Cao Yin: How should Maker adjust its monetary and fiscal policies in the liquidity crisis?

In terms of monetary policy, interest rates and collateral ratios for USDC can be lowered to expand the variety of liquid collateral; fiscal policy can consider issuing "national debt."

Original Title: "Maker's Monetary Policy and Fiscal Policy Suggestions in the Liquidity Crisis"
Author: Cao Yin, Managing Director of the Digital Renaissance Foundation

Since the sharp drop in Ethereum prices on March 12, MakerDAO's DAI supply plummeted along with the ETH price, currently at 95,468,407 on March 25, a 64% decrease from the peak of 148,369,256 before the crash. The rapid decline in DAI supply resulted in the detachment of the 1:1 peg between DAI and the US dollar. Since the crash, DAI has maintained a premium, reaching a high premium of $1.1 at one point, currently around 1.03 in the market.

Image: Historical price fluctuations of DAI

Preserving DAI's peg to the US dollar is Maker's primary monetary policy goal. Therefore, in order to restore the peg, the Maker community swiftly implemented aggressive monetary policies. On the 14th and 16th, stable fees and DSR were reduced consecutively, lowering MCD stable fees from 8% to 0.5% and DSR from 8% to 0%. Additionally, the centralized USD stablecoin USDC was added as collateral but with a punitive stable fee rate of 20% and a collateral ratio of 125%. Maker hopes that this series of monetary policies will increase DAI supply, provide liquidity to the market, and restore the peg.

However, the results of these monetary policy operations have not been ideal, with ETH and BAT collateral in MCD still decreasing, and DAI supply continuing to decline. The USDC, which was expected to provide significant liquidity, only supplied 6,841,837 DAI, accounting for only 34% of the USDC debt ceiling, and arbitrage activities were not active.

Image: Changes in DAI market total supply

Currently, there is an imbalance in DAI supply and demand in the secondary lending market, with a high utilization rate of 74.85% for DAI on Compound, while the utilization rate of USDC on Compound is only around 14% during the same period.

In the current situation, if ETH experiences another sharp decline in the near future, the premium of DAI will skyrocket to unacceptable levels, leading to Vault liquidators being unable to purchase DAI from the market to repay debts. In the current market environment, extreme fluctuations in cryptocurrency assets along with the international capital market are highly probable.

Therefore, we want to explore why Maker's monetary policy is failing, and what measures can be taken to address the liquidity crisis of DAI in the current market environment, increase the market supply of DAI, re-establish DAI at a 1:1 peg, and provide experiences for other collateral stablecoin projects when the existing monetary policy fails.

In the fiat world, the "whip effect" of monetary policy has long plagued monetary policy makers at central banks. The so-called "whip effect" refers to the flexibility of monetary policy, where tightening monetary policy is effective during inflation, while expansionary monetary policy has limited effects during deflation. When implementing a tightening monetary policy by reducing money supply and loan issuance, the effect is immediately seen in controlling inflation. In China, severe inflation occurred in the 1980s, and the People's Bank of China implemented a tightening monetary policy, which quickly brought inflation under control.

However, during economic downturns and deflationary periods, monetary policy becomes ineffective. After the Asian financial crisis in 1997, China experienced deflation, and the central bank adopted an expansionary monetary policy, but the price index did not improve, and the economy did not recover. It wasn't until 2003 that the Chinese economy emerged from the cyclical deflation. While expansionary monetary policy can reduce the cost of money creation, when there is pessimism about future growth in society, social investments do not increase. Under the mechanism of debt creating money, the amount of money created will also decrease. In crisis situations, there may even be a situation where the central bank is injecting liquidity while market liquidity is disappearing, known as Keynes' liquidity trap.

Currently, DAI has shown the "whip effect" of monetary policy and is partially trapped in a liquidity trap. Under Maker's existing monetary policy framework, monetary policy has expanded to near its limits, with the stability fee close to 0 and the DSR at 0. However, the supply of DAI in the market has not increased, and even with the DSR at 0, around 23% of DAI remains in the DSR, leading to a persistent premium on the secondary market for DAI.

