Dumb question - Still don't understand what makes the peg work

Yup I feel a bit silly asking this question.

What I DO understand:

  1. System ensures overall overcollateralization through the possibility of liquidation
  2. Total amount of DAI issued is equal to the initial value of borrowed principal.
  3. When loans are repaid or vaults are liquidated DAI is burned equal to the initial loan principal and the additional DAI (interest (‘stability fees’) and liquidation fees) go to the Maker Buffer.
  4. If an account is liquidated and there is not sufficient collateral, the additional debt is paid off by DAI Maker Buffer which receives and sells the remaining collateral. If necessary the Maker Buffer sells MKR to obtain sufficient DAI to pay off the outstanding debt.
  5. The owners of the MKR governance token can increase or decrease the savings rate to try to move the DAI back to its peg
  6. In the case of an Emergency Shutdown the protocol ensures that (except in the case of overall system under-collateralization) that DAI holders are given collateral valued at $1 per DAI using collateral prices “frozen” at the time of the Shutdown.

Given all of this I still don’t understand why the peg is so effective - or actually why it works at all.
- I don’t see that the price linkage in the case of an Emergency Shutdown can be enough as (hopefully) this is a relatively unlikely event.
- I don’t understand the incentives working on the “governors” (i.e. owners of the governance token) to try to keep the DAI at $1. How would they lose if say the price rose dramatically?
- Even if the “governors” are incentivized to try to keep the DAI near its peg - are gradual changes in the savings rate enough to do this?

What am I missing and not understanding?

I find this protocol fascinating and I would be most grateful for anyone that can help me to understand.

Many thanks

Phil

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The main mechanism of keeping the dai at peg right now is the PSM. It allows anyone to purchase dai for USDC/USDP/GUSD and the reserves in the PSM are used to trade dai for stablecoins which are available. When dai trades with a premium, you can use the PSM to mint dai and sell it for a higher price, or when its trading with a discount, you can sell it into PSM reserves for 1:1 for one of the stablecoins available.

Other mechanisms which were more important before the PSM but still relevant as Maker does not want to have such a high exposure towards centralized stablecoins are the stability fee; when there is a peg premium, governance tends to lower them to increase supply of dai via minting and when dai is below the peg they are increased which lowers the supply as the debt is more costly. Another mechanism is the DSR, which is a contract into which dai can be deposited and you receive some yield. If you want to increase demand for dai and the price DSR is increased and lowered when you want to decrease it. Vault owners also have a natural incentive to mint dai when there is a premium and repay the debt when there is a discount. The same is true for dai holders, they have an incentive to sell when price is above and buy when price is below.

For a stablecoin it is really important that it mentains the peg, otherwise users and protocols integrated with it will lose trust and stop using it, thus you won’t be able to issue dai, as with no holders, price would tank. So for the governance of the protocol or MKR token holders, this is of highest importance.

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Hi Rema,

Thanks so much for your reply. This certainly helps. I still have a couple of questions if you (or anyone else) has any further patience.

It certainly makes sense that if DAI trades at above the peg PSM users would create “PSM vaults” minting new DAI by giving other stablecoins at 1:1. They could then sell these DAI into the market at a profit. This would increase the supply of DAI and bring down the price, and the PSM users have the incentive to keep going until the price comes back to parity. The system is still safe as all DAI are backed by over-collateralized loans (“regular” vaults) or by StableCoins (“PSM vaults”). So yes, I get this bit (I think).
I am still confused about what happens if DAI falls below the peg. Certainly PSM users would be motivated to buy DAI in the market and then sell to PSM vaults at 1:1 in return for stablecoins. This will raise the DAI market price and the PSM users are motivated to keep doing this until parity is reached. BUT?? What happens if/when the stablecoins in the PSM vaults has all been used? If this happened it would seem that there would be a problem in maintaining the peg. So I am assuming for reasons that I don’t quite understand - the PSMs are always well enough funded, or there is some other reason to make this be an unlikely event. Can you help me understand how it is ensured that the PSMs are sufficiently funded? Or what else I am missing here.

Another question. In looking through the PSM doc (Module - Peg Stability Module | MakerDAO Community Portal) there is a sentence: “A PSM cannot offer DAI in trade if its debt ceiling has been reached”. This totally threw me. What debt?
I thought PSMs just held stablecoins, and have no liabilities or receivables - so I’m a bit lost on this one.

Many thanks in advance

Phil

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These are great questions - thanks for asking them!

rema has talked about the PSM which is an important cog in the machine but I can add a little about the other things that make the peg work.

