Special thanks to Sébastien Derivaux, Tadeo and Sam MacPherson for feedback and review
MakerDAO's recent decision to hike the DAI Savings Rate (DSR) to 3.49% is setting out to redefine the "risk-free interest rate" in the DeFi space. This move fundamentally alters the landscape of what we understand as DeFi, bridging Real World Yield on-chain, raising the interest rates, and potentially making DeFi competitive once again. However, there's no such thing as "risk-free" in crypto. In this piece, we'll dive into the potential impact of this development and the risks associated with it.
The increase in the DSR introduces an opportunity cost of holding DAI at 3.49%. This is because the underlying risks become evenly distributed among all DAI holders, regardless of their participation in the DSR. Consequently, we can anticipate that most DeFi protocols will embrace sDAI (Makers tokenised version of the DSR), effectively turning DAI into a yield-bearing stablecoin. For example, Aave is already discussing the integration of sDAI, thereby increasing its supply interest rate, setting a floor, and consequently driving up the borrowing rate. However, if money markets fail to integrate the DSR fast enough, they might enter into a negative loop caused by LPs withdrawing their funds to get the higher rate with a lower risk of the DSR.
We can also expect Automated Market Makers (AMMs) to incorporate sDAI starting to show higher APYs, and a shift of assets from high-risk to low-risk protocols, as their risk premium drops (similar to what we saw in TradFi last year).
At the same time, the move will likely prompt a rise in the interest rates of other stablecoins in money markets. Whether these rates match the DSR will depend on how the market prices the risk. This could potentially stimulate more on-chain activity and capital influx, but concurrently, the elevated borrowing costs might temper leverage on ETH (and other assets), affecting their short-term price.
This development also indicates a strategic shift for Maker. Originally a platform for leveraged long traders, Maker now positions itself as a bridge to real-world assets (RWA) yield. The escalation in the stability fee could result in a decreased share of DAI collateralised by on-chain assets. Other CDP-backed stablecoins might also feel compelled to increase their borrowing rates to maintain their peg. It will be interesting to see how the market values decentralised-collateral stablecoins. In particular, LUSD being significantly cheaper than DAI will serve as a sign to the market. So far, LUSD has faced challenges maintaining the peg at 1, as they don’t have a successful mechanism to drive the price down when it surges above this level. But the high spread between DAI and LUSD rates might finally be their solution.
Critics might contend that this move further centralises DAI, but it's crucial to understand that Maker is intentionally reducing its reliance on Circle. Prior to it, DAI was predominantly backed by USDC, which posed a significant single point of failure. Now, the risk is dispersed among various parties, which could bring more potential failure points and reduce the dependence on individual entities, thereby bolstering the system's resilience. In a way, Maker is decentralising its centralised collateral. Furthermore, USDC was collateralised by T-Bills, which is most of the new collateral of DAI, enabling it to capture the yield that was previously captured by Circle.
There are, in our opinion, four main risks for this move: custodial risks, regulatory risks, collateral risks, and execution risks.
Another consideration is related to payment delays. Monetalis' recent three-week delay is a case in point. Although such instances may be temporary, a combination of similar delays with other unpredictable events could potentially lead to worse consequences such as liquidity shortages, breach of trust, market instability, and in a very extreme case bankruptcy.
Regulatory Risks: With DAI gradually morphing into a yield-bearing stablecoin, regulatory oversight from the US could increase, which may not bode well for DAI, and the recent lawsuits from the SEC to Binance and Coinbase probes that regulation is hotting up. Potential regulatory actions could include placing Maker on OFAC, implementing a “selective default, “ or direct asset seizure. None of these would be done lightly, as the US cannot afford to lose even a small bit of confidence in a context of necessity: the government needs to roll over billions in debt, and will want to keep enjoying relatively cheap cost of capital. Maker DAO is taking some cautions to protect themselves against these, such as choosing non-US custodians and legal nexus, and enforcing decentralisation in the endgame plan. Regardless, these risks cannot be ignored.
Collateral Risks: Default on collateral assets is also a concern. While the majority is held in T-bills, which carries a low risk, some are held through ETFs which might add some layer of risk, and there are some other small positions to consider, such as the H.V. Bank loan.
Execution risks: Finally, there's the question of whether Maker can generate yield quickly enough if its protocol-controlled value drastically increases due to the abrupt DSR change through the PSM. If not, who will foot the bill? The surplus buffer? A gradual ramp-up of the rate or some hard caps could offer some breathing room to allocate this capital.
In conclusion, Maker DAO's decision to increase the DSR to 3.49% represents a bold step that significantly reshapes the DeFi terrain. While it presents an exciting transformation of DAI into a yield-bearing stablecoin and may stimulate more on-chain activity, it also invites a suite of new risks and challenges. The impacts are far-reaching, from potential custodial and regulatory risks to uncertainties around the ability to generate yield at a fast enough rate. But if we attempt to create a massively adopted worldwide open financial system, we must bridge the assets from traditional finance to DeFi. And it’s surely better for the ecosystem to have a native DeFi organisation trying to do it. Purely decentralised stablecoins still remain a challenge, and Maker has already ceded this responsibility to Liquity, Reflexer, et al. As the landscape of DeFi continues to evolve, these decisions will undoubtedly play a pivotal role in shaping its future. It will be intriguing to watch how these new dynamics unfold and influence the wider DeFi ecosystem.
