In March this year, cryptocurrencies like Ether suddenly fell ~50% on the back of the coronavirus. The domino effect of the collapse in the price of cryptocurrencies led to mayhem at the nascent Maker community.
Hold on- Dai is soft pegged to the US$. Why would a drop in cryptocurrencies impact Dai?
Remember how a collapse of the housing market led to a worldwide financial crisis in 2007? When markets are interconnected, a problem in one market is a problem in many other markets.
Here is what happened.
Ethereum blockchain got overwhelmed
The sudden drop in prices led to an explosion in transactions on the Ethereum blockchain where many DApps saw a high level of activity. This led to congestion of the network and a jump in gas prices. According to Glassnode mean transaction, gas price spiked 6x to ~80 Gwei.
This network congestion and high gas prices led to expensive delays and confusion in the MakerDAO mechanism. The stakeholders- Maker Vault owners, Keepers, and Exchanges were caught off guard.
To understand what happened on Black Thursday, you need to first understand the original roles of these stakeholders and what went wrong from each of their perspectives that day.
Maker Vaults
Maker Vaults is where Dai is created and destroyed. Users create/borrow Dai by posting collateral (Ether, BAT, USDC). When the user pays back the Dai, the collateral is returned to the user and the Dai is destroyed.
Why would anyone borrow Dai? Dai is pegged to US$ and hence is a relatively stable cryptocurrency. Stability offers many practical advantages in the volatile crypto world. For example, a stablecoin is useful to buy more Ether.
When you take out a loan on a house, the appraised value of the house which is given as collateral is higher than the loan amount i.e. the loan-to-value (LTV) ratio is usually less than 80%. Similarly, Vaults are also over collateralized. So to borrow $100 worth of Dai, one needs to post more than $100 worth of Ether.
How much more? The vaults specify the liquidation ratio i.e. if the value of collateral drops below the liquidation ratio of say 1.5x, then the collateral will be liquidated. Given the volatility of cryptocurrencies, it is standard practice to post a lot more than 1.5x collateral. If users find that due to drop in price, collateral is coming dangerously close to liquidation value, they can do one of 2 things: a) payback Dai or b) post more collateral.
When cryptocurrencies fell in March, users scrambled to either return Dai or post more collateral. However, given network congestion and high gas prices, they were unable to do so. This triggered an unprecedentedly large number of auctions (4,447). 1200 vaults were eventually liquidated where the users lost 100% of their collateral.
Keepers
Keepers are automated market makers that are tasked with the job of maintaining market equilibrium. They run bots that find inefficiencies and profit by executing arbitrage strategies that bring equilibrium back to the market. For example, if vault auctions are triggered when collateral falls below liquidation ratios, then Keepers bid in the auctions. If there are enough Keepers then the bids will be competitive and hence fair.
When cryptocurrencies fell in March, only 4 Keepers (operating multiple bots) were in operation. The Keeper operated by Maker Foundation ran into technical trouble that limited its ability to bid in the auctions. A second Keeper managed to continue operating but was out of Dai soon. Taking advantage of the lack of competition, the final two Keepers submitted several zero bids (bids close to zero) and got the collateral for almost free.
If this was meant to be an open market, why did more liquidators not step in and offer better price for the collateral? Because the network was jammed and bids did not get through. Some opportunistic liquidators realized that by paying high gas prices their bids of zero Dai would go through and were able to lay their hands on over $8mn worth of Ether for peanuts.
If there were more Keepers then the competition would have led to fairer prices being paid during the auctions. The jury is out on whether they were simply being capitalists profiting from the volatility or was this a coordinated hacking effort.
Exchanges
With potential liquidators having run out of Dai, centralized exchanges were the ideal place to source more Dai. However, given the aforementioned network latency, there were delays in accessing this source of liquidity.
Dai Exchange rate- Dai is pegged to the USD. At one point on 12 March, Dai traded as high as $1.126447 due to the increase in demand for the same.
Here are some alarming statistics from this event:
* Collateral auction shortfall was over 5.5mn Dai
* 1200 vaults were eventually liquidated
* 36% of all liquidations happened with zero bids
* The highest vault loss was ~35k ETC
* The highest liquidator gain was ~30kETC
* $8.32 million was withdrawn through zero bids
The Maker community has been hard at work trying to come up with ways to avoid such chaos next time there is volatility in crypto prices. Below are some suggestions:
Have a more diverse collateral portfolio. Accept as collateral an asset that is unrelated to the crypto market. This would provide liquidity and diversification. USDC was added as an acceptable collateral after the events on Black Thursday.
Increasing the number of Keepers to maintain market equilibrium.
Increasing sources of liquidity by onboarding more exchanges
References:
The Market Collapse of March 12-13, 2020: How It ImpactedMakerDAO-
On-Chain Market Indicators- https://studio.glassnode.com/
What Really Happened To MakerDAO? https://medium.com/glassnode-insights/what-really-happened-to-makerdao-f8bc2d1cf406