【LongHash Column】The Collapse of MakerDAO is Shaking the DeFi Ecosystem

Less than two months since the crash of "Black Thursday" on March 12, the prices of Bitcoin and Ether have rebounded significantly. However, decentralized finance—or "DeFi"—presents a different picture, still suffering from the aftermath of the crash.

This recent crash has particularly exposed the vulnerability of MakerDAO and its stablecoin DAI, while also highlighting MakerDAO's significant influence in the DeFi economy. Defipulse.com indicates that 54% of assets in DeFi applications are locked in MakerDAO, and its stablecoin DAI is integrated into almost every existing DeFi application.

Deep Dive into the "Black Thursday" Collapse of DAI

Due to the high market volatility, there was a surge in demand for stablecoins during the market crash from March 12th to 13th. Stablecoins are cryptocurrencies pegged to stable assets like the US dollar. Consequently, stablecoins experienced significant premiums. In particular, the market price of DAI skyrocketed, threatening the health of the DeFi ecosystem.

According to data on TradingView.com on March 12th, USDT reached $1.05 on Kraken, while PAX reached $1.02 on Bittrex. Faced with plummeting prices, investors sought ways to preserve their wealth, even though the premium on stablecoins implied capital losses.

However, no premium on any US dollar stablecoin could compare to that of DAI. DAI is a decentralized stablecoin not backed by cash reserves, and its value is controlled by the MakerDAO DeFi protocol.

As shown in the chart below, on the day of the market crash, the price of the DAI/USDC trading pair on Coinbase Pro reached $1.06 — 6% higher than the usual 1:1 ratio — with a significant increase in buyer volume. A Ethereum data scientist cited data from Coinbase in a report that the price of this pair briefly touched $1.12 during the day.

On Kraken, the price of DAI reached $1.10. This trend was even more striking on decentralized exchanges with limited liquidity, where DAI's trading price exceeded $1.12. According to observations, DAI had a 22% premium on decentralized exchanges on the crash day.

Data from CoinGecko also supports this, with their data showing that DAI briefly touched $1.20 on March 12th, indicating that the trading price of DAI on some exchanges exceeded $1.20.

Similar to USDC, USDT, and other stablecoins, investors viewed DAI as a hedge against the cryptocurrency market crash. However, another reason for the increased demand for this stablecoin was that investors needed DAI to close loans created through MakerDAO — also known as Collateralized Debt Positions (CDPs)/Vault.

CDPs are decentralized loans that require the debtor to deposit ETH and other tokens worth 150% more than the loan amount (125% for USDC), and the system issues DAI equivalent to the requested amount. If the collateral value falls below 150% of the loan amount, the system starts liquidating the collateral assets, destroying them. Theoretically, this liquidation process would cause CDP holders to incur a 13% loss on the deposited tokens.

As previously reported, on March 12th, with the historic drop in ETH price, CDPs entered the automatic liquidation process. According to posts on MakerDAO's Reddit community and first-hand accounts, some owners of liquidated loans were unable to recover any ETH.

It should be noted that the liquidation process of CDPs theoretically consumes about 13% of the collateral assets, not 100%. The issue of zero return on CDP collateral is a combination of two factors — 1) the deviation between the ETH price provided by oracles and the actual market price, and 2) network congestion. These two factors led to liquidators (known as "Keepers" on MakerDAO) failing to correctly sell off collateral assets.

As many DeFi users lost millions of dollars, CDP holders at risk of liquidation rushed to exchanges. They did so to purchase DAI for closing positions, even at a high premium. Compared to losing all collateral assets, being able to recover 83% (assuming DAI was trading at $1.20 at the time) was an obvious choice.

The increased demand for DAI, coupled with the decrease in its circulation on the market, had an impact on its price. The decrease in circulation was due to investors seeking refuge in stablecoins amidst the volatility of BTC and ETH.

Continued Premium Presence

As shown in the chart above, even after the initial turmoil subsided, the premium for DAI against the US dollar remained between 1% and 4% for seven weeks following the crash.

This persistent premium led Cyrus Younessi, a member of the MakerDAO risk team, to comment on May 1st, stating, "Dai is too high," echoing a sentiment similar to Elon Musk's previous comments on Tesla's stock price.

