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Dai Rating Change From Bronze to Neutral!

TL;DR

Reasons for Dai’s Downgrade

• No longer credibly decentralized or censorship-resistant due to centralized collateral (USDC and RWAs)
• The centralized collateral, USDC specifically, has helped Dai maintain price stability on average but has introduced new attack vectors and de-peg risk in the form of traditional banking relationships and U.S. regulation.
• Dai performed worse/depegged to a similar extent compared to USDC during the March 2023 banking crisis. The mix of crypto and centralized collateral did not limit downside risk in the March 2023 depegging.
• Dai is more capital inefficient than its centralized counterparts and no longer offers any/significant downside protection compared to its centralized competitors.
• Unfortunately, Dai has inherited the worst aspects of both centralized and decentralized stablecoins, making it an inferior product compared to many alternatives.

Maker-Dai

Maker is a Distributed Autonomous Organization (DAO) on the Ethereum blockchain with a platform designed to keep the DAI price stable. MakerDAO uses the Maker (MKR) token to act as a counterweight to price fluctuations. This combo is the basis of a simple crypto banking system built on blockchain technology that allows for simpler international payments and peer-to-peer transfers.

Anyone using Maker can create (or mint) Dai by locking ETH (or other approved crypto assets) into a smart contract as collateral and then minting the stablecoin, Dai. Dai's stability is achieved through a dynamic system of collateralized debt positions (CDPs), autonomous feedback mechanisms, and incentives for external actors. Once generated, Dai can be freely sent to others, used as payments for goods and services, or held as long-term savings. The original idea was to create a decentralized stablecoin. However, as this article will explain, the Maker protocol and Dai have gradually moved away from decentralization as the top priority in the pursuit of growth. These gradual sacrifices have nullified Dai’s leading original value proposition as a truly decentralized stablecoin independent of banks, middlemen, and governments and left it with the worst aspects of both a centralized and decentralized stablecoin design.

Recent March 2023 Unpegging

Following instability in the banking system, stablecoins—digital assets on a blockchain meant to trade at or close to $1.00—experienced considerable volatility themselves. This initially occurred due to the reserve status of USD Coin (USDC), the second-largest stablecoin, which had 8% of its reserve backing linked to Silicon Valley Bank. Off-chain reserve-based stablecoins, such as USDC and Tether (USDT), claim to maintain $1 of assets, like cash or securities, for every digital token issued on-chain. As a result of the USDC news, traders started selling the coin, causing its value to drop below $0.90. Dai (DAI), the largest on-chain collateralized stablecoin with 36% of its reserves in USDC, also experienced a significant decrease in value, falling below $0.90 as well. Notably, Dai was collateralized at 147%, meaning that even if all the USDC backing it became worthless, it would still have been over-collateralized.

As USDC and DAI experienced de-pegging and Binance USD (BUSD) continued to wind down, the primary beneficiary turned out to be the controversial Tether, which has witnessed consistent growth in supply and has traded at a considerable premium to its par value.

Source: NYDIG

What is DAI?

DAI is a crypto-native, 100% on-chain, over-collateralized cryptocurrency-backed stablecoin created by the MakerDAO protocol. It is designed to maintain a stable value, typically pegged to the US dollar. The primary feature of DAI is that it is over-collateralized, meaning that it is backed by a higher value of cryptocurrency assets than the value of the stablecoins issued. This design aims to ensure stability and reduce the risk of insolvency.
 

A comparison of Dai to other crypto-native stablecoins. Source

Maker and Dai Dynamic

Initially conceived in 2015 and fully launched in December 2017, Maker is a project with the task of operating Dai, a community-managed decentralized cryptocurrency with a stable value soft-pegged to the US dollar. MKR tokens act as a kind of voting share for the organization that manages Dai. While Maker does not pay direct dividends to its holders, it does give the holders voting rights over the development of Maker Protocol and capture revenue in the form of interest and liquidations.

MKR is destroyed when the Maker Protocol’s system surplus exceeds a minimum threshold, resulting in excess Dai being auctioned for MKR, which is then destroyed. Inversely, when the Maker Protocol is running a deficit and the system debt exceeds a maximum threshold, MKR is created and auctioned for Dai in order to recapitalize the system.

Through its governance token, MKR, users can vote and manage the DAO concerning the following topics and more:

• Add a​ ​new​ ​collateral asset ​vault
• Adjust risk parameters for existing vaults
• Modify​ ​the DAI Savings Rate
• Trigger Emergency Shutdown

As an example, suppose a DeFi user put 10 ETH valued at $20,000 into a Maker vault as collateral. The user can then mint Dai with a maximum collateralization ratio of 150% according to the vault parameters. The user can borrow a maximum of ∼13,000 Dai without having to sell that ETH. However, it should be made abundantly clear that borrowing the maximum amount leaves the user extremely susceptible to liquidation (discussed more below).

