MakerDAO gets stress tested as ETH price plummets

A good fix requires the whole system to be re-imagined a bit. You want to start with the invariant that a stablecoin holder can liquidate to Eth at any point, and that a collateral issuer can extract their Eth at any point.

Instead of having the collateral provider be the only one who can issue the stablecoin, you could build a system where anyone could acquire the stablecoin (Dai) by putting in an appropriate amount of Eth.

Any extra Eth that gets put into the pool will issue a volatile asset, which I'll call Vai here for simplicity. Where Dai has no exposure to volatility, Vai has increased exposure to volatility. As the Eth price rises, the amount of Eth that Vai can be redeemed for increases, and as the Eth price drops, the amount of Eth that Vai can be redeemed for decreases (this is the opposite of Dai).

At any time, Eth and Vai can be redeemed for Eth from the pool. As the price of Eth moves around, the pool becomes over-collateralized and under-collateralized.

If at any point the pool becomes under-collateralized, all Vai becomes worth zero, and all Dai can redeem Eth proportional to the amount of collateral that there is. Meaning, in a "black swan" scenario, Dai holders become exposed at 1x to the price volatility of Eth. This is much better than the whole system melting down, and the Dai holders do get to dodge a significant amount of the downtrend while the Vai evaporates. (Dai holders see no exposure until all the Vai is gone).

You can keep the pool balanced using interest rates. If you have a target collateralization level (say 150%), then any time the pool is under-collateralized, you can automatically drop the interest rate that Dai holders earn (going negative if necessary). If the pool is over-collateralized, you increase the interest rate.

A lower interest rate encourages Dai holders to withdraw and Vai holders to enter. A higher interest rate encourages Dai holders to enter and Vai holders to withdraw.

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The most important thing about the system above is that it is highly predictable. In all scenarios where the price of Eth moves, you can model what happens, and you have guarantees on how much Eth you can draw, and you can withdraw that Eth immediately (well, you'll need to pay blockchain fees and wait for a block, but you don't need a counterparty or any sort of system liquidity). The worst case for the stablecoin holders is that they get exposure to 1x Eth, but this only happens if Eth drops faster than people deposit Vai.

There are a bunch of math tricks you can use to allow people to select different exposure levels (you could have some Dai targeting 250% over-collateralization, meaning it's very robust to huge drops in Eth price, and other Dai only target 15% over-collateralization, and these two assets could be fully fungible against eachother) for Dai holders and Vai holders, but we are getting beyond the scope of a single HN comment.

> I think a more traditional finance person will have trouble understanding it all as in some cases, there are no analogies to the traditional finance system (e.g. flashloans).

All "cryptocurrencies" are, in effect, complex securities that are derivatives of greater market factors. The crisis of 2007 showed the risk of using complex investment vehicles that were poorly understood by investors -- and the CDOs that were sold in the mid 00s were far more transparent and predictable than cryptocurrency. Given that crypto will always be one asset class among many, if the traditional finance system (which already operates outside any single fiat currency) can't understand it, they won't use it for anything more than speculation.

Using crypto as an investment vehicle requires a reasonably accurate assessment of risk. In the case of fiat currencies, central banks manage that risk so that investors can rely on the liquidity of the overall system without wiping out deposits. DeFi has no such mechanism, and no central bank to absorb a big hit temporarily in the case of a black swan event.

I still feel that cryptocurrency is just the 21st century version of penny stocks and junk bonds. Fiat currency works because its power as currency is secured by a government able to mobilize military and industrial power to solve market problems. The most heavily traded currencies (RMB, USD, EUR) are those backed by large industrial and military powers because those countries have the scale and political power to manage market risk. Centralized governance is a feature, not a bug.

> You can hold DAI without opening a CDP

If you hold Dai without opening a CDP, the only way to convert that Dai back to Eth is to find someone who opened a CDP and is willing to buy from you.

Similarly, if you opened a CDP and then sold the Dai, the only way to get your Eth back out of the CDP is to find someone who is willing to sell you Dai. The Maker liquidity crisis yesterday happened because there were more people trying to scoop up Dai and get their Eth out of their CDPs than there were people selling Dai, which meant that a lot of people were stuck holding leveraged positions on Eth that they couldn't exit. Even worse, the auction system was malfunctioning, so it appeared as though those people may not even get a fair value for their Eth if they did get liquidated (not to mention, they'd also have to pay the 13% fee for being liquidated, even if they got a fair price in the auction).

