Maker’s Black Swan

For anyone who has been keeping an eye on the DeFi landscape, it’s hard to go far without hearing mention of Maker and their stablecoin, Dai.

Maker is a permissionless lending protocol which allows users to post supported collateral — like ETH, BAT and now USDC — in order to mint new Dai. The system is unique in the sense that there is no KYC required to do so, and anyone can actively deposit or withdraw collateral to their Vault at their convenience.

To give some context on the points discussed in this article, there are a couple of key aspects of the system which are worth keeping in mind.

Stability Fee & DSR Relationships

In the current version of Maker, tokenholders vote on the spread between the Stability Fee — a debt which is incurred by those who borrow Dai and the Dai Savings Rate — an annualized return earned by those who lend Dai.

What’s important to recognize is that the spread is used to help control the outstanding supply of Dai.

In situations where demand is low — often taking the form of Dai trading below $1 — the DSR will increase, effectively incentivizing people to save more Dai to capitalize on an attractive return. When demand is high — often taking the form of Dai trading above $1 — the DSR will decrease, as to encourage people to close their Vault and supply the rest of the market with that Dai.

Similarly, the Stability Fee is a great way to aid in the borrowing of Dai. Simply put, the higher the Stability Fee, the less likely people are to borrow, thus providing a better control on a smaller circulating supply.

Collateralization Ratios

As with most of DeFi, active positions are overcollateralized by a minimum of 150%.

What’s interesting about Maker is should a Vault fall below the required 150% collateralization ratio, the position is automatically liquidated, with a 13% penalty applied. The collateral stored in a Vault is then auctioned off to buy-back the lost Dai, generally resulting in the borrower losing ~50% of their collateral in the process.

These auctions are performed by designated ecosystem actors called Keepers, and herein lies the story of our article.

Remember how all Vaults require a minimum of 150% collateralization?

Well, what happens when the price of Ether drops by ~50% within 24 hours like what we saw on Thursday in light of the global pandemic?

To state it plainly, a very large number of Vaults get liquidated, effectively triggering a mass Keeper auction. Now while Keepers were swarming to bid on the first round of liquidations (while ETH was still around $190), the price kept dropping, going all the way down to $80.

This effectively created the largest list of liquidation auctions to date. While Keepers fought to participate in tandem with mass margin calls on DEXs like dYdX, gas prices went as high as 200 gwei, roughly 10x their normal costs.

Seeing as Keepers bid on auctions using Dai, the market suffered from an extreme shortage due to demand drastically outpacing supply.

What resulted was 99% of Keepers buying what they could, still leaving a large gap in auction capacity.

This is when one Keeper decided to do the unthinkable — bidding to buy all the liquidated collateral at $0/ETH.

Seeing as there was no other Keepers with Dai left to counter this bid, the auction *succeeded* and one Keeper made off roughly $4.5M worth of ETH for $0.*

The result? Everyone who was liquidated received 0% of their collateral in return, effectively creating a bad debt expense to the tune of roughly $5M.

This thread of Reddit goes to show just some of the dozens of Vault owners who were drastically affected by this swing.

As the dust started to settle, it was determined that Maker would hold their own auction, effectively minting new MKR which would be sold on the open market to recoup the $5M worth of Dai that had been lost in the Keeper exploit.

In lieu of the liquidity crunch and the upcoming auction, the DeFi community has banded together to create the Maker Backstop Syndicate.

The goal of the syndicate is to effectively become the buyers of last resort for the auction, ensuring that the auction results in a success and all of the system’s debt is covered through the sale of MKR.

“We are proposing establishing a pooled auction contract that would give syndicate participants a way to participate in the auction process should the price of MKR (denominated in Dai) fall to, say, 100 DAI / MKR. Anyone could trigger an auction using pooled funds at the given price once the auctions begin, and all participants in the pool would be able to redeem the tokens they minted by supplying Dai for the equivalent Dai / MKR blend held by the pool.”

