Coronavirus pandemic stresses world systems on all levels — from individual human biological immunity and mental wellbeing to potentially geopolitical order. Blockchain ecostems, still a tiny element of the global economic system, experiences this as well. Two weeks ago the Black Thursday happened, with all stock indexes plummeting to the levels not seen in decades. Cryptocurrencies got hit even harder, loosing close to 50% in some instances, in a movement correlated with stock markets’ loses. This coupling suggests that cryptos still have not become  alternative currency, a save heaven for the time of turmoil, but rather are sill regarded as investment instruments, and rather riskier ones.

Łukasz Jonak, Analityk DELab UW

Price of Ether during the initial phase of Coronavirus pandemics

DAI and Decentralised Finances

The pandemic stresses not just the first-order crypto markets, but also the financial ecosystems built on top of crypto blockchains. Decentralised Finances (DeFi) movement has been the most exiting and dynamic recent development on Ethereum blockchain. It is an ecosystem of financial services allowing users to utilise their (crypto) money in the similar manner to the traditional world of finances. Users can exchange different kinds of currencies (tokens), save and lend money with interest rates even higher compared to the legacy systems, they can trade derivatives, including the synthetical ones, corresponding to the “real world” assets such as gold, they can borrow, and speculate using leverage, if they fell adventurous. Various services complement and support each other; when you invest in liquidity pools of crypto swapping services (earning the percentage of transaction fees on crypto pairs) you actually make the operation of theses services possible, providing liquidity necessary to exchanging currency for other users. And the crucial thing about all this ecosystem is that it works in decentralised manner — there are no banks, brokers, central financial policy making agency.

Very important element of DeFi is MakerDAO foundation and its product: DAI stablecoin, living on top of Ethereum blockchain. While Ethereum’s native cryptocurrency, Ether, is very volatile, DAI’s price is constant: o unit of DAI costs around one dollar. The existence of stable coins (there are other than DAI as well), provides stability needed for the operation of all the other services of DeFi ecosystem.

The special thing about DAI is its decentralization — its stability is not contingent on any central entity and arrangement, for example, a basket of traditional currencies kept in a bank external to the blockchain systems. What stabilises DAI is the way the currency is being issued on the blockchain. DAI is backed by the volatile Ether locked in the system as collateral when users want to generate/borrow some DAI. If you want to generate 100 DAI you need to commit at least $150 worth of Ether. You get it back when you return the 100DAI to the system. This way all the DAI in circulation is secured by a safe, excessive amount of Ether.

The perfect storm

There is a number of mechanisms guarding the stability of DAI. Auctions of locked Ether take care of situations when the price of Ether falls to the levels insufficient for it to back DAI anymore. Stability and saving fees regulate the supply and demand of DAI, depending on how much it deviates from its dollar peg. These mechanisms are designed to withstand serious market perturbation and attacks. Unfortunately, the Black Thursday created a perfect storm for MakerDAO and DAI, one that the system barely survived.

Couple of things happened:

  • Ether prices dropped sharply, following the general markets’ panic,

  • Users fled to the stable DAI, increasing demand for it and consequently, its price, threatening to detach it from the dollar peg,

  • The traffic on the Ethereum blockchain increased, making it longer for some of the transactions to go through,

The results were nearly catastrophic. If Ethereum transactions slow down, everything on the blockchain, including MakerDAO/DAI mechanisms, slows down. The services providing system with the information about current prices (so called ‘oracles’) couldn’t do it on time. The users who wanted to add Ether to their devalued collateral and avoid their locked Ether auctioned couldn’t do so. The auctions themselves, designed to maintain DAI collaterization when Ether price falls, couldn’t go through. What’s worse, some rogue agent abused the crippled auction system and was able to win some of them, buying auctioned Ether for the equivalent of zero dollars, or close to it. This costed some users all their locked collateral and created dangerous, over $4 mln deficit in the system, undermining the strength of DAI as a currency and stable coin.

Saving DAI

The MakerDAO foundation scrambled to address and control the situation. Following the Black Thursday and throughout the next week, the team held daily calls during which various countermeasures were discussed. If you replay the recordings of these meetings (they are available on the MakerDAO youtube channel), you’ll notice they were punctuated with a mixture of disbelief about what was happening, worry, the resolve to fix the system, and, eventually, exhaustion. The stakes were high, there was a risk that emergency shutdown of the entire system would be triggered, annihilating all the DAI in circulation, leaving currency users with a loss of some of the value of their holdings, and threatening the existence of the whole DeFi ecosystem.

A number of solutions were proposed: the increased duration of collateral auctions gave legitimate bidders chance to participate and outbid malicious ‘0-bid’ actors. In controversial move, another, centralised stablecoin, the USDC, was allowed to be used as collateral, in pursuit of more system stability. A radical adjustments of key system parameters (meaning slashing them to the minimums) were proposed in order to incentivise users to mint more DAI and increase the amount of the currency in circulation. Finally, in order to cover system’s deficit, the minting and auctioning of MakerDAO’s native token, MKR, was discussed.

DAI price off-peg

All of these proposals went through the governance process, in which the MKR token holders (meaning the users incentivise to act in the best interest of MakerDAO system) voted for each solution. As of today the MKR auctions managed to supply system with funds enough to reduce the debt, USDC has been allowed to back minting new DAI (although with mechanisms in place to discourage its long-term utilisation in the system), the collateral auctions started to operate with adjusted parameters.

The situation seems to be stabilised, although MakerDAO and DAI are not completely out of the woods yet. The whole ordeal seems to have undermined users’ trust in the system. The bad debt has been covered, but DAI is still off peg, trading a couple of percent above one dollar. There is still not enough supply of DAI to drive the price down, possibly because the users are reluctant to mint new DAI by locking their Ether in the MakerDAO system.

The MakerDAO crisis highlights how the extreme, black swan-like, situations can expose all the vulnerabilities of highly innovative and still experimental socio-technical systems. For Maker, as well as the whole blockchain world, the coronavirus pandemic produced an extreme stress-test situation, if not straightforward existential threat. Only time will tell if the ecosystem will be able to endure these circumstances and, perhaps, fortify itself for the future.

Autor projektu: Łukasz Jonak

Projekt finansowane ze środków programu “Dialog” MNiSW