10. DAI’s stumbling road of exploration

Rune Christensen co-founded MakerDAO in 2015. The project issued the decentralized mortgage lending stablecoin DAI, which has a price ratio of 1:1 with the U.S. dollar and the equity currency MRK. In addition to its governance function, this currency also has the stabilizing effect of underpinning DAI. On September 17, 2023, DAI ranked 12th on the Coinmarketcap with a market value of 5.3 billion. Equity currency MRK ranks 37th, with a market value of US$1.25 billion.

The idea of stablecoins originated from J.R. Willet in 2012. No one outside of the industry knows about Willett. He was responsible for the initial public offering of digital currency (ICO). The cryptocurrency industry is full of such geniuses. Dan Larimer, nicknamed B.M., once had conversations with Satoshi Nakamoto in the Bitcoin community and co-founded BitShares in 2012. In 2014, BitShares issued a decentralized stablecoin, the BitUSD, backed by BitShares’ native equity token, BTS. Rune Christensen is an active member of the BitShares community. He began to explore the feasibility of launching a collateralized stablecoin on the BitShares platform. Still, he later found that the Bitshares network could not support a complex financial system, so he chose the Ethereum platform.

Among the top 12 cryptocurrency projects, apart from Satoshi Nakamoto, only three are old people in the currency circle: Vitalik of Ethereum, Charles of Cardano, and Rune. I don’t know if it’s God’s guidance. The smallest unit of Ethereum is WEI, and Rune’s stable currency is DAI. Rune knows some Chinese, and he said DAI means lending in Chinese. Is this really the case? DAI cannot reflect the essential connotation of a stablecoin and cannot be easily understood by people at a glance like USDT or USDC, and he knows how B.M.’s stablecoin, BitUSD, was named. He will never fail to understand the meaning of the name and will never mislabel it. His intention is the same as Vitalik’s: to pay tribute to Satoshi Nakamoto (i.e., WEI DAI). It just so happened that both of them were at the forefront. The deeper meaning he expressed is the understanding of Bitcoin’s ideas. This understanding is one of the reasons he and Vitalik were able to run to the forefront. Readers interested in this can refer to the author’s series of articles, “Invite out Satoshi Nakamoto to welcome the new world” (chainless.hk). Autumn can be seen in a leaf, and it is no accident that Ruen got to where he is today. In addition to Dogecoin, which has a unique spiritual value, the projects of other people who learned from Satoshi Nakamoto to “disappear” have also disappeared without a trace. In addition to store value, Bitcoin also represents a spirit. Cryptocurrencies, whether it is a centralized project or decentralized project, does not have Bitcoin’s transcendent status. In the fierce market competition, it will not work if the project side is weak, let alone if the actual controller disappears. How big can the technical difference be? The principle of competition causes projects that no one manages to die quickly.

Survive tenaciously in the fierce market competition

ERC-20 is the standard for creating your tokens on the Ethereum network. As an Ethereum ERC20 standard token, DAI was launched on Ethereum in 2017. At this time, the currency circle is in a bull market. People do not want to sell Ethereum but wish to increase their positions. Even paying a little interest is worthwhile when pledging Ethereum to increase their positions. That is a pain point. The difficulty is not in staking but in how to keep DAI stable and the price ratio of the U.S. dollar basically unchanged.

The stability mechanism of DAI has two points:

1. When DAI deviates from 1 USD, the market automatically adjusts using the mortgage principle, and someone will automatically issue and destroy DAI;

2. Adjust the mortgage interest rate artificially.

These two points demonstrate the effectiveness of the regulatory mechanism, which is market regulation plus centralized regulation. In other words, although it is a community operation, it still has operating entities and is not absolutely decentralized. Strictly speaking, Maker Dao’s market regulation is automatic, while people still make community regulations using a democratic mechanism. It differs from the spontaneous market adjustment to a certain extent, but its data is open and transparent. It is the key to meeting Satoshi Nakamoto’s machine trust standards and being recognized by the market as a decentralized stablecoin. For information on machine trust standards, please refer to this series “Nine, Ununderstood TON” (chainless.hk).

In addition to these two stabilizing mechanisms, the equity coin MRK also plays a supporting role for DAI in extreme situations.

In a bear market, people have fewer opportunities to make profits, and naturally, fewer people mortgage Ethereum. The flaw of this model is that profits are unstable. Obviously, it is difficult to maintain the project by mortgaging Ethereum alone. Therefore, they developed a multi-collateral model to accept collateral types other than ETH, promoting the increasing supply of DAI.

There are always threats to Maker Dao. The biggest threat is the change of Ethereum, the underlying ecosystem. Like when the U.S. dollar sneezes, the world catches a cold. After Ethereum changes to proof of equity, the way to make profits is not mining. Instead, Ethereum can be mortgaged to make profits, which hurts smart contract projects that rely on Ethereum to make profits, such as DAI. Ethereum’s annual mortgage interest rate can reach more than 3%. That becomes the same risk-free interest return as U.S. Treasury bonds. If the profit from staking Ethereum on the Maker Dao platform does not exceed 3%, users will not be incentivized to mortgage Ethereum. DAI’s normal mortgage interest rate is 2%, forcing Maker Dao to improve. The most significant change is the design of the liquidity pool PSM (Peg Stabilization Module).