The ongoing premium indicates that there continues to be more demand for DAI than supply. While many would welcome an excess demand for assets like Bitcoin, as it would push up their trading price, an excessive demand for stablecoins poses risks. The fundamental premise of stablecoins is that their trading price should be pegged close to a fixed price, ideally around $1.00.

Compared to USDC, USDT, or other centralized stablecoins, a premium is more dangerous for decentralized DAI. Centralized stablecoins are more likely to maintain a price close to $1 due to arbitrage opportunities where individuals can deposit fiat to obtain new stablecoins, then sell them at a premium in the market to reduce the premium. However, in the case of DAI, the entry barrier for arbitrageurs is higher due to the requirement for collateral assets.

Since DAI is not backed by USD reserves, its volatility is higher than stablecoins with reserves. However, it is risky for DAI's price to remain above $1 for an extended period. As a cornerstone of the DeFi economy, anything unfavorable to DAI poses a threat to the entire DeFi ecosystem.

Imagine a new user wanting to buy a DeFi-based stablecoin — would they choose to buy nearly $1 equivalent of USDT or the currently premium-priced DAI? They are more likely to choose USDT, as buying a stablecoin at a price higher than the fixed exchange rate implies potential losses due to a premium decline.

Although MakerDAO decision-makers — holders of the cryptocurrency Maker MKR — have taken emergency actions by reducing the stability fee on CDP collateral to 0% to stimulate the growth of stablecoin supply to meet market demand, the premium has not disappeared.

Returning to the $1 Anchor Price

Given the precarious nature of the premium issue, MKR (governance token) holders have begun discussing ways to bring DAI's price back to $1.

Currently, discussions on correcting DAI's price are ongoing on the MakerDAO forum, led by Parafi Capital, a blockchain-focused decentralized finance fund. They initiated this debate.

One of the partners at Parafi wrote that with the stability fee effectively reduced to 0%, "Given the current rates, MKR holders have effectively no other effective monetary policy levers to increase DAI supply." They proposed three solutions to reduce the premium:

The first solution is to try to introduce new collateral asset types in the MakerDAO system, allowing users to pay CDP collateral with cryptocurrencies other than ETH, BAT, and USDC. This should stimulate additional demand for CDPs, increase DAI liquidity, and then lower the price. Parafi Capital especially supports Chainlink's LINK.

The second solution proposed by the fund is that MKR holders have the ability to reduce the stability fee on ETH and USDC to 0%. Although Parafi warned that this alone "might not be sufficient" to increase liquidity.

The final solution is to create a new type of CDP that can drive demand, enabling users of DeFi applications like Compound and dYdX to create CDPs that generate "millions of DAI in value."

On May 2nd, Matt Luongo, founder of the crypto startup Thesis, proposed adding tBTC as a collateral asset type for MakerDAO. tBTC is a tokenized version of BTC on Ethereum, almost entirely decentralized, potentially serving as a fast on-ramp for many BTC holders into DeFi. Similar to the LINK proposal, Luongo and his supporters believe that adding tBTC as a new collateral asset will bring additional liquidity to MakerDAO.

There have also been discussions proposing negative interest rates on DAI, which ironically mimic the monetary policies implemented by many central banks for their national currencies. JP Koning, a columnist for CoinDesk, wrote on April 20th, "In theory, the next step to reduce DAI's premium is to lower DAI's interest rate to negative values."

Senior crypto researcher "Hasu" concurred, proposing that adjusting DAI's price is as simple as lowering the stability fee, and if necessary, even setting the interest rate to negative values. This analyst even suggested that if the stability fee were negative, there might not be a need to introduce new collateral asset types to fix DAI's price.

Currently, implementing negative rates faces technical limitations since the decentralized nature of private keys prevents the immediate removal of someone's DAI holdings.

Implementing Solutions

Since Parafi released the post on the DAI premium issue, the governance group of MakerDAO has taken some actions.

On May 2nd, MakerDAO began supporting WBTC — tokenized BTC custodied on Ethereum. Additionally, according to a tweet from "Maker DAI Bot," the protocol also reduced the stability fee on CDPs collateralized with USDC to 0%.

