DAI is the fourth largest stable coin with $7 billion in market cap. I consider it to be the most innovative stable coin because it aims to be truly decentralised. There’s no company or single person who controls it. It’s trying to be decentralised like Ethereum or Bitcoin.
In this week’s deep-dive, we’re going to dig into how DAI works and the challenges ahead of it.
Stable coins are a critical primitive
Stable coins are critical for every DeFi use case in crypto.
The premise is simple — you want to avoid the price volatility of cryptocurrencies like Bitcoin or Ethereum. Stable coins are pegged to a currency like the US dollar.
Stable coins come in 3 forms. Fiat-backed stable coins have reserves for every unit issued. Users can always redeem $1 (or whatever currency the coin is denominated in) for 1 unit of the stable coin. The reserves are usually held in a bank and audited by a third party. USDT and USDC, the two largest stable coins in the world, use this approach.
Crypto-backed stable coins use crypto currencies as reserves instead of fiat. The goal is to achieve decentralisation and censorship resistance.
With fiat backed coins, a government could choose to seize your reserves because they’re held in a bank. This is not possible if your reserves are Bitcoin or Ethereum. On the flip side, crypto-backed stable coins are inefficient. They need to hold >$1 in reserve for every unit issued. This is because their underlying reserve (e.g. Ethereum) fluctuates in price. DAI is a crypto backed stablecoin.
Algorithmic stable coins aim to achieve parity with fiat currency using an algorithm. Terra / Luna, which collapsed earlier this year, was the best example of this — my deep-dive on the collapse is here. I’m not convinced that an algorithmic stable coin is sustainable. If buyers do not have assurance of a reserve, a trader with enough money can always bring down the coin.
The DAI model
MakerDAO is the DAO that operates and manages DAI, the stablecoin. It aims to be fully decentralised — decisions cannot be made unilaterally and reserves are held on-chain.
Members vote on all key decisions. MKR is the governance token for MakerDAO. An individual’s voting power is proportional to the amount of MKR token they hold.
There are two ways to get hold of DAI. First, you can go to an exchange like Coinbase and buy DAI. This does not increase the supply of DAI, you’re just buying DAI that someone else is willing sell.
Separately, you could choose to get DAI using cryptocurrency like ETH as collateral. To do this, you you deposit ETH in ‘vault’ and receive DAI in return (see here). This increases the total supply of DAI. Each vault has the following properties:
- Dust limit: the minimum DAI required to open a vault.
- Minimum collateral ratio: the minimum collateral required. If the price of your collateral falls and the ratio falls below this amount, your position will be liquidated.
- Stability fee: fees charges by DAI for operating the vault.
- Liquidation fee: fees charged if your position is liquidated.
Anyone who holds DAI can also earn interest by locking up their DAI in a smart contract. MakerDAO determines the interest rate, which needs to be greater than zero. The current interest rate for DAI on Coinbase is 0.92%.
MakerDAO’s P&L can be summarised as follows:
- MakerDAO earns revenue from liquidations and stability fees.
- It uses this revenue to pay anyone who stakes DAI an interest, for it’s operations (e.g. frontend website) and compensation to contributors.
Challenges of decentralisation
The goal of operating a fully decentralised stable coin is exciting, but comes with its own challenges.
MakerDAO needs to choose between decentralisation and price volatility. To remain decentralised in the purest sense, MakerDAO must hold only decentralised assets like Ethereum or Bitcoin. Due to the volatility in price, users need to over-collateralise. Over-collateralisation is inefficient for users and is subject to risks.
For example, in March 2020 when crypto tanked, DAI was almost finished (read this for full detail). ETH price collapsed by over 50% on March 12 and 13. The sudden drop also led to network congestion and very high gas prices. Recall that every position on DAI has a minimum collateral ratio. If the price falls enough, the position gets liquidated — this is exactly what happened.
A big learning from that experience was to diversify the MakerDAO reserve to include centralised and real-world assets, which were less volatile in price. Since then, MakerDAO has gone back and forth on the level of decentralisation it’s comfortable with. The graph below shows the distribution of MakerDAO’s reserves. The increase in exposure to stable coins and decrease in ETH reserves since January 2021 shows the fluctuation in the level of decentralisation.
A big moment in the MakerDAO’s history was the decision to lend $100 million to Huntingdon Valley Bank. The intention was to reduce exposure to cryptocurrencies and to centralised stable coins like USDC.
The debate on decentralisation was sent into a tailspin due to recent events. When the US banned Tornado Cash, a crypto mixer, USDC blocked withdrawals for any address that had interacted with Tornado.
There was a domino effect. DAI is the single largest holder of USDC. Any risk to USDC is a risk to DAI. In other words, this starts to feel “too” centralised.
The tradeoff between decentralisation and price volatility is an ongoing challenge. If you can agree on where to sit on this spectrum, it’s as good as it gets. But that is MakerDAO’s real challenge:
Making decentralised decisions effectively.
It’s not trivial to get the entire community to agree on the path forward. MakerDAO is now seeing fractions form within the community. The thread below does a great job of summarising the three fractions within the community:
- Futurists: believe in a grand vision where MakerDAO is broken up into subDAOs that are focussed on specific functions (see this).
- Centralists: willing to accept centralisation in light of practicality. They’re pushing for MakerDAO to hold real world assets as collateral.
- Decentralists: want zero centralisation. They do not believe that MakerDAO should hold any assets other than cryptocurrency.
The three groups need to reach some form of consensus on the path forward for MakerDAO. They aren’t there yet — futurists and decentralists are willing to sacrifice the peg to the dollar to retain decentralisation. Centralists question what the point of DAI is if it loses it’s peg and I tend to agree. Centralists on the other hand want to maintain the peg and are willing to forgo some mount of centralisation to achieve this. The next few months are going to be interesting for MakerDAO and I’m going to follow it closely.
Stable coins are a critical primitive for DeFi and other crypto use cases to scale. Decentralised stable coins like DAI are trying to achieve censorship resistance and price stability. There’s an ongoing tension between decentralisation and the efficiency of capital, due to over-collateralisation. The biggest challenge though is getting a group of people with diverse opinions to agree on a decision democratically. Getting this right requires expertise on org design, decision making and political theory. Let’s hope MakerDAO gets it right.