MakerDao’s current promise to the world is to keep the Dai pegged to $1 USD while increasing decentralization on all fronts over time.

That promise is dependent on whether Maker’s credit system — which consists of community-voted parameters such as the interest rate borrowers pay ( stability fee), the interest rate or yield lenders earn (the upcoming Dai savings rate), liquidation ratio and debt ceiling — works as proposed.

By proactively managing these parameters, Maker was able to withstand a 80%+ downturn in the price of ETH, the main collateral type for all debt on Maker thus far.

But is this enough?

How may the rise of other decentralized credit protocols and apps — like Dharma’s Lever — affect Dai’s peg?

How should the community determine what rates to vote on?

This essay is meant to suggest key questions the Maker and wider DeFi communities should ask when making decisions regarding the rates and parameters on trust-minimized credit protocols.

Note that this is not an intro to MakerDao and Dai — for a primer on the project, check out the following resources:

How Significant is Maker?

First, let’s set the context of the discussion: Maker has been growing. A lot.

Here’s a look at ETH locked up in decentralized finance (DeFi) projects Uniswap, dYdX, Compound and Augur over time:

And now, with Maker added into the picture:

Maker’s scale is astounding considering the other major projects in the space have a tiny fraction of its collateral value.

Due to the increasing amount of Dai taken out, Maker had to adjust their 50 million Dai debt cap last year to 100 million. Within 9 months, circulating Dai is once again approaching the new ceiling.

So why is Maker so popular?

By implementing a stability fee of 0.5% to 2.5%, Maker essentially offered the cheapest credit facility for a stablecoin. This is especially interesting for investors seeking leverage: why borrow WETH and worry about the price risk of your principal when you can borrow Dai to trade other altcoins?

Fueled by this demand, Maker has grown to be the most dominant platform in all of DeFi (and Ethereum). With more capital at risk, and more projects launching that integrate Dai, it becomes increasingly important to understand how best to set Maker’s parameters.

It is crucial to note that the decision of where Maker sets its rates also affects the wider DeFi ecosystem beyond Maker itself. To set the context, let’s first take a look at the other trust-minimized protocols facilitating Dai loans thus far.

The State of Dai Credit Today

When it comes to permissionless lending and borrowing of Dai, there are a few projects that directly facilitate this — namely:

MakerDao (via its Collateralized Debt Positions, or CDPs)

Dharma (via its Lever interface)

Compound (via its money markets)

(dYdX currently provides tokenized margin positions but sources its lending from designated partners and is hence excluded)

On these decentralized credit platforms, Dai is by far the most borrowed asset on Ethereum — even more so than (W)ETH itself.

Dai demand is driven by a few factors, chief among which is the facilitation of leveraged investments (e.g. investors or traders who do not want to trade using their ETH holdings can instead borrow Dai to trade). Primarily, the attention Dai is getting comes from the fact that Maker is a cheap credit facility —even offering loans at 0.5% interest at one point.

But with cheap money comes easy leverage — and other challenges.

The Danger of Cheap Credit

Take Coinbase for instance.

On an exchange like Coinbase, Dai is only paired with USDC, whereas USDC itself is paired with BTC, ETH, BAT, ZEC, MANA, DNT, CVC, LOOM, GNT, and more to come.

To use their borrowed Dai, leveraged traders will have to sell their Dai for USDC in order to take positions in a selection of altcoins. Situations such as this have contributed to a constant selling pressure for Dai on Coinbase.

Coinbase Pro DAI/USDC pair

The same can be seen on KuCoin, where USDT has 26 pairs, whereas Dai only has 4. Here, USDT trades at a premium to Dai.

Kucoin USDT/DAI pair

The shrewd reader will also point out that since Dai’s official launch, ETH (a serviceable indicator of wider market performance in crypto) has fallen ~82% in price.

As such, the overwhelming demand in Dai is unlikely to have been fueled by a surge in demand for leverage. While Dai is the most borrowed asset in aggregate, breaking down demand for Dai by platform reveals that that the reason for its overall strong demand is mostly due to Maker itself.

Data sourced from https://loanscan.io; caveat is that Dai on Dharma has only launched for a week at the time of this writing

What follows is this: if Dai was able to grow consistently throughout a bear market to $90M in circulation with no strong macro tailwinds except for interest in the Maker platform itself, come next cycle, when the bulls return with reinvigorated appetite for risk and leverage, we can expect demand for Dai to grow exponentially. This speculative demand for Dai will likely put more pressure on its USD peg.

So, how can the community respond?

Raise the Rate

The Maker Foundation is keenly aware of the possibility of Dai breaking its peg, and has recently ratified a community vote to hike the stability fee to 3.5%, and we suspect there will be further hikes down the road.

So far, on Coinbase, the hike has proven effective, and we are continually impressed by the nimbleness the Maker Foundation and community has in reacting to these forces.

