The perils of using volatile cryptocurrency as collateral to create money.
You’re probably aware that the prices for most cryptocurrencies dropped like a rock yesterday.
At one point during the day, Bitcoin was down over 40%, the price of Ether was essentially cut in half, and many others tanked as well.
The drop in prices led to furious trading activity that clogged up these networks. For Ethereum, that meant a 900% increase in gas fees and average transaction times of up to 44 minutes.
This had a massive detrimental impact on the MakerDAO ecosystem. Vaults were liquidated and the process to stabilize the system broke, leaving the protocol in a $4 million deficit.
What led to this crazy situation, and what are the faulty aspects of the MakerDAO protocol that allowed this to happen?
Let’s take a look.
How MakerDAO works
MakerDAO is a decentralized finance protocol built on Ethereum that allows you to get a loan of DAI stablecoin (which is pegged 1:1 to the US Dollar) by putting up cryptocurrency (currently Ether and Basic Attention Token) as collateral.
Because of the volatility of cryptocurrency prices, MakerDAO forces you to maintain a Collateralization Ratio of 1.5, which means you have to put in collateral that amounts to 150% of the DAI loan you’ll be taking out. E.g. if you want to take out a loan of 100 DAI, you’ll have to put in $150 worth of ETH or BAT into a “Vault” to get it. This is so the system has enough collateral to account for all of the DAI in circulation and maintain solvency.
There are a bunch of things going on behind the scenes that help DAI maintain its peg to the US Dollar and keep the system stable.
If the price of ETH goes up, no problem - the system will be stable and DAI can easily maintain its peg.
But if the price of ETH tanks like it did yesterday, big problemos. The system will have to liquidate Vaults that don’t meet a collateralization threshold. The ETH inside these Vaults is then auctioned off for DAI until there is enough DAI to pay back the loan. If you don’t pay back the loan plus an additional fee, you’ll lose all of your ETH.
For a more in-depth look at how the MakerDAO system works, check out this Medium post.
So what happened to MakerDAO yesterday?
As mentioned earlier, the price of ETH tanked big time yesterday. This caused many MakerDAO Vaults that used ETH as collateral to drop below the 1.5:1 Collateralization Ratio and become available for liquidation.
Liquidation of Vaults kicks off an auction process where users in the system called “Keepers” bid for this ETH collateral. The winning bid is paid in DAI, which is then used to reimburse the liquidated Vault’s debt. The DAI raised is then burned, the debt is erased, and any ETH that remains is returned to the Vault’s owner.
The combination of a dropping ETH price and congested network (with long transaction times and high gas prices) led to a unique situation for MakerDAO.
Many Keepers stopped their network activity, possibly for a number of reasons:
- Fear of monetary loss due to dropping ETH prices and long transaction times
- Lack of DAI liquidity
- Improper configuration to participate in gas price auctions
- Miner censorship (this is speculation at this point)
This led to a situation where a single Keeper bot continued to trigger Vault liquidations and became the only bidder for the ETH collateral. This Keeper was able to bid close to $0 DAI against no competition, and won $4.5 million of ETH from the protocol in a matter of hours. MakerDAO was expecting to be paid this $4.5 million in DAI but received nothing. Before this happened, the system ran a surplus of $500,000 but is now in a $4 million hole.
Additionally, Vault holders who were liquidated theoretically should have received some ETH back, but there was no ETH to return to them. You can read more about this here.
The system instability led the DAI price to rise to $1.22 at one point yesterday, far from its $1 peg.
At the time of publishing this post, the MakerDAO community is in the process of discussing next steps on how to cover the deficit and stabilize the protocol moving forward. This may include triggering a MakerDAO has decided to mint and auction MKR (the system’s governance token) to raise enough DAI to cover the deficit, and may adjust system parameters such as the Stability Fee, the Dai Savings Rate, and many others.
The problems that led to this situation
MakerDAO is the most popular DeFi project, with approximately 2.4 million ETH locked up in the system. So the health of this protocol is very important to the success of the Ethereum ecosystem and the crypto industry overall.
But this situation exposes a few fundamental flaws with the MakerDAO system.
Using cryptocurrency as collateral
First of all, the protocol uses volatile cryptocurrency as collateral. This can cause system instability when prices drop significantly in a short amount of time, like we saw yesterday.
The quick drop in ETH price caused the domino effect where Vaults got liquidated, all but one Keeper went offline, and unfair auctions took place.
No one expected the price of ETH to dump so hard so quickly, and the protocol wasn’t built to account for the edge case of what happened yesterday.
Now MakerDAO is scrambling to figure out how to bring stability back to their system.
The dreaded oracle problem
A price oracle is critical to the MakerDAO system because it feeds in the price of ETH, which determines whether the 1.5:1 Collateralization Ratio is maintained by Vaults.
Yesterday, a Maker oracle was slow to update the price of ETH while it was crashing. While this actually had a positive effect (by giving Vault holders more time to add more collateral to avoid liquidation), the system’s dependence on a price oracle makes it susceptible to manipulation.
Oracle price manipulation can cause illegitimate Vault liquidations, users would lose a lot of money, and the existence of the protocol would be threatened.
While DAI is arguably the most decentralized stablecoin available, the stability and security of the system still depends on a small team of people who are responsible for its design and development.
There have been some issues in the past where there was conflict within the MakerDAO team about how much centralized control the company should have.
Yes, there is an engaged community of MKR holders that participates in governance to make important decisions. But even the majority of MKR is held by a small group of holders.
How Meter solves these problems
We believe that the creation of sound money:
- Should be as decentralized as possible
- Shouldn’t be backed by volatile collateral (or any collateral at all)
- Shouldn’t depend on price oracles
- Shouldn’t depend on a slow network
Meter’s stablecoin, MTR, is created by Proof-of-Work mining, just like Bitcoin. Anyone in the world can become a miner to mint MTR, making the creation of currency fully decentralized, with no need for collateral nor price oracles.
And because Meter’s hybrid consensus mechanism uses Proof of Stake to confirm transactions, the system can process thousands of transactions per second on each chain/shard, reaching finality in seconds rather than minutes or hours. This high speed and fast finality avoids the issues that MakerDAO saw with Ethereum’s clogged network.
We really appreciate the innovation from the MakerDAO team and the impact that the protocol has had on the crypto industry. We share many of MakerDAO’s ideals to create a new, open, decentralized finance ecosystem.
But it’s clear that there were vulnerabilities and dependencies in the protocol that caused a big loss of money and system instability.
We’re working hard to ensure that we build an open financial system that is sound, stable, decentralized, and open. And we’ll get there very, very soon.
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