Black Thursday: Showing the Potential for Real-World Assets in DeFi
Centrifuge’s contribution to DeFi is to provide loans to businesses around the world. For DeFi to replace our traditional financial system we need to build access to capital for businesses to grow. Gustav from the Maker Foundation and I talked about one such use case in Paris at EthCC. If you’re unfamiliar with what Centrifuge does, I’d recommend you check out the talk. In light of recent events, I want to highlight ways that we believe assets with low correlation to the current collateral pool (ETH & BAT) can stabilize the system as a whole.
What happened on Black Thursday?
Within 24 hours Ethereum crashed from around $200 to slightly above $110. This flash crash would have certainly tripped a circuit breaker several times on the NYSE. For DeFi this led to a huge increase in trading activity and lots of people scrambling to close their leveraged positions on lending protocols such as Compound, DyDx, and Maker.
With Ethereum crashing and activity rising, gas prices skyrocketed. Gas prices were suddenly in the hundreds of gwei, 25 times as much as what one would pay on an uncongested day. The huge price drop in ETH affected Maker Vault holders and quite a few of them ended up being liquidated. Dai liquidity started becoming an issue with Dai momentarily trading at $1.10 and currently still trading above the peg.
A mechanism in Maker to ensure the system is adequately collateralized is to auction off vaults that don’t meet the minimum collateralization ratio anymore. If the price of ETH crashes as quickly as on Thursday, many who probably thought they were within a safe margin suddenly saw their vaults being liquidated. It is not entirely clear why, but a lack of bids when liquidating these positions resulted in losses of over $5.67 Million. A good summary of the Maker governance and risk call that was discussing this as it was happening is on forum.makerdao.com and whiterabbit published a write up analyzing the results from these collateral auctions.
Dai Liquidity and Keeping the Peg
Multi-Collateral-Dai aims to protect against black swan events and systemic risks of individual collateral types by bringing a variety of asset classes onboard, a process that is just starting to take shape. In the meantime, as long as Dai is only backed by highly correlated Ethereum based assets (currently just ETH and BAT), a flash crash of ETH and crypto overall can affect the entire Maker ecosystem as we’ve seen on Thursday.
One potential cause for the peg to break as the market took a slide down and Dai traded as high as $1.10 is the combination of an increased demand on Dai as a stable asset relative to other crypto assets and a shortfall of liquidity as people were racing to reduce the Dai debt in their vaults to avoid risking a liquidation.
If a large majority of the Dai supply is coming from crypto correlated assets then a large shift in price in these assets will mean market conditions for Dai that will likely break the peg.
Adding assets that are uncorrelated doesn’t just ensure that the value of Dai isn’t linked to a single asset type, it can also help stabilize the price of Dai supply in times of high ETH volatility.
A more diverse collateral pool would have helped provide additional Dai liquidity to absorb the demands that high activity in the ETH collateral backed vaults generated. Real-world assets like the ones we are bringing to the Maker ecosystem can solve this problem; invoice factoring has some correlation with the macroeconomic climate and stock markets but won’t react nearly as fast to these changes as most highly liquid assets such as stocks, cryptocurrencies, and even commodities.
The Opportunity For Real-World Assets
Safely bringing real-world assets into Maker as collateral comes with its own challenges: smart contract risk is replaced by legal complexity. We will have to learn as a community to navigate not just the challenges of setting governance parameters for crypto assets but also get comfortable with auditing the process for bringing real-world assets into our ecosystem. Centrifuge is working with different asset originators that have collateral such as Paperchain and Shuttle One. We’re building the tools to make these assets stable and liquid. Over the coming weeks, as the Maker community is rolling out the new collateral onboarding process we will bring some of the first truly uncorrelated assets to vote for inclusion in MCD.
The events last Thursday showed us that a system backed solely by crypto assets can’t necessarily be made stable enough at scale. Even “completely trustless assets” as some people call it, can cause dramatic losses for our users. Adding assets to the mix with a very different set of risks can mitigate some of the problems we experienced on Thursday.
Topping Out: Current Debt Ceiling of Crypto Asset
The events on Thursday showed us that the previous ETH debt ceiling was too large and the community responded by lowering the debt ceiling to 110M. Maker could soon see the situation where Dai is limited in growth not by a lack of demand but a lack of supply. Even if there are borrowers willing to mint Dai for depositing Eth, the debt ceiling will not accommodate all users wanting to save (using the DSR), trade and use it as collateral in other DeFi protocols.
We must act fast to bring new collateral types to MCD quickly to make sure the Maker ecosystem can continue to grow at a pace independent of the ETH price.
Liquidity During the Upcoming MKR Auction
Another place where Dai liquidity can become an issue is in the upcoming MKR auction where around 5.67M Dai worth of MKR will be auctioned off to cover bad system debt. This will be an interesting time for the Dai markets as the bidders on the MKR will have to have sufficient liquidity available to bid on these auctions. Assuming there are five interested parties in purchasing MKR at the auction, each willing to bid up to a certain amount that is close to the ~5M Dai target on the entire auction, that means they will collectively have to have 20M Dai in liquidity. That is around 20% of the total supply and probably a significant part of the liquid supply. Taking this into account, an auction raising 5M Dai is likely too big and will put the Dai peg under pressure.
Dai had a rough week, it took a big hit and sadly caused unexpected losses for some people. But there are many ways we can address these issues. By tuning the auction parameters (which has already happened via a governance vote a few days ago) but also by bringing real-world assets into the system. Stay tuned!
Thanks to Dennis, Jason, Jenny, Lea, and Martin for your contributions.