Additionally, during deflationary cycles, when debtors anticipate that the collateral prices will continue to decrease, they are more inclined to repay debts early, retrieve collateral, sell collateral, and hold cash. As the pandemic transforms into an economic and financial crisis, optimism in the cryptocurrency market following the halving quickly reverses. After the crash on March 12, many digital currency investors believe that the price of ETH will enter a highly volatile period and could continue to plummet at any time.

Under pessimistic expectations, Vault holders face dual liquidity pressures. First, with the decrease in ETH price, the asset-to-debt ratio relative to DAI increases, prompting early repayment to retrieve ETH. Second, if based on fiat currency, holders may choose to redeem and sell collateral, holding stablecoins. Therefore, whether Vault holders are crypto-based or fiat-based, redeeming collateral, closing the Vault, and holding ETH or stablecoins is a rational choice under deflationary pressure.

Maker urgently introduced USDC as collateral to provide additional liquidity during crises, maintain the peg of DAI to the US dollar, and facilitate Keeper participation in collateral auctions. Motivation for USDC holders to collateralize USDC and generate DAI comes from arbitrage opportunities.

However, under Maker's current USDC monetary policy, with a stability fee of 20% and a 125% collateral ratio threshold, the arbitrage window for USDC is very small. Assuming a DAI premium of $1.03 in the market and a 0.5% deposit interest rate for USDC on Compound, arbitrageurs would need to buy back USD-priced DAI within 56 days to profit. However, in the current malfunctioning Maker monetary policy environment with external turbulence, who can be confident that DAI will reach parity within 56 days?

If parity is not achieved within 56 days, USDC arbitrageurs will face losses due to the USDC stability fee. Moreover, with a 125% collateral ratio, the capital utilization rate for USDC participating in arbitrage is only 80%, further reducing the overall profitability of arbitrage.

Under such stringent arbitrage conditions, few arbitrageurs would be willing to engage in USDC/DAI arbitrage unless for public benefit. After all, in the digital currency market, there are many risk-free and frictionless arbitrage opportunities, so why take the risk of arbitraging DAI? If there are no USDC arbitrageurs participating, in a situation where the monetary policy has already malfunctioned, the "natural" generation of DAI through Vault collateralization is unable to create a significant amount of DAI for Maker and bring DAI back to parity with the US dollar. In this case, what is the significance of urgently introducing USDC as a crisis facility?

Maker is essentially a lending protocol without counterparties. Currently, apart from repaying Vault debts, there is no urgent need for DAI. The primary use of generating DAI by Vault users is for leveraged long positions in cryptocurrencies. However, compared to a year ago, borrowers now have more options, such as Compound, dydx, lendf, and various CeFi lending services.

Even considering only DeFi lending, Maker does not have a significant advantage over other mainstream DeFi lending services in terms of counterparty risk, loan variety, collateral ratio thresholds, and liquidation friendliness. Taking Lendf as an example, it accepts various collateral types including erc BTC, can borrow various stablecoins, has lower collateral ratio thresholds than Maker, uses a more user-friendly incremental liquidation system instead of full liquidation, and has lower liquidation penalties than Maker. Unfortunately, the Maker collateral auction event with collateral worth $0 after the crash on March 12 has harmed many loyal Maker users. Approximately one-third of Maker users suffered losses, and Maker did not propose a compensation plan, leading many users to turn away from Maker to other DeFi lending services.

These competitors have attracted many existing and new DAI users, which is also a significant reason why Maker's monetary policy has failed.

This stress test of Maker's monetary policy provides important insights for how collateral-backed stablecoins can better overcome liquidity crises in the future, benefiting Maker and other collateral-backed stablecoin projects.

• Instead of counter-cyclical operations, consider pro-cyclical liquidity injections

From the second half of last year to mid-February of this year in the digital currency business cycle, Maker's DAI debt balance increased rapidly. To avoid excessive debt expansion, the Maker community has been conducting counter-cyclical monetary policy operations by consistently raising Maker's stability fees and DSR during this period to control the total amount of DAI in the market.

