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DAI Monetary Policy: Stablecoin Pegging to USD

In today’s post, we revisit MakerDao, the decentralized stablecoin. For a quick refresher on the various types of stablecoins, visit one of our earlier posts on this topic.

Quick recap – essentially there are two main types of stablecoins here, at least for the purposes of this discussion – fiat-collateralized ones, like USD Tether, Circle, Paxos, TUSD, Stably etc. which basically aggregate USD (or some other fiat currency), lock that up in a stable bank account somewhere, and issue tokens against that; and decentralized ones like DAI from MakerDAO, which are basically crypto collateralized. Essentially, you have to deposit an equivalent amount of crypto to get hold of some stablecoins. In the case of DAI, you ‘deposit’ or overcollateralize with Ethereum (and soon with other types of crypto as well), to ‘borrow’ DAI.

DAI is interesting because it is foundational to the new OpenFinance/DeFi stack that is rapidly growing, and potentially even becoming the seminal crypto theme for 2019. DeFi opens up multiple lending, trading and investment use cases, and DAI lies at the heart of DeFi, due to its decentralized nature.

MakerDAO’s community recently voted on the proposal to increase the stability fees for DAI CDPs by 2%, from 1.5% to 3.5%. DAI’s stability fee is a one-time payment to be made to the ecosystem to compensate participants who keep the DAI value pegged to $1. In addition, the stability fees needs to be paid in the form of MKR tokens, which will be burned after the payment. MKR token is a governance token for the ecosystem and with every DAI that is paid back, the total MKR outstanding decreases. Because the MakerDAO ecosystem is almost decentralized, all the protocol changes are determined by community members (MKR tokenholders) through a voting process. This decentralized governance is what drives the value of MKR token as the number of votes are directly proportional to the number of MKR tokens.

How exactly does DAI maintain the dollar peg? CDP borrowers can buy DAI if the price is below $1 to close the CDP and get their ETH back. For example, let us consider a case where you might borrow 100 DAI tokens by depositing $200 worth ETH in a CDP (200% collateralization). In order to close the CDP and get back your ETH, you will have to payback the borrowed DAI and also pay the accrued stability fees for the tenure. If the price of DAI is trading below $1, say 98c, borrowers can buy DAI from the market for less than a dollar each and redeem their ETH from the CDPs, thereby making a profit of 2%. In cases where the price of DAI is above $1, say $1.02, users are incentivized to borrow DAI by collateralizing ETH and sell the borrowed DAI on the market for a 2% profit. These potential arbitrage opportunities are expected to keep the peg as close to a dollar as possible.

Raise in the Stability Fee
Source: https://medium.com/makerdao/raise-the-stability-fee-to-3-5-f0d6731b1041

We covered arbitrage opportunities around the DAI token in detail in an earlier post.

However, when DAI is persistently trading above or below its $1 peg, the MKR ecosystem makes changes to the protocol to incentivize users to restore the price to $1 again. Stability fees is one parameter that can be tweaked to increase or decrease the supply of DAI, akin to how central banks use interest rates to infuse or suck liquidity out of the system. DAI has been trading under its peg over the last couple of months apparently due to high inventory levels of DAI according to various market makers who provide liquidity for DAI. Increasing the stability fees is expected to deter users from borrowing DAI and also incentivizes current holders to redeem their DAI for ETH, thereby reducing the supply overhang in the system. With the goal of reigning in the supply, the stability fees has been increased by 50 bps two times separately over the past few months to the current 1.5%. However, increasing the stability fees to 1.5% had limited impact on DAI’s price as the currency still continues to trade below its $1 peg. This led to a new proposal, which was approved by the community, to increase the stability fees by 200 bps to 3.5% with the expectation that the DAI price would react positively to this change. The price of DAI will be closely monitored for the next 7 days to see if the price moves closer to the $1 peg, failing which one more proposal for a 200 bps stability fees hike (rate hike) will be put forth for approval by the community.

The parallels here with a traditional central bank are very clear. Central banks use monetary policy in a similar manner to counter inflation and influence the value of a currency. The ‘Stability fees’ that DAI borrowers pay when they close out a CDP (collateralized debt position) is akin to an interest on a loan. By playing around this with interest rate, the DAI community (currently a semi-decentralized loose risk management committee, but eventually fully automated) is hoping to get the price of DAI pegged back up to $1.

Unfortunately, here is where things get complicated for MakerDAO, as they do for central banks. Let us call it the law of unforeseen consequences. One possible reason why DAI’s liquidity has not contracted in response to stability fee increasing is because users are ready to pay high stability fees in order to gain leverage to Ethereum, especially when a lot people believe that ETH price has bottomed out and has significant upside from this point on. Essentially, DAI issuance is going up as more users want to gain leveraged exposure to ETH at the bottom of the cycle. DAI liquidity is more likely to contract when the stability fees are high enough and offset the profit potential from a leveraged ETH position.

For a more complete run down on DAI and stability fees, check out this Medium Post.

Meanwhile in Crypto Wonderland….

“Bitcoin Trading Volumes Affected By Blackouts” Bitcoin transactions and active addresses have seen a steep fall this Saturday as Venezuela saw what AP calls the “worst power and communications outage” which “reached virtually every part of the oil-rich country of 31 million.” That has coincided with bitcoin transactions falling by about 100,000, down from circa 370,000 a day to about 240,000. There’s of course no direct evidence to link the blackout to this fall in bitcoin usage, but trading volumes in Venezuela on the peer to peer exchange Localbitcoins stand at twice that of the entire Europe and about as much as all of the United States.

“LedgerPrime Raises $12 million” LedgerPrime, a digital asset investment firm led by former Wall Street whizzes, has closed on $12 million of institutional capital and secured commitments for another $8 million. The proprietary trading firm, which began trading in the spot and derivatives markets for cryptocurrency in the fourth quarter of 2017, is owned by Ledger Holdings Inc., which is also the parent company of crypto futures platform LedgerX.

“Kraken is Expanding Its Team” United States-based cryptocurrency exchange Kraken is expanding its team with new high level hires. Kraken announced five new appointments to its team. The new appointments will see Matt Mason as Chief Marketing Officer, Steve Hunt as Vice-President of Engineering, Nelson Minier as Head of OTC Sales and Trading, Bob Zagotta as Head of Business Operations and Strategy, and Mary Beth Buchanan as General Counsel. Last month, Kraken acquired United Kingdom-based cryptocurrency exchange and futures provider Crypto Facilities, which is fully regulated by the U.K.’s Financial Conduct Authority, giving Kraken a major foothold in the European market.

“Swissquote To Start Offering Crypto Custody”Swissquote, a provider of online financial and trading services from Switzerland, announced that it will be possible to transfer cryptocurrencies from external wallets to a Swissquote account and vice-versa. Swissquote first begun offering cryptocurrency trading in mid-2017 in partnership with Bitstamp, and the service was then expanded further at the end of the year to cover five popular digital assets, bitcoin core (BTC), bitcoin cash (BCH), ether (ETH), litecoin (LTC), and Ripple’s XRP. In addition, the bank launched Swissquote Bitcoin Active Index (SQXBTQ) on the SIX Swiss Exchange in November 2017.

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