Recently, I read Debt: The First 5000 Years, and The Fraying of the Petrodollar System. This has led to me thinking a lot about the nature of currency, and the way that currency systems can embody core contradictions that lead to their downfall. I’m worried that DAI contains such a contradiction, and that it will create a long-term crisis if it’s not addressed.
The contradiction exists between the following three statements:
- DAI is a currency.
- Every DAI is backed by at least $1 worth of high-quality collateral
- The price of DAI is pegged to be equal to $1
(See past discussion: [Poll] Should MakerDAO print unbacked DAI to solve the peg issue?)
I believe that these three statements form an economic trilemma. The issue is that the value of a currency is always higher than the objective value “backing” the currency. That’s because currencies become valuable by virtue of their being currencies. There is a self-sustaining positive feedback loop–a network effect–which makes the currency valuable.
Consider the example of gold. Gold is objectively valuable: it’s soft, malleable, conductive, pretty, etc. However, that objective value is a tiny fraction of its economic value. Almost all of its economic value is derived from the reliable expectation, confirmed by centuries of history and precedent, that other humans will find gold valuable and will want to use it as a currency. Other currencies (like dollars or Bitcoin) have even less objective value, but still command large valuations, entirely because they are accepted as currencies.
We can encode this observation into math as follows:
(Value of an asset used as currency) = (Objective own-value of the asset) + (Network value due to its use as a currency)
Applying it to DAI:
(Value of one DAI) = (Value of collateral backing 1 DAI) + (Per-unit value from DAI’s use as a currency)
From the examples of other currencies like gold, dollars, or bitcoin, we can expect that the “Value From Being A Currency” may become much larger than “Value of Collateral Backing”.
However, if we try to hold the price of DAI to be equal to $1, then we are in trouble. The “objective” value of something backed by $1 of collateral should be close to $1. Then let’s imagine, very conservatively, that the “value from being a currency” is only 1x of the objective value (even though for gold, dollars, etc, the true ratio is enormously higher). Plugging this into our equation, we arrive at:
(Price of DAI = $1) = (Value of collateral backing = $1) + (Value of DAI as currency = $1)
Since 1+1 != 1, there’s a contradiction here. The problem will manifest as the price of DAI consistently creeping above its peg, as excess currency-driven demand pushes the price up. In response, Maker will be forced to add larger and larger amounts of riskier collateral, in order to ensure that the supply will keep up with demand. The only way to get the equation to truly work will be to erode the value of the collateral towards zero; at that point, the equation balances:
(Price of DAI = $1) = (Value of collateral backing = $0) + (Value of DAI as a currency = $1)
This would make DAI into just another fiat currency; one that is backed by nothing other than an expectation that it will be valuable. Also, the version of MakerDAO that maintains the peg by loading up on risk will be much more vulnerable to shocks that could destroy the system.
Therefore, I think Maker should abandon the 1 DAI == $1 price peg, but hold onto the rule that 1 DAI is always backed by at least $1 of collateral. The price would start to float higher than $1 (perhaps materially higher over time, especially in a climate of dollar-devaluation), but users of DAI could always sleep easy knowing that the value of their DAI won’t go below $1.
This would make holding DAI much more appealing. The holder of DAI would have upside in the case of a weakening dollar (DAI would become over-collateralized and the price would rise), but downside protection in the case of a strong dollar (DAI would never drop below $1). As someone who is long-term bearish on the dollar (see The Fraying of the Petrodollar System), I could really use an asset with these properties.
This change would be inconvenient for a certain set of users: users who (for regulatory or tax reasons) need a perfect peg for the U.S. dollar, rather than a stable cryptocurrency in general. However, for those users, I believe DAI is already strictly inferior to USDC. If you’re looking for a perfect dollar peg, then USDC is that, and there’s no reason to take all the additional risk and complexity of MakerDAO. Also, as crypto matures, the U.S. government is nearly certain to apply regulatory pressure to push users towards stable currencies that are de-facto controlled by the U.S. government. Thus, all of the users who most care about the U.S. dollar peg (for regulatory or tax reasons) are users who are likely to be pushed out of the DAI ecosystem over time, anyway. Based on this thread I understand that there’s already regulatory pressure for MakerDAO to break the peg.
If we decide to go down this road, we should put some thought into how to maintain price stability without a strict peg. I think doing some expectation-setting would help; e.g. we could target a price growth rate of 3%, and use the DSR as a mechanism to help meet the target. This might seem like it’s compromising on the goal of being a stable currency. However, a system with some short-term price variation will actually be more stable than something with no apparent price volatility, but that is built on a contradiction. If unaddressed, I think the contradiction will eventually trigger a debt crisis that undermines price stability, perhaps permanently.
Thanks for reading this post! I know a lot of folks here have a much deeper understanding of DAI than I do, and I look forward to reading your thoughts. 
