Where we are now
The DAI supply has increased by more than 250% (about 300m) in the 2-3 months since Compound kickstarted the yield farming craze. Before that period, the DAI peg was still recovering from the Black Thursday event when the DAI price reached $1.12 and needed about 3 months to finally recover in mid June, right before Compound yield farming was announced. This recovery was made possible due to bullish sentiment surrounding ETH in the second quarter this year.
Since then, ETH is still performing well and organic demand for leverage has only increased. However, DAI selling from leverage seekers could not offset the yield farming craze and on average DAI has traded at around $1.02. Potentially, market making activities also decreased due to lucrative opportunities from yield farming. Importantly, this all happened despite heavily increased debt ceilings, the onboarding of new collateral assets and 0% rates across the board. The issue is that all the conventional monetary tools at hand simply cannot compete with massive DAI demand from yield farmers and new price mechanics introduced by several AMMs like Curve.
There are multiple ideas floating around in Maker Governance about how we could address the current situation:
- Negative rates
- Strategic reserves through MKR dilution
- Direct protocol DAI minting and participation in yield farming opportunities or arbitrage directly
Unfortunately, all of them have some technical or legal implications in the short term. Furthermore, certain solutions also seem to divide the community on topics such as:
- Whether negative rates are positive for DAI adoption and potential technical implementation issues for partners
- Should MKR build strategic reserves, dilute itself and spend its capital that’s actually needed for coverage of loss events
- Does DAI become a USDC wrapper
It feels like these kinds of issues accompanied with the technical constraints of implementing unconventional tools to manage the peg mean that these solutions need more time for discussion, or a more serious peg deviation to implement. At time of writing, the DAI price stands at $1.01.
Current State of the Peg
In our recent analysis we showed how the DAI price moves by a few cents intraday only due to new yield farming opportunities. We also showed that such movements can be in our favour and we recently predicted one led by Curve farming. About two thirds of DAI issued by Vaults is currently being deposited in yield farms directly by them. This shows that if stability fees are changed in this dynamic landscape, this potentially doesn’t affect the peg because other more powerful forces are driving the change in price.
In other words, a few percentage difference in fee charged to Maker Vault owners doesn’t dissuade them from either speculating on 50-1000% APY yield farming opportunities or speculating on the current bull run of crypto assets used as collateral.
I have written in the past how Maker actually pursues three goals when setting rates: Risk Policy, Monetary Policy and Business Policy. Business policy is something that was overlooked thus far since our primary goal was and still is to manage DAI price as close as possible to $1. If we are able to reach DAI dollar parity, Risk and Business Policy can both be pursued with more flexibility. Let me first explain why Business Policy is important and then address how we can sort out peg issues.
MakerDAO Vault users prefer stable and competitive rates. If we are able to solve peg issues unrelated to how we set fees, we can finally start becoming more rate competitive and reliable, which is of high importance when we start adding real world assets (RWA) as collateral. This also means we need to change the way rates are set through Base rate on a weekly basis and set rates less frequently by having more focus on the competitive landscape and portfolio risk. This however doesn’t mean our conventional monetary levers are completely ignored; if we are able to increase stability fee, DSR can be used again as a more regularly used monetary lever. Also in extreme situations we can still use more aggressive stability fee or debt ceiling adjustments to help with peg deviations.
Finally, the community is aware of how low fees are unsustainable long term in cases when funds are needed to cover potential shortfall, particularly now that debt exposure is increasing at a fast pace. Assuming debt exposure doesn’t change as much, Maker protocol would benefit from 4m - 12m revenue per year assuming increased average fees in range of 1% to 3%. Assuming additional revenue is collected from penalty fees, we could be aiming towards 15m revenue per year, which would be a nice boost to MakerDAO’s reserves to protect against losses. Importantly, maintaining a system surplus will allow us to onboard and compensate new EPCs in order for MakerDAO to become self-sustainable. For this to happen it is critical that the Protocol has a more regular inflow of funds.
To sum up above concerns:
- DAI price doesn’t necessarily react heavily to increased SF due to other more powerful forces that determine the price currently (DAI demand from yield farming)
- Stable and higher but still competitive rates should be preferred from business policy standpoint
- MakerDAO needs more income from rates to cover potential shortfall and make governance self sustainable and grow domain teams
Cause and Effect
In practice, the major concern about increasing stability fees from a DAI peg viewpoint is potentially causing liquidity drain, vault owners refinancing to other stablecoin debt denominated borrowings and causing the DAI price to increase. Therefore it’s important to always pick a fee that doesn’t cause massive refinancing and is in line with our Business Policy and position in the competitive landscape.
“Organic” Vaults are one of MakerDAO’s long term core stakeholders and retaining them is of large importance. Luckily ETH is in a bull run and as long as we don’t increase fees too much over competitive stablecoin borrowings, we shouldn’t lose them. Even at 0% fees, using MakerDAO to borrow DAI is more expensive than borrowing DAI at Compound, where COMP rewards already offset the current borrow rate for a user (net APY of 7.5%). This tells me users still prefer to use MakerDAO when it comes to DAI borrowing, but surely there is a breakeven rate.
Defending the Peg
In case we trigger a huge DAI price increase due to increased SF, this could be mitigated by a very low liquidation ratio (LR) for stablecoin vaults, which may have a similar effect as to what PSM proposal was trying to achieve. If governance sets the USDC LR to a level of 102%, we effectively put a ceiling on DAI price of $1.02, assuming the debt ceiling isn’t utilized fully.
Of course such a strategy also has side effects and these were discussed in the PSM proposal. It is unavoidable that with lower LR on USDC we keep increasing USDC exposure, particularly in times of high DAI demand (new DAI yield farm becoming hot again). We also must be aware that we will likely need to have low fees on USDC vaults should LR be kept really low. Further, some of the USDC vaults might also need to be manually liquidated as yield farmers could abandon them in case DAI price decrease doesn’t offset their liability from fees and remaining collateral. Here I think governance needs to decide how much USDC exposure is willing to tolerate versus how much peg deviation is acceptable. Importantly, governance also needs to consider other stable coin collateral onboarding to diversify risks associated with stable coins.
The other important fact is that we also need to increase the number of onboarded collateral assets with high minting potential and charge fees. We will need more community contributors to assist with risk analysis and if protocol starts earning money from higher fees, the protocol should have the funds to compensate these contributors.
A short note on yield farming. As noted, yield farming changed the landscape in DeFi and affected MakerDAO. There are ways to mitigate it and meanwhile collect fees. Again as we showed, about two thirds of current DAI supply minted by certain Vaults is used in yield farming. Those Vaults shouldn’t be hurt by a few percentage points lower yield and they can’t really go anywhere else to borrow large amounts of DAI that is needed to farm. We must find the best strategy to a) retain them, as many of them are providing DAI liquidity in venues such as Curve and b) charge fees that are still tolerable for them. In such a way MakerDAO gets indirect participation in their APY. There are also more exotic alternatives available such as onboarding farmed assets as collateral (yCRV, cDAI, cUSDC), but risks need to be properly addressed first.
- Discussion around this proposal, specifically:
- Is the general strategy of introducing more business policy logic into governance sound enough and doesn’t affect our approach to risk and peg?
- Is governance willing to change the way how rates are set?
- How does governance view low LR on USDC and associated risks with potentially increased exposure? Do we want to use low LR on USDC only when peg escalates or do we put a ceiling on DAI price immediately by implementing it?
- What is the peg deviation tolerance on DAI to assess proper LR for USDC should we decrease it immediately to defend against price appreciation?
- Proceed with a Signal request.