MakerDAO’s Recent Trouble May Highlight Flaws In the Ecosystem

News and Analysis

The recent market crash caused a lot of trouble for MakerDAO, the platform behind the Dai stablecoin and the largest DeFi project by value locked. Being largely collateralized by Ether, the stablecoin was impacted heavily by the decline in ETH price and the resulting gap in collateralization.

In this piece, we sum up the MakerDAO’s ordeal, look at the problems emerging from it, and the solutions applied.

Ether Crash Triggered MakerDAO’s Black Thursday

MakerDAO is a decentralized protocol that services the Dai stablecoin. It is an automated system responsible for creating and destroying Dai according to the rules and the deviation from the target price of $1.

In simple terms, Dai tokens are issued when a proportional amount of collateral, such as Ether, USDC, or BAT, is locked in a smart contract. Similarly, a user can redeem Dai for whatever collateral has been used. In this case, Dai tokens are destroyed and the collateral is returned. To keep the price of the stablecoin at $1, the protocol incentivizes users to destroy or generate Dai.

Importantly, the value of the collateral behind Dai fluctuates depending on the market price of the tokens deposited. For Ether collaterals, the system requires the deposit to be worth at least 150% of the generated Dai value. If the deposit drops below this level, the collateral is automatically liquidated, meaning that it is auctioned off for Dai. The MakerDAO network participants called Keepers can then place bids to buy Ether from the liquidated collateral deposits. Ideally, when multiple Keepers take part in the auction, the exchange rate between DAI and Ether tends to remain fiar. Unfortunately, this was not the case.

Between March 11th and 12th, the price of Ether took a dive from around $200 to $100.

Ether price chart

Ether price chart. Source: TradingView

The sudden decrease in the value of the collateral behind Dai triggered numerous instances of automatic liquidation. However, there was an extra complication arising from the congestion of the Ethereum network and unusually high gas prices. March 12th was dubbed as Black Thursday.

Average gas price in the Ethereum network

Average gas price in the Ethereum network. Source: Etherscan

Because of the network issues, MakerDAO oracles couldn’t properly update the Ether price the system was using for its calculations. In addition to that, some of the Keepers who were meant to participate in the liquidation auctions were unable to do so because of the high gas prices.

There were a lot of liquidations and very few Keepers to compete for Ether in the auctions. As a result, some Keepers were able to bid fractions of a DAI and get up to 50 ETH at once nearly free of charge. According to a detailed report by the Whiterabbit research company, losses from all 1462 of such zero-bid auctions amounted to $8.325 million. After the Ether market and the situation in MakerDAO normalized, the system was $4 million short on collateral.

“The MakerDAO had a +500k$ surplus before the price drop, and now has a -4M$ surplus that needs to be filled. The protocol covers this issue, the solution being to trigger an MKR mint and auction, the DAI raised being used to fill the surplus debt. During normal operation, MKR is burned when debt from vaults is reimbursed, this would be the opposite mechanism,” reads the dedicated thread on the MakerDAO community forum.

Debt Auction Chosen As the Solution

To resolve the $4 million of negative surplus, MakerDAO launched a series of debt auctions, allowing users to purchase new MKR tokens for DAI. MKR tokens grant their holders the right to participate in MakerDAO governance and are used to pay transaction fees within the ecosystem.

During the auction, the Maker Protocol mints new MKR tokens in exchange for Dai, which are then destroyed to cut the total supply of Dai and the negative surplus. In other words, as there are too many Dai for the amount of collateral currently deposited, so the protocol buys out the “unbacked” Dai and burns them, solving the debt problem. Since the auctions involve mining new MKR, the token share of the current holders will be diluted, which is part of the compromise.

The solution seems to be working, as $3 million of the negative surplus are covered as of March 23rd.

Still, there are arguments that Maker developers should have done a better job at foreseeing things like 0 bids in liquidation auctions and be clearer about the contingency procedures in place.

Notably, as part of the debt auctions concluded, the Block researchers found evidence that shows that the Maker Foundation, the non-profit organization supporting the protocol development, was winning all of the lots. The Foundation rejected all accusations and stated that it was merely offering “limited technical assistance to some bidders on a first-come, first-serve basis to facilitate their timely and effective participation in the auctions.”

The Block researcher Matteo Leibowitz also noted that while the Foundation appears to be the winner of 33 out of 33 auctions at that time, they were not manipulating the auction price by continuously submitting higher bids.

Lessons Learned?

To prevent similar scenarios in the future, MakerDAO selected and implemented new system parameters. Among other things, liquidation auction rounds were prolonged and the lot size was increased from 50 to 500 ETH.

Notably, MakerDAO had already made a move to increase resistance to Ether price fluctuations. Back in 2019, the ecosystem switched from Single-Collateral Dai (SAI) to Multi-Collateral Dai (MCD or DAI). Although, as mentioned in our earlier article, the shift to a mode diverse collateral doesn’t necessarily make the stablecoin much more resistant to en masse Ether liquidation.

On the bright side, it seems that the community, aside from the opportunistic people behind zero bids, did withstand the blow and was willing to share the losses. Crypto-companies Pantera and Dharma each stated their willingness to support the debt auction.

“We believe MakerDAO and Dai are extremely important to the DeFi ecosystem. Thus, ensuring that the MKR auction succeeds is critical. Given the short timeline, we had to prioritize our efforts, and we decided this was the top priority,” Dharma COO Brendan Forster told Cointelegraph.

The solution is likely to have worked this time, but the fact that the failure did occur highlights the importance of being prepared for the worst, especially in decentralized systems where the time required to patch vulnerabilities and roll out critical upgrades is much greater than in their centralized counterparts.

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