March 12, 2020, was a bloodbath for global financial markets. Major U.S. stock indices plummeted firmly into bear market territory, officially ending a historic 11-year bull run. Cryptocurrency markets weren't spared either: Bitcoin and Ether crashed by over 30%. It appears that we are in the early stages of a global economic recession.
The U.S. Federal Reserve has unleashed sweeping emergency measures. They announced their second round of emergency rate cuts in a span of weeks and they have also started purchasing treasury and mortgage-backed securities along with municipal bonds. The Treasury is working with the Fed to provide "unlimited liquidity" to prevent markets from freezing or collapsing.
Simultaneously, a decentralized crypto bank called MakerDAO faced its first major crisis. MakerDAO manages a stablecoin called DAI that is loosely pegged to the US dollar. The DeFi ecosystem is populated with applications that depend on DAI, which is considered the reserve currency of DeFi. By extension, MakerDAO may be the most important entity in DeFi.
Like the Fed, MakerDAO was compelled to react decisively to avert potential systemic collapse. The plummeting price of ETH led to a series of events that allowed an unknown individual to "bid" $0 for ~$5.3 million worth of ETH collateral held by users with vaults in the MakerDAO system that are used to generate DAI. Unprepared vault holders were blindsided and lost significant sums of money due to the exploitation of this unanticipated attack vector. MakerDAO was forced to take unprecedented action to address the fact that ~$5 million worth of existing DAI was suddenly “de-collateralized” and backed by nothing. MakerDAO decided to mint new MKR tokens to be sold for DAI, effectively punishing its "shareholders” for their governance failure by increasing the supply of MKR.
Current market dynamics present a perfect opportunity to compare the ability of The Fed and decentralized crypto banks to manage a crisis effectively. MakerDAO and The Fed rely on an analogous set of tools but have radically different governance processes. This table is illustrative, not comprehensive.
For now, it appears MakerDAO has effectively stabilized the system. This is more than can be said for The Fed which merely seems to have slowed plummeting stock market prices. A centralized stablecoin, USDC, was approved by MKR holders as a new acceptable form of collateral and the auction of MKR to cover the system’s debt was successful. Still, there are a couple of important open questions.
Should vault holders, such as one user who lost $50,000 and feels “betrayed,” be compensated for their losses? While it could be argued that they should have done better due diligence and not risked placing large amounts of money in a cutting edge and highly experimental project, one could also argue that the risks of opening a vault were mischaracterized. The community is engaged in lively and mostly cordial discussions on the matter. Unhappy vault holders could be a source of future instability if their concerns are not addressed.
Is it time to accelerate research and development to support the creation of competitors for DAI, such as the proposed Metacoin project? While it appears MakerDAO has made it through its first real battle test, the event has made the dangers of allowing the DeFi ecosystem to be dependent on a single decentralized stablecoin apparent. "DeFi" that relies on a single crypto bank can not be decentralized enough to provide a secure and compelling alternative to the existing financial system.
I’m a firm believer in the potential for DAOs to help humanity tackle our biggest problems and think this recent crisis can serve as a useful case study for evaluating the challenges DAOs must overcome to reach their potential.
Disclosure: I am a MKR token holder.