The Maker community has been intensively discussing how to address the issues surrounding the DAI peg over the last three months. The recent pressure caused by COMP farmers using Dai as their asset of choice has accelerated the need to address this issue more formally.
As of today, the community is moving forward with the response of increasing the USDC debt ceiling, which is important because it means that Maker Governance is showing a willingness to defend the peg, ultimately helping keep confidence in the Maker system.
However, there are some issues with stablecoins as collateral that we must keep in mind. One of the main primary issues being that the liquidations for stablecoins are not currently turned on due to the current auction system not being well suited to handle liquidations of stablecoins.
Another important issue is that adding stablecoins as collateral cannot actually fix the Dai peg, but only make it “less broken.” This means that the people who use Dai in their daily life, for companies that use Dai for business, or DeFi projects that integrate Dai, are still not getting the peg they expect or need.
Recently, the community has proposed alternative solutions that actually go a step further and have the potential to fix the peg immediately. One of the alternative solutions is displayed below:
- A thread detailing options for responses to the COMP farming risks, by @MakerMan and @Bit. They proposed that the DAO should create an Automated Market Maker that would autonomously trade Dai against USDC at the peg, directly injecting liquidity and stability into the Dai market.
Note that this concept has been proposed in a few different variations several times by community members in the past, for example:
- By community member @LongForWisdom:
- By community member @mmoossttaaffaa:
Initial Research and Findings
After some initial research on how to implement the community proposed concept to fix the peg, the Foundation concluded that it could be achieved by reusing a variation of the code that was used to facilitate the Sai to Dai migration bridge during the Multi Collateral Dai upgrade. This solution will be called a Peg Stabilization Module (PSM).
This is great because it means that the solution has already been tested extensively, having been live and battle-tested for six months. Thus, a Peg Stabilization Module can potentially be implemented immediately, quickly giving Maker Governance an option to bring relief to the Dai peg and shift risk away from the stablecoin collateral types that don’t currently support liquidations.
How do Peg Stabilization Modules work?
A Peg Stabilization Module is very similar to using a stablecoin like USDC as collateral for Dai, except it enforces a price of 1 USDC per Dai directly in the market. This ultimately makes Dai significantly more liquid and stable.
Using USDC as an example, Maker Governance would approve a special USDC collateral type with a Peg Stabilization Module adapter. The Peg Stabilization Module adapter would not allow users to join USDC as collateral into the Maker Protocol (the way standard adapters work), but instead would allow two things:
- Allow anyone to trade USDC for Dai, given the special collateral type has the available debt ceiling.
- Allow anyone to trade Dai for USDC, given the Peg Stabilization Module has the available USDC.
In scenario #1, when a user trades USDC for Dai with the Peg Stabilization Module, it automatically uses the provided USDC to instantly generate the corresponding amount of Dai through the special collateral type adapter.
In scenario #2, when a user trades Dai for USDC with the Peg Stabilization Module, it automatically uses the Dai to pay down its debt and free up the corresponding amount of USDC.
Governance Control of Peg Stabilization Modules
Governance can control Peg Stabilization Modules in the same way that it controls other collateral types in the Maker Protocol. Primarily, the Debt Ceiling risk parameter can be used to control how much exposure the system can have to a particular stablecoin. Diversification can be used to further manage the risk of the system and make sure that all of the exposure isn’t concentrated in a single stablecoin, but is instead spread out across several stablecoins (based on their perceived risk).
Governance will also be able to set a spread on the Peg Stabilization Module, allowing it to charge a small fee on every trade that is sent to the buffer - this way it becomes an income-generating feature and helps to pay MKR holders for the risk they are taking on the stablecoin collateral.
This solution is both very useful for the short term situation that the community finds itself in, with the system out of balance for a prolonged duration, and the mounting pressure from the COMP distribution to Dai holders.
Considerations for Peg Stabilization Modules: Short and Long term Benefits
Creating more Dai utility through a stable peg
The number one objective of the Maker protocol and Maker governance is to maintain the stability of Dai, so that the people, businesses and DeFi protocols that rely on it can trust that their money is protected from volatility. Delivering against this promise will drive continued growth of the project. The Peg Stabilization Module can restore the peg and utility of Dai to users around the world, which makes it a very important change to consider.