PSM, also known as the Anchoring Stability Module, is a fixed-price currency swap agreement based on Dai. It aims to provide bilateral buffer protection for the price of Dai in the event of external market shocks. Users can mint stablecoins such as USDC into new Dai at a 1:1 ratio within a certain total amount. This part of the transferred USDC will be stored in the liquidity pool as a reserve asset. Any Dai on the market can also be exchanged for USDC in the liquidity pool at a 1:1 ratio. Only a 0.1% handling fee is charged during the exchange process, and interest can be received by injecting DAI. In order to attract deposits, Maker Dao was forced to offer high-interest rates. On August 7, 2023, the deposit interest rate of the liquidity pool was increased to 8% in the form of short-term subsidies. This loss-making trade was intended to attract small retail investors but instead attracted crocodiles. Maker Dao was subsequently forced to lower interest rates.

After the proposal to lower it to 5% took effect on August 20, 2023, some alligators withdrew from the liquidity pool, including Tron’s Justin Sun. He used 206 million DAI to redeem the mortgaged 235,556wstETH. wstETH is a cross-chain Ethereum issued by the LiDo platform, also called packaged Ethereum. Low handling fees characterize it. What is Brother Sun’s profit from saving 206 million DAI for 9 days? It was 257,000 DAI, equivalent to 257,000 US dollars, and he used it to buy 154 Ethereum. It shows that Brother Sun can seize opportunities. Once the chance appears, he will cut everything. By the way, the transparency of cryptocurrency is far higher than that of traditional finance, and everyone can see Brother Sun’s every move.

In addition to further stabilizing the price of DAI, the liquidity pool’s purpose is to adopt the same profit model as the centralized stablecoin. The centralized stablecoin project uses the U.S. dollars it receives to buy U.S. bonds. At the same time, Maker Dao uses the stablecoins USDC it receives to buy U.S. bonds and other investment products and also buys the most fashionable RWA (Real World Asset) among them. Since the current risk-free interest rate is a little over 5%, the bond interest rates of all companies and banks must be above 6%, thus creating room for arbitrage. This arbitrage space is tiny, and the high handling fees of Ethereum have become a factor that cannot be ignored. Ruen wrote that he wants to develop products similar to DAI on Solana, which can overcome the problems of high handling fees and low speed of Ethereum. His statement angered Vitalik. He liquidated all 500,000 Maker Dao equity tokens MRK in his hands and published an article recommending the little-known token RAI, describing it as a way to go. The “ideal type” of centralized stablecoins. RAI has a market value of only US$6.86 million, ranking 849th. Although its principles have merits, the market is no longer the same as when Vitalik was successful, as I said in this series “Nine, Ununderstood TON.” As I said, projects that do not understand finance and marketing will be challenging to succeed even if they have principled innovations.

Risks faced by Maker Dao

The author has always said that cryptocurrency is the greatest experiment and exploration of the people. Everyone involved is contributing their money and power to promote the progress of the times, and Ruen is one of the great explorers who adheres to Satoshi Nakamoto’s ideas. The direction of collateralized stablecoins is good, and DAI has a solid competitive advantage over centralized stablecoins with larger market capitalizations. Maker Dao’s reserves can be audited on-chain, while projects like stablecoins USDC and USDT must rely on external audits. In the case of USDT, the project has experienced increasing scrutiny recently as the source and credit quality of its reserves have been questioned.

However, Maker Dao’s business model is unstable, and profits fluctuate too much with the general trend of cryptocurrency. Therefore, the market only gives a price-to-earnings ratio of about 10 times for his equity currency MRK.

The risk of buying bonds on Maker Dao is unpredictable. Silicon Valley Bank used users’ money to buy bonds, causing its books to be insolvent and bankrupt. There is no problem when interest rates are high, but who can predict how the Fed will adjust next? The business model of USDT is simple. Although profits fluctuate with the general trend, USDT is oriented to the mainstream market. As cryptocurrencies penetrate mainstream applications, the market will continue to expand, and gains will be sustainable.

The mortgage and liquidation mechanism of Maker Dao is too complicated, far more complicated than the mortgage and liquidation methods of stocks. They are still thinking in the currency circle, unlike the stablecoin USDT, which is oriented to the traditional financial market and is the entrance to traditional finance and cryptocurrency. Maker Dao started not much later than USDT, but its market value is 10 times worse. USDT is issued on many platforms, not limited to Ethereum. If DAI is connected to legal currency, the situation and the sustainability of profits will be very different.

Maker Dao’s idea of letting the community make decisions is a good one, and it divides accounting units into small accounting units called “sub-Dao” based on project types. They thought of many ways. Ruen thinks this is Satoshi Nakamoto’s thinking and that he is too mechanical. Community decision-making is not suitable for the current state of Maker Dao because the market competition is very fierce. Community decision-making is firstly slow and secondly irresponsible. The community makes decisions by voting, which is suitable for electing a “president,” but the president doesn’t do the work, right? We cannot delegate conflicts to a lower level, as this will lead to death. Because Maker Dao is now a centralized company that adopts democratic decision-making, and most cryptocurrency application projects are “companies,” you must be careful when using community governance. Who is using community governance best now? It’s Vitalik. He uses online and offline methods to listen to and respect community suggestions and strive for consensus. The core team makes decisions.

Vitalik promoted distributed governance DAO and described excellent prospects, but he did not use it, and Ruen was into it.

Among the top 12 projects, Maker Dao is the only one with trading and equity tokens. Only they got it right.

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