J.P. Koning, a CoinDesk columnist, worked as an equity researcher at a Canadian brokerage firm and a financial writer at a large Canadian bank. He runs the popular Moneyness blog.

Does the dai stablecoin need negative interest rates?

The coronavirus smashed into markets on March 12. U.S. equity prices plunged by 10 percent, their worst decline since the 1987 stock market crash. Bitcoin and ethereum prices plummeted almost 50 percent.

Related: dForce Hacker Returns Almost All of Stolen $25M in Crypto

Meanwhile, the price of dai skyrocketed as high as $1.50. This shouldn’t have happened. Dai is a stablecoin. Its role is to mimic the performance of an underlying national currency, in this case the U.S. dollar. Since it came into existence three years ago, dai has mostly hewed to its stated target of $1 U.S. dollar. But at $1.50, dai was suddenly worth one-and-a-half U.S. dollars. It didn’t look very stable at all.

See also: MakerDAO Users Sue Stablecoin Issuer Following ‘Black Thursday’ Losses

Dai has since retreated to a range of $1.01 – $1.03. Nevertheless, it has now spent a full month above its $1 peg – and shows no signs of returning.

The Maker protocol, the set of smart contracts that undergirds dai, has a number of tools at its disposal to help push the price of dai back to $1, its target price. One that hasn’t been tried? Negative interest rates. Negative interest rates are a controversial subject, both in the cryptocurrency space and in regular fiat land. But they’d probably do the trick.

Related: Facebook’s ‘Scaled Back’ Libra Proposal Is More Dangerous Than You Think

Is decentralized finance ready for them?

Before we get to the topic of negative rates, let’s run through a quick dai 101.

The corner bank

Think for a moment how a bank works. Say you want to borrow $10,000 to invest in your small business. Your bank, First Corner Bank, needs some security before it will lend you that amount. So you put your $100,000 house up as collateral. It lends you $10,000 in fresh new dollars, which you spend on supplies.

Dai operates along the same principles. If you want a dai loan, you need to submit collateral to the dai system, say $100,000 worth of ethereum. The dai protocol lends you a fraction of this back, say $10,000 worth of dai. These new dai stablecoins can now be spent into the crypto economy.

There are several forces that stabilize the money that has been created by dai and First Corner. You’ll eventually have to pay back your loan. This means you’ll have to repurchase either First Corner deposits or dai stablecoins to cancel your debt. This ever-present demand (along with the demand of everyone else who owes money to these institutions) helps to anchor the value of dai and First Corner’s deposits near $1.

No one likes to suddenly have to pay fees after years of earning income. But stability isn’t a free good. It has to be manufactured.

If you run into difficult times, there’s a good chance you won’t repay your $10,000 loan. This spells trouble for both issuers. A portion of First Corner’s deposits (or dai’s stablecoins) no longer has a corresponding repurchaser.

But First Corner and dai have protection. They can seize your house or your ethereum and sell it in order in order to plug the $10,000 void.

And so both types of dollars are well secured and stable. This stability is prized. People like to use dollars as a safe way to save, or keep them on hand as a guaranteed medium for making future purchases. Non-stable assets can’t provide these services.

Why did dai rise to $1.50?

With all that in mind, let’s explore what went wrong with dai’s price after March 12. As the pandemic advanced, people grew desperate to get their hands on the most liquid and safe assets around, U.S. dollars. This meant selling stocks, ethereum, bitcoin and pretty much anything else.

See also: MakerDAO’s Problems Are a Textbook Case of Governance Failure

One source of funds was the ethereum collateral that debtors had locked up to get loans. To get at this ethereum, debtors had to repurchase dai in order to pay back their obligations. Their desperation to repurchase dai stablecoins was such that the price spiked to $1.50.

Thirty days later, dai continues to trade in excess of the peg, which would seem to suggest an ongoing imbalance in the dai system. There is a heightened desire for dai debtors to liquidate, pushing dai prices up. But not enough people are willing to incur new debts to the system, which would create new dai stablecoins and push prices down.

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