Maker DAI Economics, Part II
By David Siegel on ALTCOIN MAGAZINE
Is DAI Dead?
Opinions here are strictly my own and not connected to any organizations I’m affiliated with.
NEWS FLASH: Again last week, the Maker community decided to raise the stability fee, which now sits at 19.5 percent. The stability fee is the fee you’ll pay in DAI or MKR to unlock your ether later when you end the contract. It is effectively the annual interest rate you pay to create DAI. It increases demand for the MKR token, which is good for MKR token holders. Like a Mugabe scheme in an imploding economy, raising rates like that is probably going to kill the project. I believe the Maker community has just voted itself into oblivion.
Last week, I wrote about Maker basics, concluding that you don’t want to be the person who locks up Ether into a Maker contract, you don’t want to be the person holding MKR, which I believe is a security, and you don’t want to use it as a hedge, because there are better hedging products available. Today I’ll look at two more use cases for DAI and see if it has any legitimate case for survival.
A coin like USDC or AlpRockz is fully backed by cash, but you need to go through KYC and AML checks to get them. Because Tether and DAI are not seen as money, they don’t require a licensed on-ramp and off-ramp. For now, they are under the regulatory radar.
The important thing about DAI is that it really is decentralized. That puts DAI on center stage as DeFi gets going.
Anyone who accepts DAI in exchange for goods or services will want to spend them somewhere else or exchange them for another kind of currency. So it should be fairly easy to buy some DAI on an exchange. Binance doesn’t list DAI, but Coinbase Pro does. And it’s listed on most decentralized exchanges.
I’m guessing there isn’t much volume, but yes, DAI is circulating. That’s good. But remember — if you’re the person who put up your ether to get DAI, you’re the one who will pay the 19.5 percent fee (per annum, compounded) when you unwind the contract.
DAI could be very good for places like Venezuela, but it would have to compete with Tether, USDC, Reserve, and others. This will require three things:
On and Off Ramps — people may prefer DAI to their currency, but ultimately they also want choices to go to other things, including dollars in the bank, debit cards, etc.
Infrastructure — people need to be able to accept DAI. At the moment, DASH is working very hard to help small merchants in Venezuela, and Reserve is also targeting the country. One of the first things people need is a wallet that’s safe and easy to use. The second is POS software to help people accept DAI. So it takes a concerted investment to build a brand and get market share.
Confidence — if people are going to pay each other in DAI, they will need to know it’s better than the alternatives. In at-risk countries, it’s far better than their local currency, but is DAI simple enough for people to understand and compete with products like USDC and Alprockz? Is there a chance it could implode? As I discussed in my previous post, it depends a lot on the price of ether. If Ether falls dramatically, DAI contracts will close out. In a crisis of confidence, DAI could fall significantly below the peg.
I think all three are lacking for DAI in the crisis countries, so, for now, DAI will remain in the more developed countries as a unit of exchange that is fully decentralized, fairly stable, and can be used in smart contracts. Good use cases would be insurance, purchases, payments, lending, and transfers.
So let’s look at lending and earning interest. The primary lending use-case is leverage on cryptocurrency speculation. Here are two scenarios:
Borrow DAI to buy more Ether: You could borrow someone’s DAI and pay them an interest rate set by the market. Let’s suppose your deal closes at ten percent APR. You borrow $1,000 worth of DAI and buy ether with it. If, after a year, the ether goes up, you can close out the position, repay the $1,000 loan plus $100 interest, and keep any profit left over. If ether doubles, you have a $900 profit. On the other hand, if Ether goes down, you need to pay the $1,100 either way, so you’ll lose some of your collateral — whatever that is. The lender has locked in a 10 percent gain and you get the profit or loss according to the price change in ether.
Borrow DAI to short Ether: You could borrow $1,000 worth of DAI to short Ether. In this case, the economics above is simply reversed.
There are other things to borrow, but those are basic economics.
The Lender View
What if you’re the lender? Let’s suppose you created the DAI. You lend at ten percent, but you owe 19.5 percent to the contract to get your ether back, so that isn’t going to work. The only interest rate you would possibly consider would have to start at around 28 percent, maybe more, depending on the default risk. Will anyone borrow DAI from you and pay you 28 percent? Probably not.
Lenders face three risks:
- The risk of default of the borrower.
- The risk of a 19.5 percent APR in ether terms.
- The risk that if ether drops enough their contract will close, their DAI will disappear, and they will pay a penalty fee for not maintaining enough collateral.
The Incentive Problem
Could the Maker community reverse its vote on the stability fee? Yes, they could. But they have been consistently raising it to prevent themselves from going under water. And most of their contracts are protected, because they initiated them last year when the fee was lower. This is not a good incentive system. This makes it MKR holders against new DAI creators. I don’t see alignment in the incentives. As DAI dwindles away and no one wants to make any new ones, the stability fee will have to come down. But they have already demonstrated that they are willing to extract the rent from newcomers to pay for previous mistakes.
Someone, please correct me if I’m wrong about my assumptions. If they are correct, then here are my conclusions about DAI and about DeFi as we know it today (since most DeFi apps use DAI at the moment) …
- Making DAI is now more expensive than borrowing on most credit cards.
- Borrowing DAI is going to cost more than borrowing in Bolivia, probably a lot more. I don’t see how the market will support super-high interest rates.
- The only use case that works is to buy DAI in the market and then use it to pay for something. Why would someone make DAI and then sell or use it for $1, knowing that trade has to be unwound later at $1.20 after one year and $1.42 after two years?
- The whole thing only really works if ETH is going up a lot, in which case you’re better off holding ETH rather than DAI or MKR.
- The MKR token is a security.
- The MKR token benefits temporarily every time the stability fee goes up — what will happen if the stability fee goes down?
- The entire DeFi ecosystem, which is primarily based on DAI, is a house of cards. MKR, DAI, and lending can’t last long in this environment. The price of DAI may be stable, but the economics are terrible for almost all concerned.
In my view, the Maker DAI experiment is over. I haven’t been following every step, but my hypothesis is that MKR holders have been underwater from the beginning, and increasing stability fees is their attempt to resuscitate their investment with the side effect of killing the patient. Maybe I don’t understand how the fees work. But I can’t see how the project survives from here.