Increasing liquidity and stability for the DAI digital currency

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A Better, Smarter Currency

The DAI ecosystem has grown tremendously over the past five years, but its now faced with existential challenges given the interconnected nature of decentralised finance. DAI is minted by supplying ETH (or ERC-20 assets) into MakerDAO Vault smart contracts, establishing distinct Collateralised Debt Positions (CDPs). DAI avoids any immediate banking/centralised risk due to its permissionless nature, and has arguably become the most used digital collateral-backed synthetic asset in the world.

The market equivalent of more than 500 million USD is locked in various DeFi applications, and DAI is becoming a powerful medium for hedging against inflation, and making seamless e-commerce purchases. DAI is also the most supplied/borrowed asset on Compound, the largest decentralised lending platform. However, despite this impressive growth, DAI is underwhelming within the context of true user demand. For instance, in 2020 approximately 1 billion DAI (net) was minted by the crypto community. Meanwhile, USD Coin (USDC) increased its supply by more than 1.5 billion, and Tether (USDT) supply increased by almost 15 billion.

Supply and Demand

It is clear that DAI is far from fulfilling aggregate stablecoin demand. The main reason for this is straightforward: DAI supply is inherently unscalable. Given other options, there is insufficient incentive for users to lock up assets in low leverage CDPs (150% collateral-to-debt ratio) to meet demand, necessarily restricting the creation of DAI. There is also systematic risk of having to repurchase DAI at a higher price (during future periods of instability) to close a CDP and avoid liquidation. Ultimately, MakerDAO CDPs are not competitive with either centralised or decentralised lending services that offer more leverage, less risk, and a superior user experience.

This has unevitably resulted in CDP collateral becoming increasingly centralised to offset disproportionate risk; custodial-based assets (USDC, wBTC, PAX, etc.) currently account for the majority of collateral within Maker vaults. Since USDC (a custodial stablecoin with no fees to mint/redeem) is being used to create a decentralised stablecoin (with interest fees and liquidation risk), it is abundantly clear that DAI is being propped up by interested parties. Approximately 430 million USDC is locked in MakerDAO Vaults (close to 1/3 the entire market capitalisation of USDC). Conversely, virtually zero USDT is supplied to vaults, as it is irrational to mint DAI in this manner. Recently UNI-V2-DAI/ETH was approved as CDP collateral, fully establishing DAI as the Crypto Ouroboros.

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DAI collateralisation ca.2020

Most liquid crypto assets can be used as collateral to borrow DAI, but the overall market liquidity remains relatively limited since DAI is not universally redeemable (only the originator of the CDP is able to recover underlying assets). This system design creates massive risk in managing volatility; liquidators ultimately need to acquire a non-redeemable stablecoin, and then find subsequent buyers among existing sell-pressure. Absent benevolent whales, there are no financial incentives to avoid severe devaluation.

Black Thursday (12 March 2020)

Aside from the meme that DAI is worth 1 USD, nothing prohibits DAI from continuing to increase in price during sustained periods of high demand. During the 2020 Covid Crash, the collateral-to-debt ratio of CDPs fell dramatically, causing DAI to be hastily burned as positions were closed and/or liquidated. The negative feedback loop (increasing demand coupled with decreasing supply) pushed the market price for DAI up to 1.20 USD. As prices continued to exceed the liquidation ratio, some CDPs even held ETH worth less than the borrowed DAI, creating riskless arbitrage. Further, congestion within the Ethereum network caused the protocol itself to suffer losses of more than 5 million DAI due to non-competitive (0 USD bids) liquidation auctions. MKR holders adjusted the Stability Fee (SF) and the DAI Savings Rate (DSR) close to zero in attempt to dampen the avalanche of liquidations. Since the system does not support negative interest rates (artificially maintaining a redemption price of 1 USD) there is no concrete mechanism for restoring DAI/USD parity. A total of 17.25 million DAI was supplied to Compound (approximately 20% of all DAI at the time) which avoided potential seizure due to a self-imposed arbitrary price cap of 1.05 USD. With protocol incentives at 8%, liquidators could have paid an additional premium for DAI, further increasing the market price. If this artificial guard rail was removed, potential mass liquidations and almost certainly would have necessitated an Emergency Shutdown.

Market Dislocation (27 November 2020)

Six months later, the DAI market on Compound has grown to 1.6 billion DAI supplied and 1.3 billion DAI borrowed, eclipsing cumulative exchange liquidity and global trading volume of DAI by a vast margin. The price of DAI on Coinbase Pro (the primary oracle for Compound) began trading at increasing prices and volume across the DAI pairs, reaching 1.30 USD. During this period, 85 million DAI was repaid by liquidators, who seized collateral from addresses borrowing DAI. The 24-hour volume for USD-DAI was approximately 20 million USD, only a fraction of the liquidated amount. Given this occurred on one of the largest exchanges, with the most liquid DAI order book, even a weighted oracle would be vulnerable to similar exploits given the disparity of the collateral at risk.

