From the rapid growth of crypto to the dramatic volatility of the asset class, governments around the world are responding through regulatory and legislative actions. Some jurisdictions have announced clear and accommodating frameworks in the hope to create the crypto hubs […]
“The dollar [is] their god, how to get it their religion.”
― Mark Twain
DeFi’s Dollar Problem
In the underappreciated financial crisis of 1893, a mad rush for dollars forced New York banks to restrict withdrawals to $25 per day.
Many depositors were unable to get even that: The bank teller would ask why you needed the money, and if they didn’t like your reason, you'd be leaving empty handed.
Businesses were restricted to $25 a day, too, which made it hard for them to make payroll.
Employees still expected their wages in cash at that time, so larger employers were forced to go to “money brokers” to get it.
The money brokers had cash when banks didn’t because they paid up for it: They’d offer, say, $104 in certified checks for $100 and then sell the cash to businesses for an even bigger mark-up.
Much of the cash came from retail savers who had hoarded their money in tin cans, under mattresses and buried in gardens.
When the premium got high in times of crisis, lines would form outside the money brokers as the tellers busily disinfected the crumpled, dirty bills being deposited.
Solving these currency shortages is in large part why the Federal Reserve was founded: In times of crisis, banks needed a better source of dollars than tin cans and mattresses.
The unfortunate truth is that DeFi, facing the same problem, has turned to the same savior: Decentralized finance has become (indirectly) reliant on the Fed.
Live or Let DAI
DAI often gets criticized for being “wrapped USDC,” and, at first glance, it does seem odd: Why back one stablecoin with another?
The answer is that it’s difficult to peg to an asset without holding that same asset as collateral.
DAI was originally backed only by ETH, which had the benefit of decentralization, but the dis-benefit of inefficiency: You have to deposit $1.50 worth of ETH to mint $1 of DAI.
That inefficiency makes it impossible to defend against upside peg risk: If DAI trades at $1.02, it’s not profitable to arb it back down to $1 using ETH: You’d have to tie up $1.50 of ETH to make a 2 cent spread.
Which is a problem: A stablecoin that trades above its peg is nearly as bad as one that trades below it.
TradFi solved that problem by turning to the Fed, which can deliver unlimited dollars to banks in times of high demand.
Maker solved the problem by turning to USDC, which is effectively dollars and effectively unlimited.
That allows arbs to mint $1 of DAI for $1 of USDC, making it profitable for them to police the DAI peg.
Defending against upside peg risk is why so much of DAI is backed by USDC.
But, it’s made DAI indirectly dependent on the Fed: USDC is effectively unlimited, with no upside peg risk, because it’s tied into the real banking system — which gets its dollars from the Fed.
Being dependent on the Fed, even indirectly, is of course contradictory to the spirit of DeFi: What’s the point of decentralized finance if it’s ultimately reliant on a central bank?
MakerDAO was aware of that contradiction when it started accepting USDC as collateral, but it was the only way to scale in the short term and it seemed like there was plenty of time to figure out a better solution for the long term.
Post Tornado Cash, the long term may be now.
Rune Christensen seems to think the time is now: The MakerDAO co-founder ruffled some feathers on crypto Twitter last week by floating the suggestion that Maker should swap most of its USDC collateral for ETH.
That was a radical enough suggestion to draw a prompt response from Vitalik himself, who declared it “a risky and terrible idea.”
I’d agree with that (as I would with anything else Vitalik says), but I share Rune’s concern — and his sense of urgency, too.
In the wake of Tornado Cash, it’s painfully obvious that neither DAI nor DeFi is censorship resistant.
Rune’s proposal is a sort of cri de coeur: He knows removing USDC as collateral is a bad idea, but it seems less bad than the alternative, which is to remain indirectly dependent on the Fed.
What would DAI look like without USDC?
I imagine it would fluctuate widely…trading between, say, $0.80 to $1.20, just as a guess.
That would make it less useful, for sure, but maybe the market would accept that as the price of censorship resistance?
Unfortunately, I don't think so: The market does not appear to value censorship resistance as highly as Rune does.
People want dollars, and they don't want to think about what they might cost on any given day.
They do not value decentralization enough to risk borrowing DAI at 80 cents knowing it could be trading at $1.20 when it comes time to pay them back.
That may be why the "floating stablecoin" RAI has never caught on.
RAI, a fork of Maker, floats loosely around a dollar peg (whimsically set at $3.14, in honor of Pi, instead of $1). It's backed only by ETH, which makes it decentralized and censorship resistant.
But RAI has a market capitalization of just $15 million: People seem to want their digital dollars hard pegged to $1, not loosely pegged to $3.14.
They want pegged digital dollars, and they don't even have to be good ones: Tether still has a market cap of $68 billion, which suggests the market might even be putting negative value on decentralization.
That is unfortunate: The value of decentralization has never been more clear than in the wake of the Tornado Cash sanctions.
If DeFi wants to be genuinely censorship resistant, it may have to abandon digital dollars — but that would make it not very useful.
Personally, I value utility over censorship resistance, so I'm in favor of digital dollars.
Maybe, someday people will want BTC or ETH just as much as they want dollars now.
But, in the meantime, if we want DeFi to be useful, we will have to make some concessions to the almighty dollar.
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