MakerDAO’s Attempts to Gain Stability

MakerDAO is a slightly less well-known protocol, but has a very interesting use case that tends to attract some enterprising individuals into the fold. In recent weeks, there has been some issues with the basic mechanics of the lending part of MakerDAO, and watching how they handle it is useful for understanding the strengths and weaknesses in how stablecoins are governed.  

The way MakerDAO works is that users can get what is essentially a low-interest rate loan by putting up their Ethereum as collateral on these loans. A one-time fee is charged as a percentage of the proprietary stablecoin (DAI) that is loaned out. Users are basically lending themselves money.

The loans are referred to as Collateralized Debt Positions (CDPs), and putting Ethereum up as collateral offers several benefits. First, it makes it so that these users can still participate in the upside on the Ethereum, but also actively manage the Dai they borrow. Second, it allows for users to undergo capital projects without having to sell their cryptocurrency.

A Unique Business Model

The one issue with this business model is that because of the high level of volatility presented by cryptocurrencies, it is necessary to collateralize in excess. The minimum ratio of ETH to DAI is 150%. This allows for Ether to drop in value without hurting the chances of the loan being repaid or abandoned.

However, when Ethereum does drop below this minimum level of collateral, the Ether being held is liquidated at a 3% discount. If you’re a borrower and you are forced to sell your Ether at a discount and also need to pay a 13% liquidation penalty, that is clearly an undesirable outcome.

What is shocking about this is that recent studies have shown that over $5 million has been lost due to this liquidation penalty fee. With 14% of the total number of smart contracts having been liquidated in this manner, it seems like the system isn’t working so well for borrowers right now.

Governance Methods At Work

We are seeing two different efforts to solve the problem. First, you have the governance mechanism of MakerDAO working to change the “stability fee” (similar to a lender’s charge) with the goal of bringing the price of 1 Dai back to 1 USD. It has been hovering slightly below 1 USD, likely because of selling pressures from too much DAI being loaned out and then sold into the market. If raised from 7.5% to 11.5% or higher, it is likely that less Dai would be loaned out and the value may be restored. Another approach MakerDAO foundation may take is to begin to limit the supply of Dai, as that would also bring up the price again.

On the liquidation side of things, there are several third parties who are working to create APIs and tools that might provide better warnings for users before their Ether is liquidated. When the Ether is liquidated that removes the necessity of borrowers to buy back their DAI, which further hurts the value of the coin. This bottom-down approach is more decentralized and represents what happens when the top-down governance mechanism won’t work.

Overall, MakerDAO is an interesting project with a unique method of maintaining the value of their stablecoin. Most interestingly is how Ethereum is tied to the fate of the project, but isn’t part of any formal partnership.