On Coinbase, the Dai price has corrected upwards post stability fee hike

Throwing a wrench into the mix, however, Dharma Lever recently enabled Dai lending and borrowing at 0.1%, a rate lower than any set in the short history of Dai.

Ostensibly, by offering an even cheaper avenue to borrow Dai, Dharma could exacerbate the above scenario. In addition, allowing Dai to be locked up as collateral for ETH loans, Dharma also reduces the circulating supply of Dai and may render its price more sensitive to the effects of selling. This will be increasingly pertinent should Dharma offer more attractive lending rates that incentivize users to lock their Dai up as loan offers.

Note that Compound rates are money market rates and not 100% comparable

Fortunately for Maker, there are caveats.

Realistically, the impact Dharma Lever has on Dai in the short term should be minimal or even negligible due to a $25,000 cap on Dai loans per user and relatively low number of users (Lever just launched last month, and many are still on the waitlist). In addition, 0.1% is likely a teaser rate to drive adoption. Over time, as an economically rational actor, Dharma will have to have its rates converge with Maker’s.

The aggregate supply of Dai on Dharma is also limited by how much Dai people are willing to supply. This means as long as the yield for lending out Dai (0.1%) is lower than the fee you pay for originating Dai (3.5%), we need not worry about everyone opening CDPs to lend out Dai, or borrowing Dai on Dharma for cheap to execute Soros-style shorts yet.

With Maker’s upcoming Dai Savings Rate (a yield financed by the stability fee that you can generate on your Dai holdings by locking it up in a smart contract), stablecoin holders would have an incentive to hold Dai as opposed to other stablecoins which currently do not offer any interest for holding them.

But Dharma isn’t the first credit protocol and likely won’t be the last. In the future when more projects and platforms allow Dai to be lent out cheaply, how should the Maker community respond? Where will rates converge? How should the community incorporate the rise of other DeFi credit protocols for Dai when deciding the best parameters to set for Maker?

It is against this backdrop that we propose the following considerations for the Maker and DeFi communities to better inform governance decisions.

Given that Dharma is the only major credit protocol besides Compound that has launched, we will use Dharma as a stand-in for future similar platforms.

What We Think About When We Think About Rates

Setting DeFi Borrowing Rates

The tricky thing for Dharma (and future DeFi platforms like Dharma) when it comes to lending and borrowing Dai is it’s essentially becoming a middleman between users and another credit facility (Maker).

As a venture-backed business (with no tokens to capture network value as of yet) that has to generate returns for investors, Dharma Lever likely has to take a fee off loan origination eventually.

This means charging a small fee on top of the baseline cost of acquiring Dai (Maker’s stability fee). As the origination fee for Dai (through opening a CDP) is currently at 3.5%, it is unlikely that a rate of 0.1% is sustainable. Of course, it may be possible for borrowing rate to be below the stability fee as lenders could source their Dai from open market purchases, but this will forever be a subset of total Dai generated.

But herein lies the dilemma: assuming all other variables are constant, should Dharma charge even a slight spread on top of the stability fee, users have no incentive to borrow on Dharma and will instead borrow on Maker as the collateral ratio is the same and the rate is lower. When multi-collateral Dai launches, the choice of collateral will no longer be a differentiating factor between Maker and Dharma as well.

The only real trade off now for borrowing Dai is whether the user cares more about Dharma’s per person cap and 28-day duration loans or buying MKR tokens to pay for the stability fee. That being said, even the the loan duration and personal cap are likely temporary features.

Given the above points, here are key considerations for DeFi projects that want to offer Dai credit concerning borrowing rates:

Given that any borrowing rate will be highly dependent on the community-voted Stability Fee, should projects like Dharma acquire meaningful stakes in MKR to participate in governance, or at least participate actively in signalling their preferences to the Maker community?

Given that borrowing rates will need to be higher than the Dai Savings Rate (and higher than stability fee if you assume most people who lend on Dai generated their own Dai via Maker), should projects like Dharma instead compete on other feature sets (such as more collateral types)? Can they?

Instead of charging a fee off Dai borrowing, should projects like Dharma instead seek to capture value through alternative models (e.g. a native token)?

Setting DeFi Collateralization Ratios

As of currently, collateralization ratios on all DeFi credit platforms — be it Dharma, Compound or Maker — is set at 150%.

As my friend Brendan from Dharma kindly pointed out, this is not a must. Collateralization ratios need to be high in Maker because they can’t risk systemic meltdown. Dharma, in contrast, can let users set collateralization ratios themselves.

