One of the most interesting dramas surrounding the weekend's collapse took place in algorithmic stablecoins DAI and UST: when Ether (ETH) and Terra (LUNA) crashed, large sums were liquidated to keep the stablecoins stable. For a brief moment, a cascade of collapse threatened.
When prices tumble 10 or 20 or 30 percent across the market, it's a stress test for everyone: exchanges and investors, wallets and developers, and so on. The stress test was particularly stressful for the algorithmic stablecoins DAI and UST.
Since both stablecoins work in a relatively similar way, I will mostly write about the DAI dollars in this article. If you want to learn more about these smart contract stablecoins and the Maker DAO behind them, we recommend this article.
The DAI Dollars are vastly different from other stablecoins like Tether or Center Dollars: they are not issued by a central organization but by a Decentralized Autonomous Organization, a DAO, and they are not backed by dollars in a bank account but by Ether or other cryptocurrencies and tokens.
It works something like this: You can take out a loan in DAI dollars by depositing about 150 percent of the amount in ether (or other crypto assets) as collateral in a smart contract. This is how the DAI dollars are generated. When you repay the loan, they are destroyed again. So it works similar to when the banks create fiat money.
But what happens if the price of the underlying cryptocoins slips? In this case, how can the Maker DAO secure the dollar tokens?
Since this question came to a head over the weekend, we spoke to Daniel Kremerov about it. Daniel is the head of Sidestream , a Cologne-based software company, which is now a "core unit" of the Maker-DAO - more about this in this article - and as such deals with the auctions.
But from the front.
When ethers are foreclosed on
As Ether price fell about 12 percent below the $3,000 mark last Friday, many of the assets dubbed “Vault” plunged into risk territory: they were on the verge of falling below the value of the DAI.
In this case, what the protocol says is supposed to happen happened: the vaults were liquidated.
Liquidating means the ethers held in them are auctioned off for DAI dollars. These DAI will be phased out, shrinking the total supply of dollar tokens. The remaining ones are now sufficiently covered again.
As Ether price began to plummet on Friday, an ominous scenario was unfolding, with hundreds of millions of dollars worth of Ether threatening to go under the hammer. This could have triggered a terrible feedback loop: the ether dumped on the market pushes the price further, causing more vaults to be liquidated. And so on and so forth until Ether bleeds dry at $100 and all that is left of the Maker DAO is ashes.
However, this did not have to happen. As Daniel explains, Vault owners can also respond by stocking up on collateral. You increase the ether deposited. This apparently happened as only $144 million worth of Ether, or DAI, was auctioned off in the 139 auctions on Friday and Saturday . That's less than feared, but still quite a lot. It's 3-4 times what it was in March 2020, the day with the biggest auctions yet.
However, the dreaded cascade did not materialize. The market bought the ethers, the DAI dollars remained stable and there was only a slight dip in the total supply of just under 10 billion DAI.
Participate in auctions with Flashloans
As Daniel explains, some details of the auctions have changed since March 2020. For example, the “Dutch Auction” model was introduced: the auction starts at a high price that falls every 30 seconds until the bidders strike, usually slightly below the market price. The advantage of this type of auction is the speed – you save yourself from having to outbid each other. Each bid is a purchase.
There is no shortage of demand. Because you can exchange the auctioned ether directly at Uniswap or other platforms for DAI or other stablecoins. Many of the so-called keepers have bots that constantly monitor the auctions. If you strike quickly, you simply make well-deserved profits.
You don't even need enough DAI dollars in your wallet. Because Sidestream has introduced the so-called flash loans for the auctions: You borrow tokens – in this case DAI dollars – to run the auction, receive the ether, exchange them on Uniswap for DAI dollars, use them to pay back the loan – and keep it the profit. All of these actions happen in a single transaction. Since this is complex, there are not inconsiderable fees.
Daniel reports that anyone can bid with these flash loans, which is particularly helpful and profitable for secondary assets with less liquidity, such as LINK, YFA or UNI.
Passed with flying colors – but only the beginning?
The auctions worked so well that the Maker DAO passed the stress test with flying colors. This is an enormously positive signal: Algorithmic stablecoins also work in a crisis situation.
By the way, last weekend was extremely profitable for the Maker-DAO. Because if a vault is dissolved, there is a “penalty fee”: currently 13 percent of the auctioned amount is exchanged for the maker tokens (MKR), and these are then burned. The idea is that this will increase the value of the MKR tokens, which are used to control the maker DAO.
However, the auctions on Friday and Saturday were probably just the beginning. Because if prices continue to fall, there is a risk of an even more massive wave of liquidations. If Ether falls below $1,900, it is estimated that $600 million worth of ETH will be liquidated, if the price crashes to $1,400, even $1.7 billion. Such a hit could collapse the price of ether.
Of course, this is rather unlikely. While a price drop to $1,900 is entirely possible - some believe it is necessary to complete the bearish market cycle - such a drop could trigger a cascade of panic and liquidations that pushes the price to 1,400. And these … — but the owners of the vaults will probably not stand idly by and increase their vaults to prevent liquidation, which would be unpleasant for them as well.
UST also defied the crash
Similar – and even more extreme – was the case of the UST. These are the "Terra Dollars" issued on the Terra blockchain (LUNA).
The UST is also generated algorithmically and held at par with the US dollar. This works via the anchor protocol; security is deposited in LUNA tokens. The UST tokens only came to market in 2021, but have enjoyed such popularity that they very quickly reached the current number of just over 11 billion UST. UST became the largest algorithmic stablecoin almost overnight.
With both the Terra blockchain and the UST protocol less battle-hardened so far, many traders eyed the construct over the past weekend with concern about the construct's resistance to collapse.
In part, panic reigned supreme: “The $UST death spiral is insane! It looks like the Twitter economists were right: a little black swan kills $UST and all agos are doomed to collapse. $LUNA is going to 0."
In fact, Terra has fallen sharply, from $74 on Thursday to $48 on Saturday. With a loss of 36 percent, the cryptocurrency is among those that have lost the most.
This suggests that a "death spiral" was actually set in motion. However, this seems to have stopped relatively soon. UST remained stable, LUNA price quickly recovered. The tragedy was short and had a happy ending.
What exactly happened, how and to what extent, I cannot say at this point. To do this, one would need to know more about the anchor protocol underlying the dollar token. What is clear, however, is that this algorithmic stablecoin, which is still young, has passed its baptism of fire - which is why some observers are switching from panic mode to cheering mode:
“The most bullish thing I've seen in the past 48 hours is how well the algorithmic stablecoins have stayed on their feet. This shows that even in times of panic, the world is comfortable abandoning the old monetary system and embracing the new paradigm.”
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