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In the past few days, Crypto Twitter has been discussing Maker’s collateral status.
Some users pointed out that 40% of all Maker’s collateral now is IOU – which means replacing digital goods like Ethereum (ETH), which is not a debt of anyone – they rely on the compliance of the central custodian .
Some of the assets discussed are gaining popularity. They are USDC ($387 million), WBTC ($162 million), TUSD ($50 million) and PAX ($31 million). These IOUs issued on Ethereum either represent U.S. dollars in U.S. dollars or represent Bitcoin hosted by BitGo.
Snapshot: September 25, 2020, 21:00 UTC
However, this figure underestimates the severity of the situation. Although centralized collateral accounts for 40% of collateral, not all collaterals have the same collateral ratio. The ratio determines how much money Dai borrowers can get for every dollar of collateral. They need 150 USD of ETH or WBTC to generate 100 Dai, but they only need 101 USD stablecoin to generate the same 100 Dai.
Therefore, 61% of Dai is backed by these centralized assets, and 52% of Dai comes only from centralized stablecoins.
Snapshot: September 25, 2020, 21:00 UTC
Let’s start with the obvious: This development makes Dai’s support to a certain extent dependent on the actions of centralized actors. For example, Circle can freeze all USDC in Maker (instead of a single CDP2), in which case the system will print more MKR to make up the difference. In this article, we will explain why allowing stablecoins still makes sense, and why it is almost certainly temporary in nature.
MakerDAO is a permissionless credit tool that allows users to generate debt tokens DAI based on various forms of collateral. It also manages this tokenized debt to make it worth $1.00, a task that has proven difficult in the past few months.
Source: coinmetrics.io3, 7-day moving average
Like other assets, the price of Dai is determined by the relationship between supply and demand. When the transaction price exceeds $1.00, the demand for holding tokens (long Dai) is greater than the demand for creating tokens from CDP and selling tokens (short Dai).
There are two reasons for the surge in demand: one is the use of Dai in income farming, and the other is the general demand for stable assets in a period of global economic uncertainty.
It is this continued disagreement with pegging the exchange rate that has forced Maker into trouble. From a high level, there are three mechanisms for stabilizing currencies:
1. Interest rate policy
2. Open market operations
3. Collateral policy
We analyzed all three options in more detail in the previous article 4.
The point is that in terms of interest rate policy, Maker has reached the limit imposed by it (they are unwilling to drop interest rates below zero, which is equivalent to paying longs to shorts). They are also unwilling to conduct any open market operations, presumably out of regulatory considerations.
Therefore, their only remaining tool is the collateral policy. In order to increase the supply of Dai, Maker must strike a balance between increasing the collateral for system security and the collateral users want to borrow. They are actively adding more forms of trustless collateral,
But before the recent growth of decentralized finance, there were few high-quality collateral assets (LCR, COMP and LINK5 will be added soon).
Therefore, in the absence of faster due process and more types of Ethereum trust collateral, the only way to meet Dai’s explosive demand is to allow centralized assets, especially stablecoins, to enter the system.
Their addition creates excellent arbitrage opportunities for traders. For example, you can make 100,000 Dai from USDC of 101,000 USD because the collateral ratio is 101%. If Dai’s transaction price is $1.02, you can sell 100,000 Dai and get $102,000. This is an instant arbitrage cycle. (Previously, Su and I criticized its lack in an article 6 in 2019)
Here, you not only make $1,000 immediately in the transaction, but you also retain the option. If the transaction price of Dai is less than $1.01, you can repurchase $101,000 of USDC in the CDP to make a profit. For example, when its transaction price is $1.00, you can pay $100,000 Dai to buy back $101,000 USDC and get another $1,000 profit7.
There are three main points:
1. This arbitrage alone explains the rise of stablecoins within Maker.
2. As long as the collateral ratio of stablecoins is 101%, Dai will never exceed $1.01 again. As long as the price is higher than this level, the arbitrageur will cast more Dai and sell it immediately, causing the price to fall.
3. When Dai returns to pegging the exchange rate, stablecoins will naturally disappear from the system.
The last point may require some analysis. When Dai returns to $1.00, arbitrageurs will have a dual motivation to unwind their stablecoin positions. First, they still have a negative profit because of the stability fee charged on the stablecoin vault (currently 4%). Second, they should exercise options and buy back collateral with Dai, which is now cheaper.
Dai was able to return to $1.00 because the demand for holding it has fallen, and then the supply will naturally follow. Remember, Dai is a tokenized debt, generated by CDP. Therefore, when arbitrageurs close their positions, Dai will inevitably be destroyed in the process. Or, the demand for casting Dai can be increased and more natural supply can be created to meet market demand.
First of all, I have noticed the upcoming release of Year’s yETH v2 vault, which generates Da from ETH collateral and farms CRV in Curvei. If the v1 vault is any indication, this could create hundreds of millions of additional Dai – keeping demand the same – which should squeeze many stablecoins from the system.