Of Tethers & Pegs — European Financial Services Crypto-Assets Review: Part 3
In the last 12 months we have seen the emergence of an interesting new form of — so far — successful Stablecoin that is not backed by fiat currency.
The token (Dai) is created using collateralised digital assets within a smart contract debt position created by the MakerDAO group of developers. The Dai’s value is pegged to the dollar using various mechanisms discussed below. I have also considered the associated MKR token as part of this legal analysis (see further below).
One of the fascinating things about Dai is that it sits much better within the spirit and ethos of the cryptocurrency sector. There is no counterparty or intermediary credit risk and no need for an assessment or scoring of any participants. All contracts can be viewed on the blockchain publicly.
There are obviously also some irreducible risks related to the Dai token, in that the products rely on MakerDAO developers to ensure that the code is substantially error-free and not subject to risk of attack of the underlying assets. In addition, the choice of protocol on which to operate the smart contracts will have the intrinsic risks of attack and fault relevant to such protocol (currently Dai operates on ethereum).
In addition, there are a number of crucial governance functions that require human intervention and collaboration to ensure the network and products function as intended. It must also be noted that, as Dai is decentralised and not fiat backed, it is not redeemable to any issuer for dollars (though in this author’s opinion that makes it more attractive). These features make it very unlikely Makerdao is required to be authorised under European financial services laws.
Summary of Dai
Anyone with an ERC-20 wallet can create Dai by logging into the CDP (Collateralised Debt Position) platform and locking up their crypto-assets into an open smart contract. Currently the minimum level of collateral before a liquidation event could occur is 150% (i.e. for ever $1 of Dai created a person must lock $1.50 worth of Ether (or other acceptable asset) into the smart contract.
CDP Portal
If the collateralisation level is breached (because of a fall in the price of the underlying digital asset) then the smart contract will liquidate the collateral and sell it in order to ensure the debt obligation in Dai can be met and importantly to ensure that Dai maintains its peg to the dollar. In practice participants tends to over-collateralise to avoid the risk of liquidation and the costs (a liquidation penalty of approximately 13% is applied).
At the time of writing this Memorandum, ETH is at $125.5 per ETH and the global level of collateralisation across all Dai contracts is 330%. Participants wishing to cancel a CDP in Dai are required to repay the Dai and also pay the CDP fee in MKR or DAI. The CDP fee is referenced as a “Stability Fee” and is currently set at 0.5% per annum (in effect this is the cost of the loan).
How is the Dai peg maintained?
This is the most difficult element of Dai to comprehend, especially since the exact mechanics behind the scene are not fully disclosed (presumably in the interests of avoiding someone gaming the system to cause a crisis). In effect, a target price of a 1:1 (Dai:USD) peg is set by the system and the system relies on economic incentives to arbitrage any deviation away from the peg.1
If the market price of Dai is higher than the target rate (e.g. $1.10 rather than $1) then a person could collaterise, for example, $1.50 of ETH at $1 on the CDP and then sell that Dai at $1.10 and wait for the price to destabilise at the pegged rate to buy back the Dai to repay the loan (netting free money in the process). If Dai falls below the target rate then users would be incentivised to repay existing Dai CDP’s at the lower dollar rate than when it was borrowed thus creating demand for the Dai pushing the price back to equilibrium.
Ultimately, MakerDAO also rely on something called ‘Global Settlement’ as a backstop in case the market dynamics or technology fails, whereby when Global Settlement is triggered, the entire system freezes and all holders of Dai and CDPs are returned the underlying collateral. Global Settlement may never need to be triggered but it provides confidence to all participants that the peg will be defended even in a sharply declining market. In some respects, its mere existence may mitigate against the need for it to be used (a nuclear option you might say).
For a good practical analysis of how Dai functioned during a short term price spike when the peg was broken see this article:
“We can assume that with this price spike, the market price of Dai went above the target price. According to the Maker-Dai whitepaper, when this situation occurs, Maker engages a mechanism known as the Target Rate Feedback Mechanism (Edit: although this mechanism may have never been triggered in this case)
This mechanism makes it less expensive to create Dai (fewer Ether needs to be given as collateral for one Dai). This incentivizes more Dai creation (increased supply), and disincentivizes users from holding Dai — leading to a dampening of the market price to match the target price.”
Third party network participants (bots), known as “keepers”, also help maintain the price of Dai. Keepers are generally automated programs that take advantage of arbitrage opportunities to keep Dai near its peg. They also participate in CDP auctions ensuring the orderly wind-down of any liquidated contracts.
What is the associated MKR token?
MKR is a utility token that is required in order to use the CDP network to make Dai. As a utility token, MKR is required for paying the fees accrued on CDPs that have been used to generate Dai in the Maker system. Only MKR and Dai can currently be used to pay these fees, and when paid in MKR the MKR is burned, removing it from the supply. This means that if the adoption and demand for Dai and CDPs increases, there could be additional demand for MKR so users can pay the fees. It also means the MKR supply should decrease as MKR is burned.
MKR also has some other important functions:
- It is used for recapitalisation of resources;
- It is a governance token for the Maker-Dai system including setting certain key system parameters;
- MKR is to some extent Dai’s reward token. MKR holders are rewarded indirectly for holding MKR as they indirectly benefit from CDP debts and auto-liquidation fees since these fees are used to burn MKR thus increasing the value of each MKR (assuming a steady state of units in circulation). However, holders also take the risk that MKR will lose value in the event that more MKR are minted to cover any shortfall arising from liquidation events.
All MKR holders have key decision-making power over the Dai protocol. 2
MKR Regulatory Analysis
Obviously the MKR token is more complex in its nature than the Dai collateralised debt position token.
The key securities law test is whether Dai or MKR could qualify as a ‘financial instrument’, ‘e-money’ or some other form of regulated instrument or obligation.
To the extent that MKR is used purely as a utility token in an entirely transactional way, then it is not problematic and the same approach as relates to other tokens that are not security tokens under UK, Gibraltar and EU law applies — see here for that analysis 3. Recently, ESMA and the UK FCA (see report referenced above) have confirmed that European regulators do not consider utility tokens to constitute regulated ‘financial instruments’.
In respect of the other functions of MKR and the potential for persons to buy and hold MKR tokens in order to participate in the governance of the system and to (they potentially hope) gain from any increase in the value of the token then the regulatory analysis will need to be more nuanced, particularly in respect of the US securities analysis that may be applicable (given the very wide and uncertain definition of a security under the ‘Howey test’).
Keep reading for the final Part 4
Originally published at www.ramparts.eu on January 29, 2019.
