Summary: the use cases for the Dai stablecoin in isolation is limited; the asset exposure of Dai has benefits in a portfolio approach, with the Neutral Dollar being the most valuable application for Dai.
Dai (ticker: DAI) is one of the most divisive crypto-assets, with various opinions circulating around its perceived usefulness. Dai has been presented as a stablecoin set to confront the volatile cryptocurrency markets. At Neutral, we firmly believe that stablecoins must hold parity to their appropriate peg to fully live up to their name.
Otherwise, what’s the point of a volatile stablecoin?
From Maker’s site, Dai is claimed to be equivalent to the U.S. Dollar. “=” should probably be “≈”
Despite all the advertising, several issues have arisen and been brought to light by community members. Dai as a stablecoin is not very compelling — given that the price deviates quite frequently from $1, and the price stability actually pales in comparison against other stablecoins.
Dai is shown to be unstable, and often deviates from the U.S. Dollar parity. We also extensively assessed stablecoin qualities and found DAI to perform fairly poorly in comparison to other options
DAI-ETH pairs have also been indicative of trading activity below $1, as pictured above
Furthermore, Dai itself has come under scrutiny because it doesn’t scale very well. With centralized stablecoins, trading activity below $1 generally elicits opportunities for arbitrage behavior by burning supply. However with Dai, prices below $1 can happen consistently because the rate to forcing closure of CDPs isn’t advantageous enough to balance the overall supply efficiently. For more widespread adoption, supply and demand mechanics require processes with minimal friction. Even with knowledge of the complex inner workings of creating Dai, the collateralization process currently inhibits proper growth. Partial contribution to Dai’s volatility can be attributed to a direct consequence of inefficiencies on the primary blockchain, which is unavoidable and can periodically amplify instability.
The bigger question is less about how it works, but does it work? For example, we probably care less about who, how, and when a currency was issued — as long as we can spend it with some general assurance that the associated value can be preserved and appropriately transferred in regards to monetary context. If Dai was proven to keep its peg and it was able to accommodate the demand-side of consumers properly, then the question becomes less about how it functions but more about discovering all the things we could do with it in true crypto-fashion. Yet this is the most crippling factor for Dai, a problem which we think may not have a resolution for quite some time.
We can also point to the lending platforms to view market inefficiencies. Under mature markets, we can reasonably expect rates to converge across the origination process, exchanges, and platforms. MakerDAO even provides resources to enable users to keep the system efficient. It is important to note that some institutions do engage in operations to hunt CDPs or market make for profit seeking activities. However there still remains deviation caused by externalities and barriers that prevent more efficient markets, which we are curious why certain opportunities have not yet been fully exploited.
Lastly, there is still discussion on how decentralized Dai actually is. Dai has a strong dependency on MakerDAO, indicating less resilience than actually remarked. Governance processes have attempted to stabilize Dai to the U.S. Dollar reference, but again it is quite difficult to maintain autonomously, as Dai frequently goes through rate hikes. Overall we believe that for a product like a crypto-collateralized stablecoin to succeed, governance and mechanism design need to be more properly aligned.
2018’s wealth transfer in DAI was primarily insolvency
Even in light of this criticism, there has been increasing interest in Dai from many communities in crypto. As of April 2019, roughly 2% of total Ether is locked in Maker contracts.
Dai also provides a unique aspect in that the decentralized nature of the stablecoin also provides native access to margin trading. One can lock up ETH to acquire DAI and use it to also acquire different assets, essentially leveraging overall positions. The transparency of the system makes Dai a good candidate for evaluating funding options.
As Dai has survived the strong downward pressure of cryptocurrency prices in 2018, there is belief that surely Dai can also survive in the coming years. There has been very promising growth of the use cases for Dai by several DeFi protocols as well to spur demand. The vision for Dai is to be a vehicle for broad crypto use-cases, encompassing applications related to hedging, lending, remittances, predictions, and payments in a trustless fashion. Though governance can always be improved, responses have generally been supportive (initiatives such as multi-collateral Dai can also help boost the quality of the asset). Many proposals by the community are pitched such that Dai’s intrinsic value can be closely maintained to $1 parity by managing the factors that control the overall supply and demand.