Chart: Changes in Maker's stability fees and DSR

Perhaps Maker should have conducted pro-cyclical operations during the business cycle to maintain low stability fees and DSR. When Maker's overall balance sheet is healthy, utilizing the whip effect of monetary policy to significantly expand the total amount of DAI to new levels would create enough liquidity reserves for future downturn cycles. After the recent crash, Maker's overall collateral ratio remains high, indicating that Maker wasted significant monetary policy space during the business cycle.

In addition, unlike a bank's fractional reserve system, DAI is an over-collateralized system with a money multiplier less than 1, which means Maker's monetary policy effects are already discounted. Therefore, Maker should utilize expansionary monetary policy efficiently during the business cycle.

• Lower USDC interest rates and collateral ratios to provide risk-free arbitrage opportunities

Since Maker introduced USDC as emergency collateral, it should fully utilize USDC's liquidity tool functionality. The stability fee for USDC can be reduced to 0, the collateral ratio for USDC can be lowered to 100%, and the USDC DAI debt ceiling can still be maintained at $20 million. This operation can create risk-free arbitrage opportunities for arbitrageurs while maintaining the decentralization of DAI. In the shortest time possible, DAI can be brought back to parity with the US dollar, making DAI a stablecoin with a certain degree of expansion flexibility that can adjust supply according to market demand. By controlling the debt ceiling, the decentralization of DAI can be ensured without becoming a stablecoin endorsed by fiat stablecoins.

• Lower thresholds, expand liquidity collateral types

Appropriately lower the thresholds for liquidity collateral and increase the variety of liquidity collateral types. In fact, as long as the liquidation process is smooth, the risk of collateral liquidation lies with users, not with Maker. Users who borrow DAI against collateral assets should control their own risks, and Maker does not need to excessively manage risk on behalf of users.

• Adopting "Fiscal Policy" Measures

Currently, Maker only has monetary policy and lacks fiscal policy, making it inadequate in handling liquidity crises. Sovereign governments, when addressing economic crises, have various expansionary fiscal policy tools in addition to monetary policy tools, mainly various fiscal policies that increase government spending, stimulate total social demand, and inject liquidity directly into society.

Issuing "government bonds" is the most feasible "fiscal policy" for Maker. The specific approach is to expand MKR as collateral, maintain a 150% collateral ratio, offer lower or even 0 stability fees, provide a reasonable debt ceiling, then use the MKR held by the foundation as collateral to borrow DAI, sell it for arbitrage, until DAI returns to parity with the US dollar. When DAI is at parity or at a discount, the Maker Foundation can repurchase and burn DAI with the "government bonds" funds, similar to a government bond repurchase operation. Moreover, Maker's "government bond" policy can play a role in expectation management, stabilizing Vault holders' fears of DAI premiums, and injecting emergency liquidity into the market when liquidity disappears. Profits from arbitrage can be put into Maker's Surplus for MKR buybacks, benefiting the community.

The liquidity crisis faced by Maker also raises questions about the DeFi governance system. The author previously conducted a detailed study on Maker's governance, which is considered a model of decentralized governance in DeFi. However, this time, we found that many of the challenges Maker faces in a crisis stem from decentralized governance. We cannot help but ask whether a completely decentralized governance system is truly capable of operating a new type of currency. Are all democratic decisions truly correct? Are decisions that were correct at the time also correct in the future? Is there perfect compatibility between the "De" and "Fi" in DeFi projects? These questions are left for everyone to ponder.

This article is authorized by ChainNews for republication. Article source: ChainNews (ID: chainnewscom)

Further Reading

• 【Observation】What is MakerDAO Thinking by Using USDC as Collateral for DAI?

• Market Crash Tests DeFi Resilience, MakerDAO Encounters Bad Debt, High Liquidations on Various Platforms

Join Telegram now to get the most accurate blockchain news and cryptocurrency updates!