The questions that follow are:

How should Dharma users set the collateralization ratio such that the resultant collateralization ratio and APR combination presents a compelling alternative to Maker’s offerings? (e.g. borrowers can evaluate whether a loan with 125% collateralization and 3.6% APR is better, or to go for one with 150% collateralization and 3% APR)

To maximize protection against systematic downturn, should Maker set higher collateralization ratios for other ERC20 collaterals that have lower liquidity and higher volatility than ETH? How will this affect adoption of other collateral types and overall reliance on ETH as collateral?

Setting Maker’s Stability Fee

Voting on the right stability fee (that will likely need to adjust to demand and supply flexibly over time) is paramount to Maker and DeFi projects offering Dai credit as it:

Determines how much MKR is burnt per Dai borrowed; Determines the upper bound of the Dai Savings Rate; and Influences the rate of all other platforms that borrow and lend Dai

Given that we are in the early days of Maker, setting the fee is mostly a directional rather than a quantitatively precise effort (i.e. if demand for Dai is too high -> hike stability fee by a bit).

Over time, as DeFi matures beyond its crypto bubble to be a bona fide financial solution in the future, we suggest the Maker community to keep an eye on loan rates in the legacy financial world as well. Some crucial questions to ask are:

Should Maker compare its stability fee to the secured loan rates offered by major banks? Why should they? Why should they not?

Should Maker undercut bank rates (and by how much) to spur usage of Dai, and to make it less cost-prohibitive to markets where a price-stable borderless currency is needed?

Or should Maker charge a slight premium (to the benefit of MKR holders), justified by the ease of getting a loan with crypto collateral?

Should the stability fee and collateralization ratio for each different collateral type under multi-collateral Dai be different to account for varying liquidity and volatility levels? If so, how much higher is too high?

Some back of the envelope math to further put words into numbers:

At the time of this writing, 3,598,168 Dai are drawn from 898 CDPs in the last 7 days. This puts the average loan value of each CDP at ~$4000. Note that this is a rough estimate from a limited data set.

The APR for a secured (collateralized) loan at $4000 from Wells Fargo falls towards the lower end of the 7.49% — 24.49% range. Should Maker want to target the legacy financial market in the future, the Stability Fee could be set under this range (say 7.00%).

Setting Dai Savings and DeFi Lending Rates

Lending is the bread and butter of Dharma (if no one lends, no one can borrow). As a result, Dharma — and Dharma users in the future when rates are set individually - will likely price its lending yield competitively to attract lenders.

Conversely, the Dai Savings Rate exists primarily to incentivize people to hold Dai, hence limiting the number of Dai that’s sold in the market. In fact, as the DSR is financed by the stability fee (which flows to MKR holders via a token burn), it is in MKR holders’ best interest for DSR to be lower.

This is a great alignment of incentive as all projects, including Maker, should want DSR to be as low as permissible without compromising the Dai peg.

The two rates will likely converge over time, and key considerations for stakeholders are:

How much higher should projects like Dharma price their lending rates to out-compete Dai Savings Rate?

Should Dharma participate actively in Maker governance to ensure DSR is sufficiently low for Dharma to price in a premium on their lending rates and still have sufficient leeway to set a sufficiently low borrowing rate?

If acquiring enough stake is too cost prohibitive — could Dharma or platforms like Dharma instead borrow MKR to cast a vote and sway the results in their favor? Is this ethical?

Should Maker consider other staking projects or bank deposit rates when determining DSR — or are they not comparable due to volatility of most staking assets?

A Note on Debt Ceiling

So far, the debt ceiling has been raised once, from $50M to $100M. This ceiling is an important mechanism to prevent sudden upward spikes in Dai drawn.

However, with growing demand for Dai, the Maker community will have to determine whether to raise the ceiling (and prevent potential upward peg break), and if so, by how much.

Conclusion

All in all, we see the rise of trust-minimized ways to borrow and lend Dai beyond Maker itself as a net positive for the wider Maker ecosystem.

By allowing users to post Dai as collateral and generate a yield by lending out Dai (before the launch of Dai Savings Rate), platforms like Dharma increase the utility of Dai. Increasing the utility of Dai and increasing Dai-asset pairs ultimately serve to strengthen the incentive for people to hold onto Dai, which may alleviate selling pressure. Beyond credit protocols, we expect to see more Dai-backed decentralized financial products in the near future.

However, the rise of these platforms also complicate the governance considerations for the wider DeFi community. The decision about where to set the rates for Maker will now have a material impact on all third party platforms that seek to add utility to Dai by offering Dai credit as well. Setting rates too high may price other Dai credit platforms out.

To conclude, we believe the governance of Maker’s stability fee and savings rates will be be increasingly informed by the emerging credit protocols on which Dai is lent and borrowed. Eventually, the decision of where to set these rates may very well be influenced by the legacy credit market should Maker continue on its steady course to growth.

The rise of platforms like Dharma provide another informative angle to think about the implications of the cost of capital on the price of Dai, and we’re excited to keep our eyes on this ongoing experiment.