The Maker Syndicate garnered a fair amount of traction as prominent DeFi community members pioneered the effort. Some of the well-known names include:

  • Brendan Forster (COO of Dharma)

If you’re interested in looking at the full list of pledges, you can visit the official google doc here.

It is a relief to see that the DeFi community have elected to support the Maker Protocol during these troubled times. The strong community sentiment is a testament to Maker’s increasing antifragility — a property found in crypto protocols where shocks, volatility and other stress events result in an increased capability for the system.

As a response to the system’s malfunctioning, a multitude of new implementations are being considered to help prevent an event like this from happening again.

While the community-driven efforts are well-received, MakerDAO has also proposed a handful of system changes to combat the issues and return Dai’s peg to its rightful place. These changes include:

  • Lowering the DSR to 0%

DSR To 0%

The most shocking change here is the DSR dropping to 0% — the lowest it has ever been since inception back in November 2019. The cut to the Dai Savings Rate came as a by-product of the decision to cut the stability fee to 0.5%.

The drastic reduction to the stability fee creates a new dynamic for Dai (as we outlined above) as it is now cheaper to borrow Dai from Maker than any other DeFi platform, theoretically creating an influx of new supply from users.

How the changes to the DSR and Stability Fee will play out in third party lending markets is yet to be seen, but we’ll be keeping a close eye on it in the coming weeks.

Governance Security Module (GSM) Changes

Even though the recent introduction of the 24-hour GSM was a safeguard against flash loans, it constrained the ability for MKR holders to react swiftly during times of volatility. In turn, MakerDAO submitted to the proposal to reduce the GSM to 4 hours as a measure to ensure protection against governance attacks while speeding up the turnaround time for new executive votes.

Decentralized Circuit Breaker

The last major addition to the suite of executive votes includes what effectively is a decentralized circuit breaker, to be utilized only by the authority of MKR holders.

The proposed solution, engineered by the Maker Foundation, will enable the ability to temporarily disable Vaults from being sent to the auction liquidation module. To re-enable liquidations, MKR holders would have to pass a subsequent executive vote.

It’s important to note that the proposed module lives outside of the GSM and is not subject to the aforementioned 4-hour delay.

The introduction of the circuit breaker provides another tool for MKR holders to effectively ensure the proper functioning of the system at large. From a high level, this is a relatively simple mechanism to implement at a technical level as well as decentralized at the social and governance level.

However, all of these tools and changes may still not be enough to restore and battle-harden the Maker system.

There’s one last thing MakerDAO is looking to implement.

With the above-mentioned measures in place, Maker effectively looked to stimulate Dai supply however they could. Unfortunately, this was not enough to bridge the gap for the upcoming auction demand. Instead, the team decided that introducing a new type of collateral was the best way to quickly allow users to create new Dai.

To a high degree of contention, USDC was selected as the new collateral type, effectively allowing users to supply the permissioned stablecoin at a 20% Stability Fee to create new Dai.

The theory is that the high Stability Fee can be seen as a short term measure to allow users to mint new Dai to participate in the upcoming auction while discouraging average users from using USDC to create Dai in the long-term.

Here’s a great thread on why USDC was chosen as the newest form of collateral.

On March 19th, Maker hosted its auction to recapitalize the system — effectively selling batch amounts of newly minted MKR in exchange for Dai.

The details of the auction can be found here, all of which will be quite interesting to watch unfold.

For Vault owners who were affected by this situation, we largely expect the proceeds from the auction to go towards reimbursing those who lost all of their collateral, but that is still yet to be discussed.

It’s interesting to note that despite the drop in the DSR to 0%, roughly 27M is still sitting in the contract — largely highlighting the lag in information across all Dai users.

In the meantime, we recommend staying up to date on all things Maker via their official forum or by following their Twitter.

If anything, this exploit goes to show DeFi still has a long way to go before its ready for primetime, and that experiments like these are perhaps some of the most novel forms of decentralized coordination we’ve seen play out to date.

Until then, stay safe out there!

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