For what it’s worth, Dai is the most compelling crypto-collateralized stablecoin and much more decentralized than other alternatives being that it is fully transparent and functions almost entirely on the Ethereum blockchain with ample use of smart contracts. Furthermore, it’s a testament to a stablecoin that is fully/over collateralized and verifiable in real-time, compared to fiat-backed stablecoins that may engage in fractional reserves and attest periodically. Redeemability is also much more seamless for Dai, as it avoids using central counterparties that may not manage flow completely in the user’s favor. We find that Dai can combat exposure to forced selling so long as the use cases for Dai became more widespread and the community is committed to keeping the project alive.
Regarding existing stablecoins, the Dai community has been the most vocal and the strong proponents for extending stablecoin applications, which we find to be inspiring. In addition, Dai is ideologically more supportive of a more decentralized, transparent world than fiat-backed stablecoins. However, inherent problems do exist in relation to the stability which can prevent usage. As we stated earlier, once the question transitions from ‘how it works?’ to ‘does it work’ can we begin to fully address all the demand-side applications for Dai and stablecoins in general.
The team at Neutral figured out exactly how to get the best out of Dai. Dai in isolation has experienced challenges, but Dai is particularly useful when considered holistically. That is, using a portfolio approach, we can create a new instrument that represents a basket of assets where the exposure to the Dai stablecoin is actually valuable with regards to stability and risk.
A property in financial diversification exists such that the stability, or volatility of a portfolio, can be better collectively as a portfolio than any underlying asset. That is to say while Dai is a very volatile stablecoin, under certain conditions the portfolio will actually benefit from the inclusion of this asset, so long as the asset is experiencing low or negative correlation with other assets.
The formula to calculate the variance of a portfolio
We observed the behavior of stablecoins relative to one another, and found that adding Dai to the basket can actually be beneficial in this situation. We constructed a pairwise correlation matrix to show that the contribution that Dai can have to lowering volatility is actually significant in a basket model.
Dai is quite lowly correlated to other stablecoins. The same relationship cannot be said with others
An intuitive way to describe it is that if one asset in your portfolio fluctuates in one direction while another asset fluctuates in the opposite direction, then the overall portfolio movement is neutralized. In the case of Neutral Dollar, the team was deciding on what constituents to add into a metastable basket comprising of different stablecoin candidates. It turns out that because Dai has such low correlation with other stablecoins, the exposure was very useful for diversification and could create far more stability against different compositions. At inception the Neutral Dollar basket will consist of four different stablecoins: USDC, PAX, TUSD, and DAI. The three fiat-backed stablecoins are closely correlated with one another, and DAI having low correlation will actually mitigate overall basket movements.
Neutral Dollar does track Dai movements, but the price fluctuations are much less severe. Coupled with the exposure to other stablecoins, the Neutral Dollar actually results in a superior stablecoin than any underlying constituent
Lastly, Neutral has developed an economic incentive where a user can obtain this superior exposure to underlying stablecoins by collateralizing individual stablecoins through decentralized order flow. That is, one can trade exposure to a single stablecoin, like Dai, for Neutral Dollar which represents exposure to many different stablecoins. A corollary is that one can redeem Neutral Dollar for any supported stablecoin. This means that parking stablecoin assets into Neutral Dollar can serve as a better hedging, trading, and investing instrument given its stability. If there is an application that is specific to any stablecoin at that point in time, then a user can redeem to their underlying asset of choice. The implementation of the construction process also accommodates for idiosyncrasies of underlying stablecoins. For example as long as Dai is properly collateralized to the fair value represented by the Neutral Dollar, then pricing and subsequent trading activity for the other stablecoins shouldn’t be too affected on a relative basis. In other words the Neutral Dollar system may see biases towards collateralization vs. redemption across all supported stablecoins, but should maintain equilibrium as Neutral Dollar scales up which is also completely verifiable on-chain.
In conclusion Dai is useful because not only does it represent niche aspects of the crypto ecosystem, but the stablecoin is particularly more useful in the context of the Neutral Dollar, given its uncorrelated exposure to other underlying stablecoins. The whole is greater than the sum of its parts, which is why we believe the Neutral Dollar system offers the best attributes of every stablecoin while providing unrivaled optionality for all users.
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