Strengthening the collateral portfolio by replacing collateral types that cannot be liquidated
The Maker protocol currently has a lot of Dai generated from the USDC-A collateral type, which has liquidations disabled. This is an undesirable situation, because the Maker Protocol wasn’t designed to support having collateral types with liquidations turned off, and it could potentially result in Vaults with more debt than collateral value that would be abandoned by their owners, yet still remain in the collateral portfolio.
But having liquidations disabled was necessary due to the fact that the current auction system is not well suited for liquidating low-risk assets, so it was done as a short term solution that would be replaced in the future. The Peg Stabilization Module is such a solution that would be able to replace this collateral type. It would allow Maker Governance to altogether remove stablecoin based collateral types from the system in the short run, solving the issue of disabled liquidations entirely, and removing any risk that the system will end up having abandoned, unliquidated Vaults with more debt than collateral value.
Encouraging natural Dai generation from other collateral types through stability and liquidity
A significant advantage of the Peg Stabilization Module is that it helps with stability and liquidity when the price goes above the peg. It also helps to provide liquidity and stability for when there is Dai supply to sell. This means that it helps encourage vault creation and Dai generation from other assets, such as ETH, because it gives vault users a lot of reliable liquidity to sell their Dai to if they are looking to pull fiat currency out from their vault.
Generally, a reliable peg makes Vault holders more willing to generate Dai. In contrast, an uncertain peg makes it riskier to generate Dai, since it is less clear if it will be possible to later unwind the position again without having to buy back Dai at a price different from the peg. Providing a solution to this issue with the Peg Stabilization Module is a significant advantage in the short run to try to get the Protocol back into a natural balance. Still, it will also continue to be a substantial advantage in the long term. It generally improves the user experience and value proposition the system offers to its users, both Dai users and Vault users.
During times when the Maker Protocol is out of balance, the Peg Stabilization Module will keep the Dai peg stabilized by building up potentially large amounts of stablecoins as collateral. Since the Peg Stabilization Module encourages natural Dai generation, the built-up stablecoins within the Peg Stabilization Module will be used by new Vault users to exit to fiat if there is a significant buildup (this will only be temporary).
This means that the Peg Stabilization Module naturally unwinds itself as the system goes back into a balanced state. Therefore, the Peg Stabilization Module will not contribute to the long-term buildup of stablecoins as collateral in the system. Instead, it will work against it by helping to bring the system back into balance quickly. This ultimately minimizes the amount of time the Maker Protocol needs to have substantial exposure to stablecoins.
Becoming the trading hub for stablecoin swaps
Another long term advantage that the Peg Stabilization Module offers is the ability to become a hub for trading different stablecoins against each other.
If Maker Governance adds multiple stablecoins to Peg Stabilization Modules and enables low-fee 1:1 trading for each of them (against Dai), it would allow the trading of different stablecoins against each other as a side-effect. As a result, this would ultimately help with overall liquidity in the DeFi ecosystem. At the same time, Maker would be compensated by charging the Peg Stabilization Module spread twice for providing the service.
Creating a reliable on-chain signal for automatic Dai Savings Rate (DSR) and Base Rate adjustments
A planned feature of the Maker Protocol is a system for automatically adjusting the DSR and Base rate in response to changes in the market dynamics of Dai, to help better keep the long term stability of Dai. This would be similar to an earlier described feature of the system known as the TRFM (Target Rate Feedback Mechanism). Because changes in the market dynamics will instantly be reflected in the balance of stablecoins against Dai in the Peg Stabilization Module, this will provide a reliable, on-chain signal that such a system could
The Peg Stabilization Module is a very powerful concept, so it isn’t unlikely that there would be even more long term advantages that will be discovered by the community, once the immediate issue of managing the peg has been dealt with.
Overall, this forum post aims to make the community aware that this proposal exists and that it is indeed technically feasible to implement on very short notice since a variation of the code used to facilitate the Sai to Dai migration bridge during the Multi Collateral Dai upgrade can be used.
In terms of the immediate future, the plan is to continue research and development over the course of the weekend to test further the feasibility of implementing a Peg Stabilization Module quickly - So Maker Governance will have the option to use the Peg Stabilization Module to bring immediate relief to the peg as soon as possible.
Initially, due to the time-sensitivity of maintaining the peg, the Peg Stabilization Module would be proposed as a non-Maker Improvement Proposal (MIP) executive vote that could be done on short notice. However, if the proposal is accepted by the community, the Maker Foundation will work with the community to create an official MIP that formalizes the various governance aspects surrounding Peg Stabilization Modules, and allows the community to iterate and build on top of the concept.