what kind of stability fee would be necessary considering uh future ETH/USD price appreciation, expected price appreciation.

And the numbers are actually kind of staggering. So, you know, if you expect ETH to appreciate 10% within a week, and even if you're selling Dai at a 5% discount, uh you would actually need um you know, a a 100 over 100% uh annual stability fee uh to to make opening a CDP uh unprofitable. So, it's going to be it's going to be very very difficult to to stem demand for CDPs in the next bull market. It's going to be really fascinating to see how the system holds up.

Interesting. Well, the one thing is uh as I was grilling Vitalik about when I interviewed him, Ethereum faces some headwinds, and uh so it's not clear how well ether will do in price going forward. But one other thing that's happening kind of in the Maker DAO environment is that multi-collateral Dai is on the horizon. So, how could that affect Maker's quest to keep the value of Dai at a dollar? That's very interesting. Really, it just increases complexity, the the complexity of the system by an order of magnitude.

It means that you have to set risk parameters on a per collateral basis. So, that is, you know, the collateralization ratio that's necessary for for using these assets as collateral. You have to determine what the liquidation penalty should be, uh what the debt ceiling should be for that particular kind of collateral as well. So, you're going to need uh a lot more eyes on the Maker system from a risk management perspective. And in all likelihood, we're we're we're probably going to see these stability fee adjustments increase in frequency. So, most likely on uh to to a weekly basis.

Um and and today I think, you know, since Maker launched, we've only actually seen six adjustments in the stability fee. So, that that will make a huge difference. Yeah, one other thing I wanted to ask about was there's kind of a lag between when the stability fee goes into effect and when they might see uh an effect on the price. So, even if you start increasing the frequency, then it's does it kind of muddy your uh ability to understand the the results? Well, another thing to add here, too, actually, Ron Klink, is you can't forget the interplay between other protocols and even custodial lenders that are offering rates on these assets.

You know, some of these can change rates, offer rates dynamically in real time, um which definitely throws a wrinkle in the process of setting rates every week through or on a bi-weekly basis through the governance process. All right. Well, I guess we will see how Well, all plays out. Um well, it's been great having you both on the show. Thanks for coming on Unconfirmed. Thanks Laura. Thanks, Laura. It's a pleasure. Thanks so much for joining us today. To learn more about the topics we discussed, be sure to check out the links in the show notes of your podcast player. If you haven't yet signed up for my weekly newsletter, be sure to do so at unchainedpodcast.com.

New episodes of Unconfirmed come out every Friday. If you haven't already, rate, review, and subscribe on Apple Podcasts. If you liked this episode, share it with your friends on Facebook, Twitter, or LinkedIn. Unconfirmed is produced by me, Laura Shin, with help from Railing Gallopoli, Fractional Recording, Jenny Johnson, and Daniel Nuss. Thanks for listening.