Rather than mint the max, the user is more conservative and mints 10,000 Dai. Now the collateralization ratio is safely above 145%. If suddenly the Dai price loses its peg and drops to $0.99 in the market, the Maker Vault remains unaffected. It still has the same outstanding loan of 10,000 Dai with the same collateralization ratio. However, when Dai is at $0.99 or lower, this presents the user with an opportunity to buy cheap Dai and repay the loan. When Dai is below the peg, Dai borrowers would be incentivized to buy cheap Dai and repay loans. When a loan is repaid, Dai used is burnt.

Collateral

Much of Dai’s growth has come with adding centralized assets as collateral. Greater than one-third of Maker’s collateral comes from centralized assets such as USDC and WBTC. While adding other collateral types helps with diversification and central downside risk, Maker could also be exposing itself to a new attack vector through its centralized assets. As of 2023, 50%+ of the Dai supply is collateralized by USDC and RWA.

Source: Glassnode

Having a large portion of the total collateral as USDC brings incremental risk to Maker. If regulators asked CENTRE—the consortium that runs USDC—to blacklist USDC in Maker, Dai would suffer.

How Does Maker and Dai Work?

Minting

In order to take out a loan or “vault” within the Maker system, users must deposit any of the several accepted crypto assets into the Maker vault and then are able to borrow Dai against the value of those tokens. Typically, the collateral must be at least 150% of the value of the loan. The protocol then charges borrowers a stability fee for borrowing Dai. This fee is variable and subject to the discretion of Maker governance. Ultimately, the stability fees collected by all the Dai loans are used to buy MKR from the open market and then burn it. This stability fee/burning mechanism is the primary source of value accrual for MKR.

Source

The Maker Vaults, which backs Dai, has been in development since 2014 by the MakerDAO project and were originally called Collateralized Debt Positions (CDP). With a CDP, users deposit an asset (ETH, USDC, BAT) into a smart contract as collateral for a loan. Once in the CDP, the user can then generate ~60% of the USD value in Dai that they wish to borrow. Users cannot borrow 100% against their collateral due to liquidation risk and price volatility in the underlying assets. However, with the new funds they do have from the loan, users can then spend their Dai like any other cryptocurrency, even to buy more ETH. The originally deposited assets inside the CDP can be retrieved once the user has paid back the same amount of Dai they initially borrowed plus any interest accrued during the loan. 

Maintaining the $1 Peg

One big obstacle is Dai's volatility. Even though it is considered a stablecoin, price fluctuations in Dai can meaningfully change in as little as an hour. The incentive structure between MKR stakeholders and Dai is still new and inefficient enough that the Dai-US dollar pair can fluctuate ~5%. This doesn’t sound like much but it can dissuade users who may opt for a more consistent stablecoin.

However, since Q4 2020, DAI’s price has become increasingly stable until recent issues in March 2023 (discussed more in future sections).

Source: CoinGecko

It is also worth mentioning the stability methods in place to keep DAI at a $1 peg:

• Arbitrage: Bots use simple buy and sell scripts to quickly capture any profits resulting from DAI being above or below $1.
• Auctions: “Keepers” are third-party bots that take part in buying up discounted tokens when collateral levels become dangerously low. There are some really interesting functions in place that Keepers participate in to ensure the health of Maker reserve levels that you can read more about here.

Source

Dai provides a solution to counterparty risk by creating an over-collateralized stablecoin in which its solvency is not reliant upon trusted third parties. All Dai is backed by various crypto assets held in public, transparent smart contracts on the Ethereum blockchain. This allows any user to verify the system’s health/backing in real time, unlike the legacy financial market. Additionally, users can transact with one another in a peer-to-peer (P2P) fashion anytime and from anywhere without the need to trust a bank or counterparty. 

Target Rate Feedback Mechanism

Maker controls the Dai-USD peg with its Target Rate Feedback Mechanism (TRFM). The Target Rate determines the price changes needed for Dai to reach the Target Price of $1 during market volatility. For example, if Dai is trading at less than $1, the TRFM will increase, causing the price of Dai to increase, which then causes the generation of Dai through CDPs to become more expensive. This effect concurrently causes Dai holders to gain a profit which will increase the demand for Dai. This newly increased demand for Dai causes the price of Dai to be pushed back up to its Target Price.

