The $1.00 Stablecoin Worth $0.98

Grapefruit Trading
Apr 3 · 8 min read

Dai is a decentralized stablecoin governed by Maker and organized by the MakerDao foundation. The basics are simple: a user deposits ether as collateral and can withdraw up to 66% of the value of the collateral deposited in the form of Dai. In addition to the collateral posted the borrower must pay interest on Dai minted; MakerDao refers to this as the Stability Fee (SF). This creates a Collateralized Debt Position (a CDP), in which the user will now receive Dai.

An integral part of any debt system is the liquidator. If the value of the CDP’s collateral ever falls below 150% of the Dai borrowed, the collateral is liquidated. Whenever a CDP is liquidated a 13% liquidation penalty is applied. 3% goes toward offering the collateral at a discount, a mechanism that incentivizes liquidation, and 10% goes into the MakerDao ether contract (PETH). Anyone with access to the Ethereum chain is able to purchase the collateral with the requisite amount of Dai.

The mechanisms that keep Dai at a dollar can be simplified into two cases.

1. The value of Dai at exchange is above a dollar.

In this case, people are incentivized to mint Dai via a CDP and sell it at an exchange for more than a dollar. For example, if the market price of Dai is $1.02, we can deposit 1 ether at a market price of $150, withdraw 100 Dai against that collateral, and sell that Dai for $102. Then, if the market price of Dai drops back to $1 we could buy back our 100 Dai for $100 and repay our loan, returning $2. In the scenario where Dai takes longer than expected to trade back at the $1 peg, users will be forgoing interest on their locked ETH as well as be paying the financing charges of the Stability Fee.

However, there is constant selling pressure within Dai. It is likely today that most Dai printed is used to buy other cryptocurrencies or, in some cases, dollars. For example, InstaDapp offers CDP Loops where Dai is repeatedly minted and sold for ether to gain leverage (more on this later). In other words, people aren’t minting Dai just to be long Dai — they are minting Dai to immediately sell it for something else.

2. The value of Dai at exchange is below a dollar.

When Dai is below a dollar, those with open CDPs are incentivized to buy Dai to receive their collateral back at a discount. For example, imagine if you had previously deposited $150 worth of ether, received 100 Dai, and then immediately sold that Dai for $100. If the price of Dai goes down to $0.98, you could now buy 100 Dai for $98, then pay back your CDP, receiving your $150 of ether, resulting in a net $2 gain.

From the scenarios above, Dai should be rather stable around a dollar; however, looking at the current Coinbase DAI-USDC spread (USDC being fungible with USD), we see Dai with a mid-price of $0.98. What is causing this?

The short answer: People are not capitalizing on their opportunity to pay back their CDP’s at a discount. The mechanism to keep Dai near a dollar is not working as intended.

The long answer:

First, we must understand why are people entering CDP’s in the first place.

On the surface, entering a CDP makes no sense. I’m locking up $150 of an asset, just to get $100 of a different asset in return? Why would I ever do that? The answer is exposure. Imagine I have a bunch of faith in ether, and I believe that the project, and the value of the coin, will go up in the future. I buy $15,000 worth of ether. This is perfect. I have the exposure I wanted, and I’m ready for ether to go up. But in the meantime, I want some spending money. I’ve just used my money on ether, and I have no money left. What can I do? Open a CDP. I put up my ether as collateral, and receive 10,000 Dai in return. I sell that 10,000 Dai to USD, and boom, spending money for the year. Awesome. And I still have all my ether exposure! After ether 10x’s, I’ll be able to get my $150,000 just by returning 10,000 Dai.

Imagine my confidence in ether’s future surpasses that of McAfee and Bitcoin. Using Dai, I can create something called a CDP Loop, in which instead of spending my 10,000 Dai on food and clothing, I use it to buy more ether. I then use that ether to open a second CDP. And then I use Dai from that CDP to buy more ether, and continue to repeat this. Now my ether exposure isn’t just $15,000. It’s $15,000 + $10,000 + $6,666 + $4,444… and so on. I’ve more than tripled my exposure toward ether at a low cost. Now, after the moon, I’ll have more than ever before.

A Collateralized Debt Position might sound familiar. Collateralized debt, otherwise known as a loan. Your ether is your collateral, just like your house in a traditional mortgage. Say you want to buy a vacation house? You can borrow money from the bank by putting up your current residence as collateral! Pay a bit of interest, and when you are ready, pay back that loan. The CDP and a traditional loan may seem similar at first, but they have some major differences.