Liquidity to Stability

Systematic stability is critical in order for DAI to continue to grow; community altruism and VCs protecting their interest in MKR tokens has finite financial outcomes. Also, users need a way to hedge against the risks of collateralisation inefficiency and market dislocations, which are bound to re-occur with even greater consequences. The potential to dramatically increase liquidity is the panacea for these issues. Long-term prices in an economy are proportional to the total supply of money in circulation. Enabling a method for quickly and efficiently expanding/contracting DAI will minimise volatility and risks within the entire ecosystem. In contrast to collateralisation where market participants are incentivised to stabilise the price through the backing with collateral, DAI can be governed by market forces.

ZAI: Zero Collateral DAI

ZAI is an experimental, DAI-pegged algorithmic stablecoin designed to enable open market activities and capital efficient supply dynamics. At its core, ZAI is a fork of Empty Set Dollar (ESD) with mechanics evolving the fundamental components of Stability, Composability, and Decentralisation.

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With ZAI, Open Market Operations (OMO) can be performed not by selling external assets, but synthetic assets (coupons) generated within the ZAI ecosystem. In essence, ZAI is a synthetic token as a tool for more rapidly responding to market conditions. Similar to ESD, the ZAI token can expand supply to ultimately satisfy elastic market demand for DAI. As ZAI tokens are created, by proxy the effective collateralisation ratio of DAI continues to decrease, potentially to create a functional ecosystem where synthetic dynamics can enable sustainable, under-collateralised lending.

ZAI serves a hedge against DAI migrating from its 1 USD peg:

· If DAI-USD peg decreases, (DAI < 1 USD) the ZAI protocol incurs debt and coupons are available for purchase

· If DAI-USD peg increases, (DAI > 1 USD) ZAI is minted to repay previously issued coupons and distributed to bonded LPs and DAO participants

This counterbalance creates a hedge against DAI deviating from 1 USD, and can reduce future volatility exposure. In the example of a price shock, a borrower can burn ZAI for coupons, and when DAI returns to 1 USD, expansion of ZAI (corresponding to increased market demand for a DeFi stablecoin) allows coupons to be redeemed at a premium against liquidation loss. Through these mechanisms, ZAI fulfills the aggregate demand for DAI, without requiring additional DAI (and compounded liquidation risk) to be created. ZAI is capital efficient synthetic DAI, generating increased market liquidity and enabling additional OMO processes.

Liquidity Catalyst

When DAI is supplied to MakerDAO Vaults as collateral, leveraged positions are created by lending ETH. Correspondingly, ZAI can be represented as a synthetic proxy for an unsecured crypto-based DSR Credit Default Swap (CDS). This can be used to inject liquidity into the DAI markets since ZAI provides a standardised platform (coupons, maturities, incentives) for MakerDAO Vault credit risk. Creating and trading DAI (bond proxy) is expensive relative to creating and trading ZAI (CDS proxy). ZAI also improves DAI allocation because it allows long-term investors to become levered basis traders. Some LPs can become “negative basis traders” who hold collateral positions with DAI and can purchase CDS protection. If basis traders cannot take leverage, they do not affect the price of the underlying bond. If basis traders can take leverage, they push up DAI price.

ZAI Parameters

As with ESD, ZAI was launched with on-chain decentralised governance so adjustments and upgrades can continuously be made to the protocol with token holder voting.

The most relevant parameters specific to ZAI include:

· Initial ZAI oracle constructed from ZAI-DAI Uniswap pair

· 30-minute epochs, 48 epochs per cycle (24 hours)

· Coupon expiry length: 365 cycles

· Bonding length 5 cycles (DAO), 3 cycles (LP)

30-minute epochs allow for quick responses to market demand, either via expansion or redemption of coupons to immediately inject supply into the market when it is most critical. Longer coupon duration is intended for greater longevity of the protocol, and ensuring hedged debt positions mature over appropriate time scales while helping maintain metastable equilibrium.

Conclusion

As more central banks and private consortiums seek to issue permissioned, centralised currencies it is imperative to continue driving liquidity for DAI as a decentralised, stable asset. Otherwise, DAI remains one of the largest existential risks in DeFi as one of its most important LEGO blocks.

ZAI has no pre-mine, and no VCs or private funding. ZAI is and always will be an open-source, community-led effort. Help us continue the effort to ensure that DAI can be used by anyone, anywhere, anytime.

Special thanks to Empty Set Squad for pioneering and evolving many of these concepts.

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