The TRFM and Target Rate are determined by exogenous market supply and demand dynamics. However, MKR voters can dictate the Sensitivity Parameter of the TRFM. The Sensitivity Parameter determines how quickly and to what extent the response of the TRFM should be when the Dai price deviates from $1. This Sensitivity Parameter (and the limitations voted on by MKR voters) ensures there is an adequate amount of response time to trigger a global settlement in the event of a network attack.

Peg Stability Module (PSM)

MakerDAO creates DAI primarily when users deposit collateral to permissionless vaults at an overcollateralized ratio. However, the minting technique alone does not protect against price swings across DeFi and DEXs. MakerDAO uses a combination of interest rate policy (via the Dai Savings Rate) and open market operations (termed Price Stability Mechanism) in order to peg DAI to USD. 

Prior to the implementation of the Peg Security Module (PSM) in December 2020, DAI relied on the previously discussed mechanisms to maintain its stability. However, four significant challenges plagued DAI's stability:

1. Absence of reserve redemption - When DAI's value fell below the peg, DAI holders were unable to redeem 1 DAI for $1 of collateral within the system (except during an emergency shutdown), despite being fully backed. This constraint hindered arbitrageurs from driving the price back up.
2. Liquidations causing upward pressure on DAI's peg - As keepers bidding for collateral liquidation needed DAI, this demand exerted upward pressure on DAI's price.
3. Diminished supply due to vault closures - Market crashes led to collateral values plummeting, which in turn prompted vault creators to close their vaults to avoid liquidation. Consequently, DAI's supply decreased when it was most needed for maintaining stability.
4. Activation of arbitrage loop only when DAI exceeded $1.5 - In the absence of robust stability mechanisms, DAI's value could theoretically reach $1.5. When DAI surpassed $1.5, an arbitrageur could deposit $1.5 of collateral in a vault (at a 150% collateralization ratio), mint and sell DAI for more than $1.5, and retain the difference. This process would continue until DAI's value returned to $1.5.

The introduction of DAI's PSM addressed these challenges by allowing any user to exchange USDC for newly minted DAI on a 1:1 basis without opening a vault. This innovation facilitated an instantaneous closed arbitrage loop. Since the PSM's launch, DAI has maintained its peg effectively, as evidenced by the subsequent chart. However, this solution introduced centralization risks. By incorporating USDC, a stablecoin issued by a centralized financial institution, Maker has compromised decentralization in favor of stability.

The Maker protocol offers a Peg Stability Module (PSM) that enables users to swap collateral directly for Dai at a fixed rate rather than borrowing Dai. The PSM was designed just like a regular vault but for stablecoin collateral. If users swap stablecoins for Dai, they experience no stability fee and a liquidation ratio of 100%. Unlike the case with regular vaults, users of PSM don't retain ownership of the asset and borrow Dai. Instead, they swap the asset directly for Dai. From the user perspective, the PSM is simply a DEX for swapping stablecoins at the best rates.

Via the Price Stability Mechanism, MakerDAO commits to swapping one unit of USD for one unit of DAI at a 1:1 ratio, allowing arbitrageurs to benefit if DAI moves above the peg. This algorithmic technique aims to dampen any excess demand for DAI by diluting the circulating supply. The strategy proved effective at limiting DAI's upside relative to the peg, while the downside is mostly managed through over-collateralization.

The PSM was designed to help keep the Dai peg close to $1 during times when Dai demand outstrips Dai supply. One other difference between a PSM versus a traditional vault is that the PSM allows Governance to collect fees on stablecoins at the point of the swap rather than over time. Another difference is ​​​​​​the stablecoins deposited into the PSM by users as collateral are allocated in the same big liquidity pool i.e. no siloed vaults.  This pool is known as PSM reserves. Essentially, a PSM is just a stablecoin vault type in the Maker Protocol and all the parameters that apply to vault types also apply to a PSM. 

The PSM offers several advantages:

• Increased stability due to the instant arbitrage opportunity when the Dai price diverges from the price of the collateral type underlying the PSM
• Fees are taken upfront 
• Because a PSM has no slippage (stablecoin to stablecoin), it attracts and executes significantly more volume than vaults

Post March 2023’s depegging event, MakerDAO has introduced circuit breakers for its peg-stability-module (PSM) to disable the use of unstable stablecoins as collateral during periods of market turbulence. Furthermore, a governance vote that concluded on March 16th authorized Maker to allocate $750 million towards U.S. Treasury bonds to diversify DAI reserves while generating an anticipated annualized yield of approximately 4.5%. This step is vital for Maker's expansion, as over half of its revenue now comes from real-world asset (RWA) investments. Investing in U.S. treasuries offers a more secure alternative, as government bonds are supported by the full faith and credit of the U.S. government, ensuring a higher degree of safety than engaging with potentially volatile banks. This move should place crypto-based treasuries in a more secure position amid macroeconomic challenges arising from the ongoing U.S. banking crisis. We anticipate this trend to persist as attractive interest rates encourage more projects to benefit from RWA investments.

