How Dai Addresses Centralization and Counterparty Risk
The fall of Lehman Brothers is often regarded as the domino that led to a chain reaction of global banking catastrophes: Merrill Lynch’s hasty sale to Bank of America, the AIG bailout, and the near collapse of both Goldman Sachs and Morgan Stanley.
Traders, investors and hedge funds lost tens of billions in assets in the collapse.
The warning signs of unsustainable counterparty risk had long loomed over global financial markets, but what were once considered vague concerns had suddenly spiraled into the forefront of bankers and investors minds alike. This starkly highlighted the need to have better insight and transparency into the counterparties supporting these “trusted” systems.
Not since the Great Depression had banks suddenly faced default risks so steep that their own fate rested entirely in the hands of counterparties.
In this context, counterparty risk is the risk that the other party (the counterparty) of a financial contract will not live up to its contractual obligations.
As globalization increases and banks become increasingly opaque, new counterparty risks emerge. Even regulators struggle to maintain transparency on this deep underworld of shadow banking.
In the cryptocurrency space, these counterparties can be even more dangerous. A centralized exchange is a counterparty, and many centralized exchanges are highly dependent on undisclosed banking infrastructures. These exchanges are typically the complete custodian of your funds, meaning users have little or no recourse if, or when, something goes wrong.
Fortunes have been lost due to the weaknesses of a central counterparty, as was the case in the fall of Mt. Gox.
The Failing of Trusted Counterparties
Nothing highlights the pitfalls of the 2007–08 economic collapse more prominently than the decision of the US government to bailout the banks. The government pursued a $700 billion Troubled Asset Relief Program to bail out the entire banking industry in order to mitigate the counterparty risk pitfalls of the centralized banking system. Unfortunately, not all banks received a bailout. Hundreds of hedge funds and institutional traders who kept their funds at Lehman Brothers, for example, lost their assets and faced years of legal proceedings in attempts to recover funds.
“No one ever expected a prime broker to fail without a bail-out or some means to keep business going and transfer accounts to another firm. We’ve never had a major counterparty simply shut down before, so this is completely uncharted territory,” said Chris Addy, president of Castle Hall Alternatives.
This cautionary tale served as a case study in the dangers of blindly trusting third parties due to their inherent lack of transparency. While people’s assets vanished overnight, if there was a silver lining to the whole crisis, it was the renewed interest in a series of radical ideas for the financial world: The concept of decentralized consensus, stored on a shared, public ledger..
These technological developments, kickstarted by the creation of Bitcoin, promise unprecedented gains in efficiency, transparency, and safety for the financial system.
Yet, Bitcoin was not always a reliable store of value. Hacks became rampant, steep market crashes occurred, losses increased due to unstable exchanges and counterparties.
Just recently, the Japanese exchange Coincheck confirmed that about $524 million worth of the digital coin NEM had been stolen. Making it the single largest single hack on any exchange; a value that exceeds even the Mt. Gox breach of 2014.
Centralized financial institutions, no matter how big, will always be vulnerable to theft due to the dangers of centralization and counterparty risk.
A sizable portion of all cryptocurrency users have faced loss due to theft, hacking, and the freezing of the assets held by their counterparties. People are losing their funds, and many feel there is little they can do to maintain stable value without having to trust someone.
Addressing Counterparty Risk: The Missing Piece
Dai is a fully collateral-backed currency token whose value is kept predictable relative to the US Dollar through a series of competing financial incentives.
Unlike centralized stablecoins, the currency lives completely on the blockchain, its stability is unmediated by any locality, and its solvency does not rely on any trusted counterparties. All Dai is backed by a collateral that has been escrowed into publicly viewable smart contracts on the Ethereum blockchain.
The core concept of a stablecoin is simple — it’s a price-stable token that exists on a blockchain. But unlike bitcoin, ether or most other tokens, dai has very low volatility and is roughly pegged to the US Dollar. This alone, is unprecedented in the decentralized world.
There are significant benefits to holding dai versus a centralized option. There is no need to rely on a central counterparty, trust the stability of fiat banking deposits, or the vagaries of shifting local regulations. Additionally, traders using CDPs, instead of centralized alternatives, can manage their own operations instead of getting financing from an opaque crypto exchange or a prime broker.
The uses of Dai are broad. This includes everything from users wishing to maintain stable value of their digital asset portfolio, ICOs looking to maintain stable value on their funds, exchanges looking to offer stable trading pairs, individuals looking to gain leverage on their Ethereum, or funds that want to maintain stable value but keep the benefits of blockchain.
There is no need to trust your exchange, broker, or custodian. You maintain the full control and safety of your funds, similar to holding your own cash in a safe or using a crypto wallet. DAI is a completely fungible ERC20 token that can be stored in any standard Ethereum wallet. It can be freely exchanged with anyone, without having to interact with the advanced mechanics of the Dai Stablecoin System. Once Dai has been created it is fully owned by whoever holds it– it is not encumbered by CDP creators or the MakerDao foundation.
Strong Performance To Date
Dai has been live for more than four months, and the team is proud to report its ongoing stability thus far.
While the Dai Stablecoin System significantly increases transparency while reducing counterparty exposure, risks still exist. Smart contracts are nascent technology, a financial ‘Black Swan’ event could precipitate a redemption of outstanding Dai, a failure in the underlying blockchain could halt or force a rollback of transactions, etc. Liquidity risks are also present in the early stages of Dai. For example, a large number of traders looking to cash out may impact Dai’s liquidity if CDP owners are unable to capitalize on the increased demand quickly enough
In every financial system risk can be transferred from one group to another based on the participants desire for increased returns or increased safety. In the MakerDAO model, the risk is radically transferred away from DAI holders and towards CDP, and MKR holders.
By using a more transparent system than we see with existing centralized options, Dai holders can properly assess the risk of their backing collateral portfolio when engaging in the Dai stablecoin system.
MakerDAO, by design, creates a system where transparency and technologically-determined behavior, together with good management will minimize any risks that emerge. Additionally, the public, regulators, and users can audit the system to make a good judgement.
Dai offers a number of easy ways for users to get involved. Everyday users are able to purchase Dai on a number of exchanges, both centralized and decentralized.
Users can even generate their own Dai by collateralizing Ethereum on an entirely decentralized platform.
The age of stability has arrived.