A Look into the MakerDao Protocol
As of now, the MakerDao platform and Dai stablecoin have limited real world usage beyond margin lending to fund crypto trading. Dai can be purchased and used by almost anyone, but it still faces many hurdles in attempting to expand adoption, use cases, and access to financial services. For example, no standard business would create Dai (essentially take out a Dai loan) on the platform because you would run the risk of your collateral being seized by a ‘keeper’ in the middle of the night and waking up ~15% poorer the next day.
For those who are unfamiliar with MakerDAO, it is the creator of Dai, a decentralized stablecoin based on the Ethereum blockchain and pegged to the U.S. Dollar. The protocol’s notable contributions to the crypto community include: i) the good work involved in designing and launching their crypto-collateralized ecosystem, ii) they’re beginning to establish partnerships and on-ramps, and iii) their funding, governance, and issuance has earned praise for being decentralized.
Yes, MakerDao has done a respectable job of maintaining Dai’s stability and proving that a decentralized stablecoin can move beyond the conceptual phase, but the system really only works when it is extremely over-collateralized and the collateral is increasing in value. Think of the extreme over-collateralization as a disinflationary cost imposed on the ecosystem’s growth, at the expense of new adopters. Assuming you are willing to bear that growth imposition, you are still making an explicit bet that the value of the cryptocurrency collateral will increase even if your intent of using the Dai stablecoin was to avoid cryptocurrency volatility in the first place.
MakerDao’s Systemwide Margin Call on Sep. 6, 2018
The Dai ‘economy’ contracted by 16% on September 6, 2018 (and has contracted 26% from the peak) as a result of volatility in the underlying cryptocurrency asset that backs the Dai stablecoin. The Dai ‘economy’ and its beneficiaries were subject to a large margin call, the kind that can damage businesses like the one described earlier. Not only was a sizeable amount of collateral seized and liquidated by the MakerDao protocol, it was done via a penalty auction process that results in unfavorable pricing during an already illiquid period. So as the creator and holder of Dai to fund your business, you are now worse off for your involvement with the MakerDao protocol than if you had taken a standard loan from a bank. This exposes another core problem with MakerDAO’s design. Dai’s demand side and supply side are not entirely aligned and when they do not match, the economy is in trouble. Actual demand for Dai most likely did not drop by 16% within a day, but its market cap did as a result of a collateral crash. This disequilibrium is likely to create a chokehold on growth and prevent Dai from becoming a widely used currency in the real economy.
In addition, any holder of Dai currency is placing an outstanding bet that it will always be sufficiently capitalized by anonymous actors willing to bail out the system, otherwise the entire thing automatically shuts down and is liquidated. This last scenario is a low probability event, but something to keep in mind because we don’t fully know each of the actors’ reaction functions when their money (cryptocurrency) is on the line. As Dai revealed in this latest episode, rather than attract capital inflows and act as a haven of safety during periods of market turmoil, Dai actually experienced capital outflows. Check out the below MakerDaiBot Twitter feed warnings about the forced shrinking of the ‘economy’ and some of the CDPs (collateralized debt positions) that are at risk of being seized and liquidated.
MakerDao proponents argue that multi-collateral CDPs (like adding stablecoins) and other changes will help diversify the collateral pool, lower costs, and improve resiliency, but these enhancements are not sufficient in the face of other protocol shortcomings when applied to the real economy. Your cost of capital and risk exposure are still much greater than if you had instead transacted through traditional banking channels (though this may not be an option for some individuals and businesses). Decentralized solutions should lower costs for the greatest number of users, rather than raise costs. Thus the MakerDao protocol and Dai have still not solved the ultimate stablecoin use case — creating a decentralized currency that will be used widely by people in their everyday lives. There are many other variants on the MakerDao model, such as Havven, BitShares, among others, but they all function the same in that there’s a shortcoming in the protocol design that makes them costly and inhibits real adoption, or worse, forces margin unwinding and significant losses.
There’s a Better Solution. Introducing: Terra
At Terra, we are excited to build a next-generation stablecoin solution using a different model than other stablecoins. In fact, we are launching with a formidable alliance of e-commerce partners and investors to drive global adoption. (TechCrunch: “Terra is an ambitious crypto project to build a stable coin through e-commerce”) Here’s how it works: Terra, the stablecoin, achieves stability to a basket of currencies by algorithmically adjusting money supply, using the Luna stability reserve token to contract the money supply when necessary. Luna is initially backed by fiat currencies and small transaction fees levied on Terra transactions. This gives Luna real utility as a stability mechanism because its value is backed by global fiat currencies and Terra transaction fees, which is a much different approach than MakerDao employs. Luna holders that are performing a utility for the benefit of the ecosystem, such as staking their tokens in the stability reserve, earn these transaction fees. It’s important to note that your assets won’t be seized like in the MakerDao model.
As the Terra economy grows, new money supply is funneled into the stability reserve as well as channeled to our e-commerce partners to help them fund discounts for customers. Naturally customers like the idea of getting a discount on products they already want to buy, and e-commerce partners enjoy not having to pay a sizeable portion of their sales to cover credit card processing fees.
These are some of the innovative ways Terra is tackling core stablecoin design challenges — by creating clear partnerships and growth incentives to drive rapid adoption. If you’re as excited as we are about transforming the global e-commerce and payments landscape, then we invite you to check out our website, join us on social media, and stay tuned for Terra coming to a store near you.