Maker requires oracles to provide real-time market price information to the system to adjust the Target Rate when needed. Oracles and Global Settlers are external actors and not native to the platform. Another key exogenous actor in the Maker ecosystem is Keepers. Keepers are independent entities incentivized by profitable opportunities within the Maker system to contribute to the system. Keepers can also make a profit trading Dai and arbitraging the spread when Dai deviates from its $1 peg.

Dai Savings Rate

Stability Mechanisms

1. Dai Savings Rate (DSR) - This mechanism has a short-term effect on reducing DAI supply and works best when combined with other mechanisms. Historically, when DAI demand exceeds supply, causing the value to rise above the peg, lowering the DSR to increase supply is only partially effective since it cannot be reduced below zero.
2. Stability Fees - Like the DSR, Stability Fees have a short-term and limited impact on DAI's price. Their effectiveness depends on factors such as market sentiment and alternative stablecoin yield opportunities. If higher yields are available elsewhere, users may continue to borrow at higher stability fees, negating the expected decrease in supply.
3. Borrower Actions - When DAI is below its peg, borrowers may be incentivized to buy cheaper DAI to repay their loans. However, this incentive may be insufficient if leverage is the primary objective of borrowing. Conversely, when DAI is above the peg, borrowers might sell DAI, expecting the price to revert to $1. However, this strategy exposes arbitrageurs to the collateral's directional risk and requires them to rebuy DAI from the market to close their positions, potentially increasing DAI's price. Thus, reliance on vault creators provides temporary stabilization at best.
4. Emergency Shutdown - This last-resort mechanism suspends core borrowing functions and provides an exit to the underlying collateral for both vault creators and DAI holders. The logic behind this mechanism is that the expectation of an impending shutdown prevents DAI from trading too far away from the peg. However, the effectiveness depends on arbitrageurs' confidence in a potential shutdown. Without clear, objective triggers for initiating a shutdown, it becomes difficult for arbitrageurs to assess the probability and consequently, the risk-reward potential and time value of money.

Liquidations

Liquidation is the mechanism by which collateral is sold to cover the amount of Dai minted from a user's Vault when the loan-to-value (LTV) ratio surpasses a predetermined threshold. This process ensures that Dai maintains adequate collateral backing (in USD terms) by closing Vaults that fall below the required minimum collateralization ratio. Liquidations are automatically initiated by the protocol, which sells or auctions enough collateral to cover the debt, including a liquidation penalty. The protocol evaluates the liquidation ratio against a Vault's current collateral-to-debt ratio. Each Vault type has a unique liquidation ratio, determined by MKR voters based on the risk profile associated with the specific collateral asset type.

In May 2021, Maker introduced Liquidations 2.0 after identifying shortcomings in the previous liquidation method. Liquidations are now conducted through auctions in which anyone can participate. Bidders, known as Auction Keepers, are external actors incentivized by profit to automate certain operations on the Ethereum blockchain. Liquidation penalty proceeds contribute to surplus auctions, resulting in burned MKR.

Liquidations are no longer managed through a single Dutch auction. In a Dutch auction, the collateral's initial high bid gradually decreases until a buyer accepts the price. If no buyer emerges, the collateral's price continues to be reduced up to a predefined limit or until the auction concludes. Potential liquidators must decide whether to buy at the current price or wait for a deeper discount, risking loss to a competitor willing to accept a slightly higher price. Consequently, liquidators opt to liquidate when the bid is sufficiently profitable.

Dutch auctions allow larger loans to be liquidated profitably at a lower discount percentage compared to smaller loans, enabling the discount to scale more effectively with gas prices. During network congestion, a higher discount percentage is necessary to complete the auction, all else being equal. The liquidation system relies on the following components:

1. Keepers - Actors who facilitate liquidations by assuming the DAI-denominated debt and a portion of the collateral from defaulting borrowers. They also arbitrage DAI when its value deviates from the peg.
2. Oracles - The system obtains collateral prices from Oracle Feeds (whitelisted actors), which are averaged (median) to eliminate extreme values. Medianized values pass through the Oracle Security Module, which imposes a 1-hour delay before prices are published. This delay allows sufficient time for Emergency Oracles to intervene in case of malicious attacks on primary Oracles.