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MakerDAO finally lowers its stability fee as Dai overshoots peg

MakerDAO token holders voted to decrease the stability fee on the Dai stablecoin by 2 percent to 17.5 percent.

MakerDAO finally lowers its stability fee as Dai overshoots peg

Cover art/illustration via CryptoSlate

MakerDAO token holders voted to decrease the stability fee on the Dai stablecoin by 2 percent to 17.5 percent. Executed on May 28, this will be the first time the fee has been lowered in over five months.

The MakerDAO platform offers collateralized loans in the Dai stablecoin to users who deposit ether into its smart contracts. Dai acts as a decentralized on-ramp for dollar-backed stablecoins, in contrast with stablecoins backed by deposits of U.S. dollars.

Finding a balance for Dai

Dai has consistently traded below its peg since January. While the stability fee makes economic sense, the recent debacle with Tether demonstrates that the expectations of the market can behave in interesting ways. Despite the revelation of USDT not being fully-backed as promised, it only fell to around $0.92.

At only 74 percent backed, it is possible to infer that the expectation of the peg outweighed the expectation of Tether to be backed by the dollar. For MakerDAO, this raises questions about the influence of the stability fee versus the expectation of a peg.

Adding a new variable to the experiment, voters can now signal their preference within a range of 12.5 to 21.5 percent. Voters can choose to lower the stability fee to gain cheaper CDPs at the risk of Daiโ€™s peg floating but if expectation holds more influence than the fee then it may be a good bet. In any case, MakerDAO plans to move from a single-collateral to a multi-collateralized system that will help eliminate the stability fee at some point in the future.

Anatomy of Ethereum collateralized loans

The MakerDAO platform consists of three parts: the MakerDAO token, the Dai stablecoin, and collateralized debt positions (CDPs). The MakerDAO token enables holders to contribute to platform governance by voting on proposals to increase and decrease the stability fee. Dai is a cryptocurrency that aims to maintain a one-to-one peg with the U.S. dollar; CDPs are the smart contacts that enable users to deposit ether and create Dai.

For traders, CDPs offer a way to leverage their exposure to Ethereum up to 150 percent. In other words, the amount of Dai generated with a CDP needs to be collateralized by 150 percent of its values in ether. If the collateral value falls below this threshold part of the deposit is liquidated.

If the market suddenly drops and the price of ether crashes, the user loses their ability to mint Dai and will be hit with a 13 percent liquidation penalty to claim their collateral. Many traders use Dai to purchase more ether to lock in CDPs, effectively enabling even higher exposure to cryptocurrency.

Purpose of the stability fee

The stability fee acts as a counterweight to balance fluctuations in the supply and demand of Dai and maintain its peg to the U.S. dollar. When a user creates a CDP, they agree to pay the stability fee in order to withdraw their ether. At 17.5 percent, that can take a heavy toll.

If users create too much Dai, however, then the price of Dai should fall below its peg with the dollar (and vice versa). Raising and lowering the stability fee helps control the amount of Dai being created and helps prevent wild fluctuations in the supplyโ€”and priceโ€”of Dai.

In the meantime, Dai has become an important part of other decentralized financial products, including fiat on and off ramps in places with unstable currencies, a debit card, exchanges, and charitable projects like Social Alpha Foundation and Giveth. MakerDAO CDPs currently hold 1.64 million etherโ€”roughly 1.5 percent of the total supply at the time of writingโ€”making Dai the most popular service in decentralized finance (DeFi).

June 6, 13:50 PDT: corrected error on Ether to Dai collateralization ratio.