Maker DAI Economics, Part I
My name is David Siegel. Opinions on Medium.com are strictly my own.
This is part 1 of 2.
SUPPOSE you are a fearless cryptonaut and you want to explore what you can do with your cryptocurrency. As I have explained, cryptocurrencies are not money. It’s crazy to price things using volatile cryptos. Better to price things using money.
Enter Maker DAI — a way to lock up your ether and use that to borrow dollars. Because DAI is not a contract for a dollar — it’s a token that is pegged to the value of a dollar — you don’t need a money-transmitter license to buy or sell it. That makes it a good candidate for a stable coin — as long as it stays stable. In this series of posts, I’m going to give three use cases for DAI and explore the economic outcomes of each:
- DAI as a hedge
- DAI for purchasing
- DAI for lending
This short piece is on DAI as a hedge. I assume you understand DAI basics.
First, let’s look at the price of DAI to 1st of May, 2019:
The price for the past year has bounced between 98 cents and $1.02. It dove for some reason in April, then it spiked on the news that Tether assets had been used to pay some Bitfinex debt, driving a lot of people out of Tether.
How stable is this? Not very stable compared to a tokenized dollar, like USDC, and not very stable compared to just dollars in the bank, but very stable compared to the dollar price of ether.
Today, ether is trading around $160. Suppose you bought ether a long time ago and have a fantastic gain. You now have $2.5 million of ether and want to reduce your exposure. Let’s say you want to take $1 million off the table and let the rest ride. You have three choices:
A. Create DAI. You take around $2.5 million of ether and lock it up in the lending contract. Why so much? Because you don’t want the contract to liquidate in case the price drops precipitously. It could have a spike down and that would force the sale of your ether at just the wrong time.
B. Trade for exchange dollars, like Kraken or Coinbase dollars.
C. Buy DAI on an exchange.
Let’s skip forward a year and assume you want to liquidate everything back to dollars:
Scenario 1: Ether appreciates.
Let’s say ether doubles to $320 and you decide to cash everything. How did that pan out?
Strategy A: You now have $1m in DAI plus $5m in ether. If you want to unwind your trade, you pay your 16.5 percent stability fee, which is essentially the interest rate you have to pay to borrow DAI. So you return your $1m of DAI, add the $165k fee (interest), and then cash out all your ether. You have a total dollar gain of $2.35m and total cash out of $4.85m. Your hedge has cost you $165k. But — were you ever truly hedged? I’ll discuss that later.
Strategy B: You went to an exchange and purchased $1m of exchange dollars, like Kraken or Coinbase dollars, in which case you wouldn’t have been charged anything. Your $1.5m worth of ether doubles and you end up with $4m after cashing everything out. Your hedge cost you $1m. You are worse off because you actually truly hedged and took $1m off the table. The hedge was thwarted by the appreciation of ether.
Strategy C: You went to an exchange and purchased $1m of DAI from someone else. Now that ether is way up, it’s relatively easy for you to sell your DAI and ether, giving the same results as scenario 2, above. However, in this case, someone else is out $165k — the person who opened the debt position and created the DAI. (It depends what he traded his DAI for to understand how it worked out for him — if he had bought and kept your ether, then it worked out well because your hedge is his leverage.)
Scenario 2: Ether depreciates
Let’s say ether is cut in half, to $80. Here are the scenarios:
Strategy A: You still have your DAI in the contract. To unwind it, you return the $1m DAI but lose $165k stability fee. Your ether is now worth $1.25m. After subtracting the stability fee, you have $1.085m.
Strategy B: You went to exchange dollars, like Kraken or Coinbase, in which case you put $1m aside and lost $1.25m, so your net result is $2.25m. Now you can see how a true hedge works — the DAI was not a hedge, because your full $2.5m was stuck in the ether contract and it all went down.
Strategy C: You bought someone else’s DAI and again net result is $2.25m. The person who sold you the DAI must unwind the contract and loses half his money plus the stability fee. It sucks to be him.
What can we conclude? That creating DAI is very expensive, and it isn’t a true hedge. The stability fee of 16.5 percent is meant to prevent selling when demand drops, but it creates credit-card-like economics that is very bad for borrowers. People who hold MKR are doing better now that the fee helps compensate them for their risk, and we can see that’s true:
On a dollar basis, holding MKR has been a terrible investment (not to mention I believe it is a security), but when the stability fee goes up, that helps push the value of MKR up. The latest vote — to 16.5 percent — should be very good for MKR holders, at least until demand drops again. But I think it ruins the economics for anyone creating new contracts. Creating DAI is like getting a cash advance from a credit card company.
I haven’t even mentioned the fragility of DAI. It's lower bound so far is 96 cents, but it could become a “falling knife” situation and drop dramatically some day. I think DAI economics aren’t stable enough to support a $10 billion market, and that’s about how much you need to give people confidence that the peg will hold.
- DAI doesn’t hold much promise as a currency hedge.
- DAI is very very expensive. As much as the credit cards we are all trying to get away from.
- It is better to buy DAI from someone else than lock up your ether and make it.
- MKR has been a very poor investment and is likely to continue as such unless there is a tremendous demand for DAI. Anyone holding MKR has probably lost money unless she could arbitrage it against the upcoming fee raises each time. It’s a kind of “buy on the rumor, sell on the news” security. That’s not a good deal for the person on the other side of the trade.
- The only scenario in which DAI really works for everyone is when ether goes up steadily, in which case it’s much better to be holding the ether.
In Part II, after the fee went up yet again, I ask: Is the Maker project dead?
Those are my thoughts and I am responsible for them. You’re welcome to correct me in the comments, I would appreciate that.
Next: Shopping with DAI