Key highlights:

During yesterday's crypto crash, some Maker protocol users were able to purchase ETH for 0 DAI through the liquidation auction mechanism

The Maker protocol now has around $4 million in bad debt

The protocol will create new MKR tokens and auction them in order to cover the debt

The extreme price action during yesterday’s cryptocurrency crash put a major strain on the Ethereum network as well as the decentralized finance (DeFi) ecosystem that has emerged on top of it. From peak to bottom, the price of ETH dropped from around $192 to $95 in less than 24 hours. The largest DeFi protocol by far is Maker, and it represents around 55% of the total value locked in DeFi protocols tracked by DeFi Pulse.

Through Maker’s Vault feature, users can post their ETH and BAT as collateral to take out loans in the form of DAI, a stablecoin designed to trade as closely to $1 as possible. If the price of the assets used to collateralize the Vault position is falling dangerously close towards its liquidation price, users can either provide additional collateral or (partly) repay DAI back into their Vault to avoid liquidation. If the user fails to provide the necessary collateral or repay DAI and the value of their collateral falls below the liquidation price, their positions are liquidated through an auction mechanism.

Those who participate in this auction process are called “Keepers”, and they can either be humans or automated bots. Their role is to recover the debt that is created when a Vault is liquidated. They place their bids for the collateral with DAI (usually at a slight discount to the collateral’s market value).

Rapid fall in crypto prices and congestion on Ethereum allowed users to exploit a loophole

Yesterday, the Ethereum network was experiencing congestion, and gas prices saw a sharp increase. As a result, some of the “Keepers” were able to bid 0 DAI and still receive the collateral, as nobody else posted a higher bid. This has resulted in about $4 million in bad debt for the Maker system. To put it in different terms - there’s now about $4 million worth of DAI tokens in circulation that shouldn’t be there.

The Maker protocol has a mechanism in place to mitigate such an issue – new MKR tokens will be minted and auctioned off to cover the debt of around $4 million and ensure that the system is collateralized appropriately again.

While the MKR auction is necessary to re-collateralize the system, it will also inflate the supply of MKR, which is an undesirable outcome for existing MKR holders.

In their summary of yesterday’s events, the Maker team says certain parameters of the Maker protocol will need to be adjusted to prevent a similar situation from occurring again in the future:

“The current state of the Maker Protocol is healthy. However, while there was no hack, no bug, and no Emergency Shutdown planned, modifications need to be made. Accordingly, the MakerDAO community will hold an executive vote on Friday, March 13, to adjust parameters to help ensure a similar situation doesn’t happen again.”

While practically no crypto asset was spared during yesterday’s bloodbath in the cryptocurrency market, the MKR token was hit particularly hard. At one point, the token was posting a 24-hour change of -50%. Today, MKR was able to find support around the $200 level and the token is currently changing hands at $230.