This is the problem I am seeing:
“How does MakerDao scale while also defending the Peg and restoring confidence in the system in a manner that is sustainable and limits exposure to collateral risk (mainly USDC is the current focus)?”
We need to balance demand. Demand on one side of collateral in the system generating Dai as a loan and Demand on the other side of Dai as a stable-coin in the markets.
We want this balanced in a way that fits the risk tolerance MakerDao has for all of the different collateral types especially custodial stable-coins.
We implement a PSM. The exact details are still open for debate. This will accomplish many things including these main pros:
- Increased confidence and liquidity in the system from all sides
- Massively increased collateral in the system and Dai being lent
- More fees being generated by the system
- A tighter kept and defended Peg price for Dai
- All positive side effects and feedback loops associated with above
MakerDao fears these main cons from PSM implementation:
- Too much collateral builds up in the system (specifically USDC)
- Risks that come with increased collateral such as devaluation or blacklisting of that collateral. Think USDC falling to $0.00 overnight.
- Potential negative impact of PSM on MakerDao incentive structure
- Long term negative feedback loops / outcomes that stem from the above
Ok great, What?
Now, we discuss mitigation of the cons because I think it is clear that the demand problems MakerDao has are ones associated with not having enough collateral in the system and the PSM massively increases collateral but as of the current thinking comes at the expense of these cons listed above.
If MakerDao can navigate these cons it can extract the value from the pros at the least cost possible yielding a good return from a PSM implementation.
These are the four major cons again and what I think can be done to mitigate them:
Too much collateral builds up in the system.
MakerDao can address this by inviting more of the collateral types it wants into the system and trading out via lending for Dai the ones it wants to remove exposure to. In doing so it will actually generate even more fees and pull more collateral into the system but in this case the collateral it chooses. It will do so as a result at better rates than the competition because it can afford to subsidize these loans if needed using PSM profit.
Risks that come with increased collateral such as devaluation or blacklisting of that collateral. Think USDC falling to $0.00 overnight.
MakerDao can address this by loaning out the collateral types that it wants to reduce exposure to and accepting collateral of other types in return. So it would loan out the USDC for example essentially selling it for 1 Dai debt each in the process and take in more collateral of other types. This will earn MakerDao more stability fees, increase Dai supply further, and at the same time remove the exposure of whatever asset that gets loaned out.
Potential negative impact of PSM on MakerDao incentive structure
The negative impacts that are unseen I do not have an answer for yet because they are unseen, but the ones that have come up so far in discussion appear to be overstated. For example: the main one I have heard is that market makers will have less room to market make. This is not that big of a deal compared to the pros MakerDao is getting in return and also these market makers can still work inside of any range excluded by MakerDao PSMs, can front run PSMs, and can get engaged in other parts of the MakerDao system to make profit such as trading to the PSM etc… I feel that this isn’t that big a con and has some pros along side it anyway.
Long term negative feedback loops / outcomes that stem from the above
The feedback loop MakerDao needs to be aware of is that this collateral lending and trading is not infinite. If at some point the demand for Dai is just too high and there is no collateral to onboard as a result of debt ceilings being maxed across all collateral types and users refusing to take out loans of the collateral MakerDao wants to limit exposure in there is no simple easy solution. The best solution I have I will share in a future post, but here is a quick summary of it:
In the event that all other options are exhausted and negative interest rates or simply creating Dai out of thin air or backed by MKR as collateral will not suffice as they break the MakerDao social contract to not inflate Dai (granted this can still be done instead of global settlement it just isn’t what MakerDao will likely want).
MakerDao will solve this by reducing the collateral requirement ratios to their lowest safe levels while also lowering the liquidation penalty to as low as it can (for the sake of example lets say 5%). It can then set one last PSM at the highest price it is willing to let Dai go before global settlement and simply use the proceeds to buy collateral from the market and generate Dai with that collateral indefinitely because the proceeds of the Dai being generated and sold through the PSM are so high that the system can afford to keep buying assets. I am not certain that this last part holds true however, so please have a think on it. We are very far from hitting this point and by then MakerDao need to have a well crafted solution in place.
In the meantime MakerDao is FAR from having those type problems and the PSM is a good choice right now to continue to allow MakerDao and Dai to develop and grow.
TLDR: Peg Stabilization Modules have many pros and only a few relatively easy to mitigate cons. They should be discussed in detail and put in place to help support the MakerDao Ecosystem as it grows.
At least, this is my perspective.