So far, these solutions have seen some success, with crypto investor Spencer Noon stating that the number of MakerDAO CDPs has returned to the levels before "Black Thursday," and the DAI market has begun to regain liquidity. Data from Daistats.com also indicates that users have started generating DAI with WBTC, with the DeFi protocol locking in 39 tokens.

DAI's Continued Collapse Threatens DeFi

Although MKR holders are strategizing to restore DAI's price, some of the strategies may backfire.

Adam Cochran, a partner at MetaCartel Ventures, a community fund investing in Ethereum DeFi applications, summarized his thoughts on DAI in a tweet. He believes that the ongoing addition of more collateral asset types to MakerDAO is playing with fire.

"Peercoin, NXT, Mastercoin, Quark, Megacoin, Primecoin, and Feathercoin were all considered top projects in 2014. Looking back now, they are all worthless. What happens if one of these assets becomes the asset supporting your digital dollar?"

His point is that the more assets DAI requires to maintain a peg to $1, the higher the likelihood of DAI's eventual collapse. Cochran likens the basket of cryptocurrencies supporting DAI to the "2008 collapse of junk bonds," where the risk of assets added to a basket of junk bonds increased, leading to a market collapse.

It makes sense: the more cryptocurrencies a DeFi protocol supports, the wider the impact. If DAI is supported by ten cryptocurrencies (each accounting for 10%), the collapse of one asset could easily disrupt the MakerDAO system, pushing DAI's price away from its peg.

A prominent DeFi commentator known as "@DegenSpartan" added that based on MakerDAO's current trajectory — adding USDC and WBTC — this decentralized stablecoin is becoming more centralized, which contradicts the essence of decentralized finance. USDC and WBTC are both produced by centralized authorities and can be frozen by issuers.

Declining Popularity of Maker in DeFi Users

Considering the recent issues surrounding DAI, this cryptocurrency and its associated protocol MakerDAO seem unprepared for their golden age. Yes, the crash of ETH and its subsequent impact is not the fault of this protocol, but commentators have pointed out the protocol's sluggish response during crisis moments.

The aforementioned commentator "@DegenSpartan" commented:

"The persistent premium on DAI and Maker's inability to expand supply to meet demand is a big issue that is causing them to lose a lot of users."

Ryan Berchmans, a senior engineer at Augur, a derivative market on Ethereum, also concurred with this view. This DeFi engineer commented on April 29th that after spending "20 hours researching Maker's response during and after Black Thursday," he decided not to use the protocol and mentioned DAI's premium as a clear signal of "trust betrayed" by MakerDAO.

Parafi Capital confirmed this sentiment, stating that they have heard that the premium issue has actually caused some businesses and individuals to stop using DeFi, or at least to stop using DAI and MakerDAO. In their post on the premium status, the venture capital firm wrote:

"Our research leads us to believe that the lack of stability and liquidity is transforming into uncertainty about using DAI as a decentralized stablecoin in many DeFi protocols. We have heard of a few DeFi teams expressing disappointment in DAI's lack of liquidity and stability, with some opting to use USDC as an alternative."

The loss of MakerDAO users exacerbates the stability of DAI's value, as its ability to anchor to the dollar depends on its liquidity.

Demand for Competitors of MakerDAO

However, there may still be a glimmer of hope: the premium issue with DAI could spur competition in the DeFi space. If members of the Ethereum community indeed lose trust in MakerDAO, this could be a good opportunity for other platforms to enter the market, creating competition that ultimately improves the entire DeFi sector.

So far, MakerDAO's leading position in decentralized stablecoins and lending is almost undisputed in the Ethereum community — DAI is the only decentralized stablecoin in the top 100 cryptocurrencies. While the market is always changing, there has yet to be a solid project that can replicate Maker's unique model of issuing stablecoins through decentralized loans.

The Block reported on May 4th about the emergence of a new stablecoin protocol on Ethereum called Liquity. According to the project's website (which states the project is "coming soon"), Liquity and its stablecoin LQTY promise to differentiate from MakerDAO in the following ways:

1. Loans will always remain interest-free, unlike MakerDAO's CDPs,