【Analysis】What is MakerDAO thinking by using USDC as collateral for DAI?

MakerDAO governance community is considering whether to include the stablecoin USDC as collateral in the system, to enhance market liquidity for its decentralized stablecoin DAI, and to enable more DAI liquidity to be injected into the decentralized finance (DeFi) ecosystem.

Open USDC as Collateral

During last Thursday's ETH price crash, the system incurred a financial deficit of approximately $4.5 million due to certain liquidators winning collateral liquidation auctions with a bid of 0 DAI. In simple terms, these auction winners did not provide enough funds to cover outstanding debt. As a result, the MakerDAO system will issue additional governance tokens MKR at the Wednesday auction to cover the total deficit of over $5 million.

To mitigate liquidity risks for DAI in the market, MakerDAO community members have decided to include the stablecoin USDC as an option for collateral. This also means that USDC will be the third collateral supported by MakerDAO, following ETH and BAT. Specifically, adding stablecoins as collateral assets can bring many benefits to market makers and the system.

Addressing Liquidity and Price Volatility Issues

Firstly, since the collateral is a stablecoin, its volatility and risk are relatively lower, resulting in a significantly lower liquidation ratio compared to the current supported collateral (ETH's collateralization ratio is 150%).Assuming a collateralization ratio of 100.5% for USDC as DAI collateral (meaning $100.5 worth of USDC can be exchanged for a maximum of 100 DAI), if a market maker holds $1 million worth of stablecoins in inventory and a customer wants to convert $100 million to DAI.

Under the current circumstances, converting $100 million to DAI would result in significant slippage issues. However, with USDC now allowed as collateral, the market maker can convert the full $100 million into USDC, add their own $1 million USDC as collateral in the system, and immediately generate 100 million DAI. In addition to solving liquidity issues, supporting stablecoins as collateral assets can create arbitrage opportunities for market makers, stabilizing the price of DAI at $1.

According to community members:

"Given the uncertain liquidity risks of DAI in the market, both the community and Maker Foundation members advocate for adding USDC as collateral to help alleviate this liquidity risk."

Another reason for supporting USDC as collateral is to facilitate smooth governance token or collateral auctions in the future. If auction participants purchase DAI from the market to participate in MKR auctions, it would drive up the premium of DAI and the participants' costs. According to data, if the price of ETH falls below $56 in the future, approximately $52 million worth of ETH collateral will be liquidated. In a situation where DAI liquidity is insufficient, it will reduce auction participants' willingness and cause DAI to deviate significantly from its pegged price of $1. However, if stablecoins can be directly used to exchange for DAI, it can prevent auctions from being unable to complete smoothly due to insufficient liquidity.

USDC Collateral Details

MKR holders completed the proposal vote on 3/17, and the proposal was quickly added to the protocol.

Details of the proposal, including stability fees, collateralization ratios, and debt ceilings for using USDC as collateral, are as follows:

The collateralization ratio is set at 125%, meaning that even though USDC is a stablecoin, 125 USDC can generate a maximum of 100 DAI, and the debt ceiling parameter is set at $20 million, indicating that the system can issue a maximum of 20 million DAI through USDC collateral. From these two parameter settings, it can be seen that the community members are initially adopting a more conservative approach.

In addition, the stability fee rate for using USDC as collateral is 20%, which means that you need to pay 20% interest annually to generate DAI by using USDC as collateral. This high parameter design is mainly intended to reduce the willingness of general users to collateralize USDC to mint DAI. In simple terms, the feature of "Open USDC as Collateral" is designed for market makers, liquidators, or arbitrageurs in the DAI ecosystem, and although general users can also use this feature, they will hardly benefit from it (you are essentially exchanging more money for less money and paying an annualized 20% interest).

Kevin Yedid, Managing Partner at Parafi Capital, commented on the latest update:

"Maker adding USDC as a new collateral option is significant as it can inject funds into the market at critical moments of turbulence and provide liquidity for DAI."

Community Backlash

As a decentralized stablecoin issuance project, using centralized stablecoins as reserve assets is bound to provoke community backlash. After all, the creation of DAI began with a lack of trust in centralized stablecoins, and now using assets with trust issues to back DAI, even if not 100% backed by centralized stablecoins, inevitably raises questions about whether this DAI violates its original vision.

Related Reading

• Market Crash Tests DeFi Resilience, MakerDAO Faces Defaults, Platforms Undergo High Liquidations
• Will DeFi Pass All Exams This Semester? Data Websites Summarize Recent Progress of Major Projects

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