Dai is now 60% backed by centralized assets – what does that mean?

Source: coinmetrics.io, 7-day moving average

Like any other asset, Dai’s price is the result of supply and demand. When it trades above $1.00, there is more demand to hold the token (go long Dai) than to create it from CDPs and sell it (go short Dai).

There are two reasons why demand has exploded: Dai’s use in yield farming and general demand for stable assets in a time of global uncertainty.

It is this persistent divergence from the peg that has forced Maker into a corner. From a high level, there are three mechanisms to stabilize a currency:

1. Interest rate policy
2. Open market operations
3. Collateral policy

We analyzed all three options in greater detail in a previous article.

The gist is that Maker has reached its self-imposed limit in terms of interest rate policy (they are unwillig to go below zero rates, which would be the equivalent of longs paying shorts). They are also unwilling to perform any open market operations, presumably because of regulatory concerns.

So the only remaining tool in their toolkit is collateral policy. To increase the supply of Dai, Maker has to strike a balance between adding collateral that is safe for the system and that users want to borrow against. They are actively adding more trustless forms of collateral, but
there have been few high-quality collateral assets before the recent DeFi runup (LCR, COMP, and LINK will be added soon.)

So, in the absence of a faster due process and more trustless collateral types on Ethereum, the only way to meet Dai’s explosive demand has been to allow centralized assets, especially stablecoins, into the system.

Their addition creates a fantastic arbitrage opportunity for traders. For example, you can make 100,000 Dai from $101,000 of USDC – because the collateral ratio is 101%. if Dai trades at $1.02, you can sell the 100,000 Dai for $102,000 of USDC – an instant arbitrage cycle. (The lack of which was something Su and I had previously criticized in a 2019 article)

Not only did you make an instant $1,000 on your trade here, but you also retain the option to rebuy the $101,000 USDC in the CDP at a profit if Dai ever trades below $1.01. for example, when it trades at $1.00, you can buy back the $101,000 USDC for $100,000 Dai for another $1,000 profit(1).

There are three takeaways:

1. This arbitrage singlehandedly explains the rise of stablecoins inside Maker.
2. Dai can never go above $1.01 again as long as the collateral ratio on stablecoins is 101%. At any price higher than that, arbitrageurs would mint more Dai and sell it at an instant-profit, pushing the price back down.
3. The stablecoins will naturally disappear from the system when Dai has returned to its peg.

The final point might need some unpacking. When Dai returns to $1.00, there is a double incentive for arbitrageurs to unwind their stablecoin positions. First, they still have a negative carry because of the stability fee charged on stablecoin vaults (currently 4%). Second, they should exercise their option to rebuy the collateral with the now cheaper Dai.

Dai can return to $1.00 either because the demand to hold it has decreased, and then supply would naturally follow. Remember that Dai is tokenized debt, created from CDPs. So when arbitrageurs unwind their positions, Dai is necessarily destroyed in the process. Alternatively, demand to mint Dai can increase, creating more natural supply to meet market demand.

For one, I have my eyes peeled on the upcoming release of the Yearn’s yETH v2 vault, which generates Dai from ETH collateral to farm CRV in Curve. If the v1 vault is any indication, this could create hundreds of millions of additional Dai, which – holding demand constant – should flush out many stablecoins from the system.

(1) Further, liquidations for regulated stablecoins are currently disabled. Their value of $1.00 is basically hardcoded into the oracle.

AUTHOR(S)

THANKS TO

monetsupply, Musa and Su zhu

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