Here’s what Maker Governance promises in general. If DAI is trading above $1, we will cut stability fees across all vault types to make it cheaper to take out loans. There’d be more DAI supply in the market and hence the price would come down. The opposite would happen if DAI was trading below $1 - we’d just crank up stability fees and incentivize vault owners to repay their debts and shrink DAI supply. This is the primary peg control technique we have, but it is a long-term response i.e. it takes some days for this effect to become apparent.

The short-term peg stabilization comes from two other sources.

The first is the PSM. I’m just going to use the USDC PSM in this paragraph. If the DAI is trading above/below 1 USDC, you can instantly arbitrage the difference and profit. This has the effect of boosting/shrinking DAI supply which corrects the price too. You are right that when DAI is below the peg and the PSM is empty or if DAI is above the peg and the debt ceiling of the PSM has been hit, this mechanism doesn’t work. Debt ceiling here simply refers to the maximum amount of USDC we can hold in the PSM. The “debt” nomenclature comes about because the PSM is minting DAI and the collateral is USDC.

The second reason why DAI remains on peg in the short term is game theoretic. Essentially, people trust that Maker Governance will eventually bring DAI back on peg. So if right now it is, say, below $1, it is profitable to buy DAI and later resell it when it’s back on peg. Demand for DAI therefore goes up as everyone tries to get some profit and this naturally pushes the price up. Similarly, if DAI was above $1, it is profitable to open a vault and mint DAI. You’d sell it for dollars and wait till DAI is back on peg. At that point, rebuy DAI and close the vault. You’ve made a profit assuming stability fees over this short period is insignificant. Moreover, your action of opening a vault and minting DAI boosted DAI supply while it was trading above $1. Win-win!

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Discount is easier to fix, because stability fee is not limitied upwards, while currently we don’t have negative rates. This makes premium more problematic than discount as the lowest stability fee is zero.

Each stablecoin PSM has a debt ceiling set by governance. You can check it here. This limits how much dai can be minted from each stablecoin and thus limits our exposure towards it. We want to have diversified exposure towards different stablecoins, but there is lack of options for us to chose from.

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these are helpful questions, at least for me.

is there a presentation/discussion of the monthly vault activity? Particularly around the inflows and outflows of various collaterals, across various platforms/exchanges and overall competitive dynamics?

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Thanks for your reply. Yes of course that makes sense - the mist is clearing. Thanks again

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I think - for wider adoption’s sake - we need to make sure people don’t feel “dumb” when asking basic questions about things that are inherently complex. Just a thought.

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Maybe there is a potential for @Content-Production to turn these kind of questions into something presentable for a wider audience?

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Yeah, this gives me a few ideas. Thanks for the heads up!

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No free lunch. Who lost?

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After AstronautThis’s clear reply I think I get this. Yes of course it is a zero sum game - the person who lost in this case is whoever bought the DAI when it was above the peg. Assume that there is a temporary spike in demand driving the price to $1.02. I and anyone else who wishes can post collateral and get DAI - which we then sell at the inflated price so adding to the supply. Assuming that the price comes back down to the peg we can then buy back at $1 and pay off our loans with a $0.02 profit per DAI - and the losers of this same amount are of course those who bought in at $1.02 and can now have DAI with a market price of $1

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I think pberent put it perfectly. If you buy DAI when it’s above peg or sell when it’s below, you’d have been better off waiting.

The point here is that any deviation from the peg creates an arbitrage opportunity for the entire market - this is what makes it self-correcting.

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I think the fourth piece of unsolicited advice in @TheExistence’s thread is very relevant here:

• Don’t be afraid to ask a question that may sound stupid because 99% of the time everyone else is thinking of the same question and is too embarrassed to ask it.

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By the way following the great help from you and Rema I published this on Medium to try to cement my understanding.
I hope that no one objects to this. Also if you have a chance to look , let me know if there are any errors.

Many thanks

Phil

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Looks good, thanks for publicizing Maker and DAI! Some things I spotted that you might want to edit

  1. The collateral types include ETH and stablecoins but there are many more.
  2. and others: The collateralization ratio is not always 150%. It depends on the collateral itself and can be changed by governance.
  3. During liquidations, the liquidation fee of 13% is also not fixed and depends on the collateral type.
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Thanks will make edits

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This is good.

One other KEY point: it is essential that Maker maintain solid collateral backing the DAI so folks are confident that each DAI otstanding is worth at least one dollar. From my perspective this is an existential risk and failing to maintain confidence in the DAI could destroy Maker/DAI very quickly.

This book does a very good job explaining how monetary systems work, including crypto. It takes you from the beginnings of monetary systems all the way to the present. Given your interest in the PSM, I highly recommend that you read it.

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Thanks very much for that. Will check out the book.

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the sections of crypto dont start till page 95 but its very useful info on the history of money before then

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