> An important part of DeFi are DEXes (decentralised exchanges) such as Uniswap and Kyber. There is a liquidity pool where you can instantly buy/sell assets.

This only works if the total number of buyers and sellers are balanced. The way Maker is set up right now, its possible for a large percentage of your Eth pool (or Dai pool) to be completely unavailable because the holders have not listed the Dai on an exchange. Simply having a decentralized exchange does not automatically guarantee liquidity - people have to agree to sell their assets on that exchange.

> You can do this easily by buying DAI on a DEX

The entire problem yesterday is that all of the Dai was scooped up from all of the Dexes. There was a period yesterday where the Dai price was >$1.11, meaning that CDP holders were paying an 11% premium to exit their positions. The Maker system had no exit valve for people stuck in this position.

> The DeFi, specifically the Ethereum space, has moved very quickly in a short amount of time, so there are a lot of new concepts and instruments out there.

There are also a lot of old concepts and well understood financial relationships that are being ignored, and a lot of highly predictable failure modes that are being forecasted as "black swans". The best team is likely composed both of people who have a very solid background in cryptocurrency as well as people who have a very solid background in traditional finance.

If there really are people that literally put their entire life savings into a single, unproven vessel then they almost certainly did so because they were gambling it would make them (an order of magnitude+) more money than a more reliable stable alternative. They won’t find much pity.

It's more complicated. Their collateral ratio has dropped below the liquidation level of 150%. So at best they would only get a fraction of their collateral back (any liquidation has a discount and a 13% penalty) - fundamentally they lost because their speculative bet didn't pay off. So yes, they lost more than they should, but describing it like they lost everything because of the liquidation problem alone is misleading.

The "attack" was trivial in that there was only one bid at an auction - not enough people liquidating undercollateralized positions, but now so many people are looking at this it's never going to repeat again. It's an obvious risk only in hindsight.

I dont think it was an unforeseen use. People that execute these smart contract dark patterns knew for a long time and didnt steer public discussions that way.

The very foreseen problem was that people dont show up to governance decision in crypto. Yes you can use a blockchain for voting but nobody shows up.

The real problem is that there are no alert protocols built into wallets and client side defi apps.

Now people are discussing it.

The bigger gamble was whether liquidation and auction could occur fast enough to prevent emergency shutdown. They did, one person showed up to the auction and bid $0.

System worked.

Everyone with dollar signs now is going to research that and bid $1 until the order book is populated and it never happens again.

Software updates to overfit for this possibility would be worse.

Well the solution is to have some sort of emergency fund which activates in black swan events to rebalance the portfolio. It's just something to factor in. Adds some costs to operations but only fractions of a percent.

That's true, and it has dealt with it, is the point.

Quite the opposite actually. At least to me it means that institutions actually have been holding crypto reserves, which I'd say gives it a fair amount of legitimacy.

Crypto didn't sell off in a vacuum this time, it sold off with the market at a time when it should be selling off.

I know what you're thinking, but that's not the case. Right now, same as in 2008, institutions are liquidating "store of value" assets to open up more liquidity. That $1.5T in fed repo? Well the fed doesn't take BTC as collateral. And since they don't nobody else is right now. Same with gold. Cash and T-bills are king, so liquidate everything else.

Really this shows that crypto is at least starting to be folded into the main financial world. It actually for once has some degree of beta.

TL;DR: This is good for bitcoin.

The real idea here is even beyond going long on ETH. It's multi collateral DAI. The idea that you can (eventually) lock up any collateralized asset and mint DAI. Need to take out a mortgage on a property you own? You can do it automatically and atomically through smart contracts without any middlemen. Eventually people could tokenize things like their future earnings and take out a loan against that now. As dystopian as that last point sounds, it illustrates the point.

> Or you just don't understand how it works. Dai is a complicated solution to a complicated problem, but its not some trick.

But the problem isn't complicated. If you need something worth 1USD, buy 1USD. It is by definition stable relative to 1USD. You don't need to understand complicated terminology or esoteric failure modes.

DAI is effectively never worth exactly 1USD: https://coinmarketcap.com/currencies/multi-collateral-dai/

You could use something like uniswap and use their ETH/USDC pool as a source of price data for ETH. This is a bad idea because its easy to manipulate that one price feed but that is technically a truly decentralized price feed.

No, you would save up to buy a car. Same for a house, you would save up to buy it. The average house price would be lower because demand would be lower because only people who could afford it would be able to make an offer. Same supply, lower demand means lower price. You won't have to compete with over-leveraged fools who are on their 20th credit card as is the case today.