  1. There is no strict 150% auto-liquidation value on a traditional loan like Dai has. If you are unable to make your payments for a home loan, for example, the bank takes legal action against you. In a decentralized world, a smart contract suing your wallet won’t work out so well. Because of this, in a CDP, your collateral will simply be sold if the value reaches 150%, to ensure that the collateral will never be worth less than the amount of Dai in circulation.
  2. Assume you are unable to pay back your CDP. Perhaps your collateral is still at a safe level, say, 2.0x your initial deposit, but there are no signs of you being able to pay back that CDP. And you can’t sell your locked ether like you can sell your house. Nor can anyone else seize your ether like the bank can seize your house. Your ether will just sit there in the contract, forever, until perhaps ether crashes or Global Settlement occurs (see below), for you are the only person who can pay your debt back.

Take a closer look at the second case above, this person who has taken out a CDP, whose collateral is worth more than 150% of the loan, but who is unable to pay it back. Let’s walk through the steps this person, who I will dub Alice, might have taken. For the purposes of these examples, say ether is currently worth $100, and Dai worth $1.

  1. Alice takes $20,000 out of her savings account and buys 200 ETH.
  2. Alice takes 200 ETH and opens a CDP. She withdraws 10,000 Dai, keeping a 2x collateral.
  3. Alice sells 10,000 Dai and pays her bills with the proceeds. Since she has minted and sold Dai for USD, there is selling pressure, and the price of Dai now falls to say $0.99.
  4. Ether falls to $80. Alice still has 1.6x collateral, and so there is no liquidation.
  5. People would love to buy Dai at $0.99, in order to fund Alice’s CDP and receive back the $15,000 of ether at a 1% discount, but Alice is the only person who can do that.
  6. Alice, after paying rent and bills, is unable to buy Dai and pay back her CDP.
  7. That ETH is still in the CDP, and unless ether goes below $75 and the CDP is liquidated, or Alice manages to scoop up the money required, Dai will still be worth below $0.99.

In short, Dai is currently below a dollar because some contract owners are not liquid enough to execute the mechanism designed to keep Dai from falling below a dollar. As the number of people using Dai either to pay for goods and services or to leverage a position increases, the price will only continue to fall, until contracts are liquidated, either via an ether crash, or Global Settlement.

What are the solutions?

There are a variety of strategies that the MakerDao foundation could employ to increase the price back to a dollar.

  1. The Maker community could (continue to) vote to raise the Stability Fee. By increasing the SF, the cost to borrow Dai via a CDP increases. Higher costs incentivize CDP holders to manage their Dai borrowing more efficiently. The goal of raising the SF is to decrease the Dai supply. CDP holders will need to buy Dai to repay their debt which should increase exchange price. However, with an increase in the Stability Fee, it also dampens the whole MakerDao ecosystem.
  2. A CDP marketplace. CDP holders currently not in a position to buy back their debt could sell their CDP to someone who could buy Dai. This would allow buyers to redeem Dai for $1 worth of ETH and drive a new wave of demand for Dai. Imagine if you owned a CDP with 100 Dai outstanding and you want your ether that is locked, but you can’t buy back your debt. You could list your CDP for sale and avoid needing to buy Dai and paying off any outstanding fees. Another scenario where a CDP marketplace would be helpful is to avoid the liquidation penalty. If you have a CDP and believe it is going to be liquidated you could sell it and avoid the liquidation penalty.
  3. A group of oracles called the Global Settlers (yes, that’s right) could enact a Global Settlement. Once activated, all functions of CDPs freeze and the last ETH/USD MakerDao price is recorded. Using the last price, the system determines each Dai and CDP holder’s claim to ether. Each Dai will be redeemable for $1 worth of ether. Imagine if you bought a 100 Dai, at any price, and a Global Settlement is triggered, you could redeem the 100 Dai for a $100 worth of ether based off the price feed. A few examples of when a Global Settlement could be activated: in the event of a malicious attack, error in a core contract, or a significant destabilization in the Dai market.

The Global Settlement is the most effective method at restoring Dai to $1 but it is the least likely due to the severity. Think of it as a nuclear option. The Stability Fee is the most likely to occur, however, it is still unclear how effective the method is at moving Dai to $1. A CDP marketplace is the most effective and likely way to bring Dai back towards $1. Recently Bloqboard & Wyre partnered to create a market — well, a bulletin board for now — for CDP sellers with a minimum outstanding debt of two hundred thousand. If Dai is to trade at $1, this is a step towards building the necessary infrastructure, but more action needs to be taken.

Grapefruit Trading

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Deep liquidity for cryptocurrency

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