MakerDAO Soft Pegs 1 DAI = 1 USD
The Maker system “soft pegs” the value of the DAI token to the USD dollar. Pegging isn’t that special: countries and companies have been pegging currencies to each other for centuries. DAI’s peg is special because the no one enforces the peg by direct convertibility. No organization stands ready with a reserve of dollars ready to redeem each DAI. This makes the peg “soft” instead of hard.
In this article, we’ll simultaneously review how the pegging mechanism works, and explore the strength of this pegging.
How Hard Pegs Work and Why They’re Effective
Before diving into soft pegs, it’s worth understanding how classical hard pegs work, and why they’re so effective.
A classical hard pegs occur when a Market Maker stands ready to convert between two currencies. For example, the Saudi Arabian Monetary Agency (SAMA) acts as the Market Maker. They peg the Saudi riyal to the United States Dollar at a 3.75:1 ratio. Anyone can go to the SAMA and (as of 2020) convert 3.75 riyals to one US Dollar, or vice versa. This results in a hard peg.
The peg is hard because if there is even a small price discrepancy, there is a large restorative force. Suppose any market was willing to convert Saudi Riyals to USD at even a 2% discount or premium to the peg. Traders would be thrilled to put in huge orders on this market. They can then go directly to the Saudi Arabian Money Agency to get a 2% sure profit.
Classical hard pegs apply not just limited to classical currencies. In many ways, the USDC issued by Coinbase and the USDT issued by Bitfinex are classic hard pegs, even though they are crpytocurrencies. Coinbase stands willing to redeem each USDC for 1 USD, and vice versa. Classical hard pegs happen even in defi (decentralized finance). For example, the pools on curve.fi are hard pegs between different stablecoins.
How DAI’s Peg Works
Day to day, DAI’s peg is very rough and soft. To understand DAI’s system more, it’s worth considering a thought experiment.
DAI’s Upper Bound: Hard but Loose
What prevents DAI from trading at extremely high prices, say at $100=1 DAI instead of $1=1 DAI? The answer is easy. If DAI traded at $100, then any user can use Maker to deposit say $300 worth of ETH. The user then generates 200 DAI, which would be worth $20,000. This would net you a handsome profit of $19,700, providing a strong restorative force when DAI is too high.
When would this force stop working? If you go through the math above, since the ETH collateralization ratio is 150%, the strong restorative force stops working when DAI is below $1.50 (with ETH collateral). $1.50 is not a tight bound for DAI, which is supposed to be worth $1.00!
In general, a hard upper bound for DAI is the minimum collateral required to issue 1 DAI. This is exactly what motivates Maker to allow stablecoins like USDC to be collateral at very low collateralization ratios. By allowing 1 DAI to be backed by as little as 1.05 USDC, an upper bound of $1.05 is placed on DAI.
DAI’s Lower Bound: Soft and Enforced by Vault Owners
What prevents DAI from trading at extremely low prices? The short answer is liquidations — albeit in an indirect and soft way. Empirically, liquidations happen regularly, at least many times a month, as you can see on this dashboard here.
Now as a thought experiment again, take the extreme and supposed DAI has fallen a lot in value. 1 DAI = $0.01. In these regular liquidations, users bid DAI in exchange for collateral. Since DAI has low value on the open market, liquidators are willing burn a lot of DAI in liquidation auctions. This soaks up DAI, decreasing the supply and pushing up price. Anyone can take part in liquidations, but liquidations in an average month involve a small fraction (e.g. <5%) of the DAI in circulation. A large base of people can partake in a small enforcement, making this a soft force.
The threat of liquidations generates a secondary stronger force that pushes up DAI prices. With low DAI prices, vault creators want to buy DAI to burn to pay down their vault’s DAI debt. This reduce their chance of liquidation. Further, if these vault creators issued DAI debt when DAI equalled $1.00, repaying that DAI debt at $0.01 locks in profits.
DAI Lower Bound is Soft
The Maker system has other mechanisms to try to push DAI prices back up. This includes global settlement and breaking dollar parity. These mechanisms are discretionary and not used often.
If the above pegs sounds hand-wavy, it’s because it is. There is no theoretical reason that liquidations must happen regularly. Everyone using Maker could just issue little DAI debt and not risk liquidation. Most Maker community members could simply believe that DAI is worth $0.01, and it would be a self-fulfilling stable equilibrium. Vault owners would be in no rush to buy back the DAI, and DAI wouldn’t rise in value.
No outside arbitrageur could obvious make money in such a situation and push the price of DAI back up. This is in sharp contrast to a hard peg, where even a 10% or 2% drop in market price would allow anyone to forcefully push the price back up.