Ether Plunge Tests DeFi Giant While Ripple Effects Have Just Begun

Hello Defiers, yesterday was a big day for crypto and DeFi, with the entire market crashing. A more than 30% plunge in ETH caused a $4 million shortfall in MakerDAO’s system, whose members went as far as to considered an emergency shutdown, which has now been averted. Still, DeFi and Maker aren’t in the clear yet. Dedicating this issue to MakerDAO’s black Thursday.

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MakerDAO Avoids Shutdown As Ripple Effects Begin

DeFi giant MakerDAO was almost brought to its knees by what’s becoming an increasingly common new problem in the space —faulty oracles— and by an issue that’s plagued Ethereum from the CryptoKitty days —a congested network. 

The space has come up ahead each time. Will it now? It probably will, but traders are paying the price. And not just MakerDAO holders and borrowers; all of DeFi will feel the ripples. Today, MakerDAO’s MKR token holders are voting to slash rates by about half to 4% from, which makes open finance more attractive for borrowers, who are mainly sophisticated traders, but could drive away savers, or the more mainstream users DeFi has.  

Here’s What Happened

As with any market debacle these days, it starts with COVID-19 pushing all asset prices lower. Ether was no exception, plunging more than 30% yesterday. MakerDAO is holding millions of dollars in ether, which was deposited by traders who got the Dai stablecoin in return. When the ETH price falls, the collateral that’s backing Dai becomes less valuable. When the collateral ratio falls below the required 150%, those Dai loans (the Dai users took out against ETH) get liquidated and there’s an auction for the ETH collateral. Liquidators pay for the ETH in Dai, the Dai is used to pay off the debt and then burned, and if some ETH is left, it’s returned to the borrower.

There was a perfect storm which allowed a liquidator to run off with $4.5 million of ETH collateral for free, without actually breaking any rules, caused by the following:

1) The market crash increased the number of transactions on the Ethereum network and this raised the average gas price per transaction —gas is the unit paid for computation on Ethereum. That means anyone wanting to transact on Ethereum was required to pay higher fees than usual.

2) MakerDAO has 14 so-called oracles, which feed market prices to the system. The oracle system failed and was telling Maker the ETH price was higher than it actually was.

The high gas and ETH prices required to buy ETH collateral from liquidated loans meant no liquidators wanted to put up bids —except for one, who took advantage of the lack of competition and placed bids for 0 Dai. The high gas prices didn’t matter because he would be taking home free ETH, and there was no-one else to outbid them. Result: They got millions in ETH for free. 

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Market Reaction

MakerDAO’s MKR, the token that’s used to vote in governance, plunged almost 60% to as low as $191 the lowest ever.

MKR’s falling knife. Image source:

Dai’s 1-to-1 peg with the dollar, which had already eroded in the past few days with Dai trading at above $1, broke further, with the stablecoin trading at $1.06, the highest since the system’s upgrade to multi-collateral Dai in November 2019. Dai had been trading above $1 as an increasing number of traders switched to the stablecoin from more volatile crypto assets amid a market sell-off.

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Low Dai liquidity has caused lending rates to spike across the board in DeFi platforms, to as high as almost 24% on dYdX.

Image source: ConsenSys Codefi Data

MakerDAO wasn’t the only lending platform under stress, as plunging ETH caused loans to get liquidated across the board:

Image source: Twitter

It’s worth noting, that even though the MakerDAO system is undercapitalized, it’s not undercollateralized. The system;’s collateralization ratio is at over 260%, the lowest in about two months.

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How to cover the $4 million shortfall ($4.5 million the liquidator took, minus the $500k in surplus the system had)? MakerDAO members agreed on a call to mint and sell additional MKR tokens and raise the Dai needed to cover the bad debt. At current market prices, about 17,000 MKR would need to be minted. With current MKR circulating supply at 986k, that would put total supply back at 1 million. For context, MKR tokens are used to pay so-called stability fees —similar to a loan’s interest rate— and burned after the fee is paid. This mechanism is meant to reduce supply and make sure MKR token holders benefit as activity on the platform increases (burning MKR tokens, leads to lower supply, lower supply should lead to token appreciation). This additional issuance has the potential to push MKR supply back to its highest ever. (h/t to Aave’s Marc Zeller for pointing this out).

To prevent 0$ bids from winning a liquidation auction in the future, MakerDAO members are discussing possible solutions, according to a summary of yesterday’s call.

MKR holders are also voting to lower the stability fee (similar to the system’s borrowing rate) dramatically lower the rate by 5.5 ppts. to 4%. This should incentivize borrowers to issue more Dai loans, increasing Dai supply and helping the peg fall back to $1. The system’s lending rate, the so-called Dai Savings Rate, which is pegged to the borrowing rate, would also be set at 4%. Today DSR is at 8.5% and driving users into the space. With savings rates falling to not that much higher than fintechs like Betterment, the DeFi’s draw for mainstream becomes weaker. 

Biggest Losers

The most directly impacted from MakerDAO’s black Thursday are holders of Dai loans, which got liquidated and weren’t able to get any of their ETH back, and MKR holders, as the token continues sliding on the expectation that additional supply will be poured into the market.

What is though is that Ethereum dapps have seen worse, and come back stronger. This can be the case for MakerDAO too.

The Defiant is a daily newsletter focusing on decentralized finance, a new financial system that’s being built on top of open blockchains. The space is evolving at breakneck speed and revolutionizing tech and money. Sign up to learn more and keep up on the latest, most interesting developments. Subscribers get full access at $10/month or $100/year, while free signups get only part of the content.

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About the author: I’m Camila Russo, a financial journalist writing a book on Ethereum with Harper Collins. (Pre-order The Infinite Machine here). I was previously at Bloomberg News in New York, Madrid and Buenos Aires covering markets. I’ve extensively covered crypto and finance, and now I’m diving into DeFi, the intersection of the two.

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