DAI is a stablecoin that is soft pegged to the USD. On the other hand, MKR is the governance token of MakerDAO. With MKR, you can issue and manage the DAI stablecoin. If DAI gets de-pegged, MKR is the “last resort” of liquidity. As of now, there’s a proposal that you can use MKR to borrow DAI. In other words, are we about to see a makeover of the Terra Luna/UST death spiral?
So, let’s dive and see what this relationship between DAI and MKR is all about.
Did @MakerDAO just go #Terra #Luna #UST?#MKR was supposed to be the governance token and the liquidity of "last resort" when DAI gets off peg.
Borrow DAI against MKR = liquidation cascade once MKR price crashes.
Death spiral anyone? This is a negative on DAI solvency… pic.twitter.com/nmLOhgzfLE
— Duo Nine ⚡ discord.gg/ycc (@DU09BTC) February 24, 2023
What Is DAI?
DAI is a stablecoin, and one of its features is that it’s pegged to the USD. This prevents it from being volatile. DAI launched in 2017. MakerDAO, a decentralized and autonomous organization, created this stablecoin. It runs on top of Ethereum. Now, if you want to change the DAI parameters, you can do so by voting on it. For this vote, you use the MKR token.
This stablecoin is not backed by the U.S. Dollar, but by an overcollateralized debt in ETH. You can also use other crypto assets. So, this is what happens. You lock your crypto assets into a smart contract. This is your collateral. Now you can create DAI, in the form of a loan.
The moment you want to retrieve your collateral, you need to pay this back, with an additional fee. However, if you can’t pay back your loan, the collateral goes to MakerDAO. Now they can sell this off with an auction mechanism.
Of course, you can also go to an exchange and buy DAI. However, now you need to sell your crypto assets. If you prefer to hold on to your crypto assets, you can mint DAI by depositing a collateral. MakerDAO holds your collateral in a CDP (or Collateral Debt Position). These are secure vaults that hold your collateral.
The overcollateralization is to account for the volatility. For example, you must deposit $200 in ETH to receive $100 in DAI. So, even if the price of ETH now declines by 25%, your collateral is still worth $150 and more than the value of DAI you minted.
What Are the MakerDAO and MKR Positions?
Now, we can see that Duo Nine from the original tweet (shown above) may be right. If you can use MKR to borrow DAI, we may get a “death spiral.” That’s the same what happened to LUNA and the UST stablecoin.
Here is how the death spiral worked for LUNA and UST. First, UST went off the peg and, at the same time, LUNA was dropping. However, it was dropping so fast then when people were burning UST to get their LUNA back, it created even more LUNA. As a result, this created even more sell pressure. This vicious circle is what we call a death spiral. LUNA and UST were directly linked to the mint and burn process.
Duo Nine is right in that the more linked MKR and DAI are, the more likely such a spiral can happen again. It is a similar setup as with LUNA and UST. This is something to keep an eye out on. Now, in all fairness, UST was only backed by LUNA.
So, having said that, we never eat soup at the same hot temperature that it’s served at. In other words, Duo Nine might be wrong. Currently, USDC backs DAI with 40.9% of all collateral. This adds stability and decreases the chance of a de-peg. You can also use other assets besides USDC and MKR as collateral. So, this reduces the risk, but it’s still not a great move by MakerDAO. With this move, MKR gets linked to the mint process.
Currently, there appears to be a limited risk. However, it makes you wonder what the future of DAI may look like. The picture below shows the current collateral used for minting DAI. USDC is at 40.9%.
Source: DAI stats
Conclusion
The move by MakerDAO to allow borrowing DAI against MKR seems surprising. This has all the potential and ingredients of a death spiral. The same as we saw with LUNA and UST. However, the current risk seems limited. The DAI collateral is 40.9% in USDC. This gives stability. You can also mint this stablecoin with more crypto assets than just MKR. This spreads the risk. Still, DAI’s future seems to look less bright.
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