Dai Breaks Peg Amidst COMP Yield Farming cDAI Update

Dai – DeFi’s defacto decentralized stablecoin – is facing a major hurdle as Compound adjusts it’s COMP token distribution to favor new assets earning the most COMP/day.

Liquidity mining incentives are powerful.

So powerful that they can cause exogenous shocks to other protocols.

Is @MakerDAO up next?

Props to @cyounessi1 for being ahead of the curve here.https://t.co/nLl4KsdYzE

— Will Price (@will__price) June 29, 2020

With the passing of Proposal 11, COMP is now allocated relative to borrowing demand, meaning farmers are incentivized to borrow the most amount of money while paying the least amount of interest.

This has drastically favored USDC and DAI, with both currencies dominating the number of COMP earned per day. However, unlike USDC which has a 1:1 oracle peg, vast liquidity, and centralized custody from Coinbase, Dai does not. As outlined in the forum post,

“Due to the high APY for COMP farming (circa ~70-100% APY), there is a chance (likelihood, even) that (Maker) sees an unprecedented demand for Dai. Much of the natural supply for Dai could also be locked up in COMP farming, thinning out sell-side orderbooks. It is almost certainly more profitable to farm COMP than to sell Dai for a small premium. This could break the peg sharply. Even the creation of new supply (generated through Maker) might go to COMP farming rather than selling. All of the debt ceilings might instantly be maxed out (except maybe USDC-B).”

Well, less than 24 hours into Proposal 11 this seems to be how things are shaping up.

DAI on chain: 108m
DAI in @compoundfinance : 344m

This seems safe. @MakerDAO pic.twitter.com/ASCu6n0ahO

— Dan Yanev (@dan_yanev) July 2, 2020

The total supply of Dai is now at $162M, with the 140M ETH debt ceiling just over 93% capacity. At the time of writing, Dai is trading at $1.02 – 2% above it’s $1 peg.

What’s more bizarre is that the total market cap of cDAI – Compound’s interest-earning version of Dai – is now sitting at a market cap of $482M according to DeFiMarketCap – roughly 3x the amount of Dai currently in existence.

This is due to yield farmers supplying Dai and using InstaDapp’s COMP Maximization strategy to take out a leveraged borrow on that Dai which is then resupplied to Compound and repeated again.

if the difference between the global $DAI supply on Ethereum and DAI borrowed on @compoundfinance confuses you, this is why it is what it is https://t.co/1TCCqJuFVp

— 찌 G 跻 じ ⚡ 🔑 (@DegenSpartan) July 3, 2020

The most frightening part is that there’s not really anything Maker can do address this other than drastically spiking up the stability fee to encourage people to pay back their Dai loans. Even then, the APY earned from leveraged COMP farming still exceeds the double-digit stability fee which largely harms anyone with a Maker Vault – especially those who are not yield farming.

How to Prepare

Looking at the situation as a trader, the most obvious answer was to market buy Dai. As demand becomes more and more scarce, Dai will continue to trade at a premium and savvy traders can exchange Dai for other stablecoins at a profit.

Update pic.twitter.com/WplTAPsrGq

— Steven (@Dogetoshi) July 3, 2020

If you’re a Vault holder, you should be prepared for an Emergency Shutdown. To quickly recap what happens, all deposits are disabled and Maker essentially takes a snapshot of all the collateral currently in the system. Users can withdraw their collateral by paying back their debt, but no new loans can be opened.

While it remains unclear how this situation will play out, it’s pretty evident that something needs to be done to rebalance the Dai supply. The fact that the vast majority is locked in Compound to yield farm places a choke on every other DeFi product which leverages Dai – most notably stablecoin aggregators like Curve and mStable.

In summary, it’s crazy to think how far yield farmers are willing to go to farm COMP. To anyone just getting into yield farming, please proceed with extreme caution.

There are so many unforeseen risks that for a new trader the small returns earned from farming COMP in the short-term do not outweigh the high chance of liquidation is one of many things go wrong.

On one side of the coin, it is fascinating to see composability being pushed to its max. Despite this, we’re sitting on the edge of our seats seeing how the two biggest DeFi protocols interact with one another to address this loophole.

To keep up with the situation, keep an eye on the Maker forum.

The post Dai Breaks Peg Amidst COMP Yield Farming cDAI Update appeared first on DeFi Rate.

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This Week in DeFi – July 3rd