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Another imminent stablecoin collapse in crypto?

Date: 2022-08-17

Another doomsday event on the horizon?

collapsed house

Photo by Issy Bailey on Unsplash

“If we get nuked by the U.S. government, we simply die.”

The tornado is getting bigger and bigger

Those are the words of Rune Christensen, founder of MakerDAO. Considering he is the creator of that protocol, those words can’t be taken lightly.

But why is Rune and the rest of the MakerDAO community so afraid of the U.S. government? What is MakerDAO and why is this important?

Chain of events

On August 8th, 2022, the U.S. Treasury Department, on behalf of the U.S. government, sanctioned and blacklisted Tornado Cash, a crypto mixer — a blockchain protocol that enables you to make your transactions completely private — thereby making any sort of use of the protocol a federal crime in the U.S.

Automatically, Circle, the company behind the centralized stablecoin $USDC, froze all wallets indirectly o directly tied to some sort of use of the privacy-focused protocol, rendering all that stablecoins inside those wallets utterly useless.

The reason?

Tornado Cash has been accused of being the main tool that hackers in the crypto industry use to launder dirty money. Then, on Friday the 12th, the Dutch FIOD arrested a lead developer of Tornado Cash accused of profiting from such illegal activities.

And why does this matter?

If a trace of USDC used on Tornado Cash to MakerDAO’s USDC PSM contract is found, a sanction on that contract would mean the death of the whole protocol.

Another doomsday event like the one in Terra/Luna could be the final blow to the DeFi space.

Now, what does this really mean?

MakerDAO, one of DeFi’s most successful stories…and a secret — not so secret — weakness

Founded in 2015, MakerDAO is a decentralized organization that provides financial services through the use of blockchain technology. The company’s goal is to provide an accessible, stable, and secure financial system for all.

MakerDAO offers a variety of services including lending, borrowing, and exchanging cryptocurrencies. The company’s native token, Dai, is pegged to the US Dollar and can be used to stabilize prices in the event of volatility.

The protocol lets you use ETH, USDC, and other cryptocurrencies as collateral in exchange for the stablecoin DAI, to then be used in the decentralized financial markets, all while using the MKR token as the governance token of the DAO (to put votes through).

How MakerDAO works

As mentioned, in order to get DAI you have to first put some of your assets as collateral. However, not every cryptocurrency you own can be used as collateral.

MakerDAO is a really well-governed decentralized autonomous organization. Hence, every time a new cryptocurrency wants to be included in the list of acceptable collaterals, this is put to a vote and, if successful, that coin is now officially accepted as collateral to borrow DAI.

Whenever you want to recover your collateral, you have to pay back, in DAI, the full amount in debt plus a Stability Fee. Stability Fees are a Risk Parameter designed to address the inherent risk in generating Dai against collateral.

A portion of the Stability Fee is diverted toward sustaining the operation of the Maker Protocol, which includes the DSR, Risk Teams, and other costs associated with maintaining the protocol.

The importance of USDC to the MakerDAO ecosystem

Among the list of accepted collateral, USDC is, by far and large, the most used coin of all as collateral, representing 33.9% of the total deposited in the protocol.

This value accounts for 3.59 billion USDC — $3.59 billion as USDC is a stablecoin — which is considerably more than the next biggest holder of USDC, Binance, with around 1.78 billion USDC, making MakerDAO’s USDC wallet the biggest in the whole crypto space.

And here is where things get ugly…

To say that MakerDAO has a strong dependency on USDC is an understatement. Although it is always important to be as diversified as possible, this shouldn’t have to be a problem, in theory, as USDC is a stablecoin (very little volatility).

However, there is an issue with USDC. It is centralized, and, therefore, censorable.

And censoring was just what Circle, the company behind USDC, did.

Although it wasn’t explicitly asked for, Circle blacklisted the wallets that were related to Tornado Cash the moment the U.S. government announced the sanctions, making the stablecoins inside those wallets useless.

The USDC “Blacklist Policy” states that when an address is “blacklisted,” it can “no longer receive USDC, and all of the USDC controlled by that address is blocked and cannot be transferred on-chain.”

If the USDC PSM — the MakerDAO’s wallet holding the USDC — gets sanctioned, Rune Christensen has stated that MakerDAO will be compelled to execute an emergency shutdown. Christensen revealed that he intends to propose a Decentralized Voter Committee dubbed Phoenix, which will be in charge of developing a strategy for how the code will react to an emergency shutdown.

And what is an emergency shutdown?

Well, according to MakerDAO’s documentation:

Shutdown stops and gracefully settles the Maker Protocol while ensuring that all users, both Dai holders, and Vault holders, receive the net value of assets they are entitled to.

If that wasn’t scary enough, Rune added:

“In the short run we simply do not have the ability to resist a crackdown, and we can’t pull it out of a hat,”

At least he is wholeheartedly honest, we at least have to give him that.

So what now?

Although a blacklisting seems unlikely, Rune acknowledges that MakerDAO is doomed if sanctions apply now, but it’s fair to say that he and the rest of the members of the DAO aren’t sitting still.

The objective, find a way to reduce exposure to USDC, diversify their collateral and, hopefully, make sure that in the future, all accepted collateral is decentralized.

Some have championed the idea of unloading its USDC in exchange for Ether. However, Vitalik, the founder of Ethereum, was quick to criticize the idea, by stating on Twitter that:

“This seems like a risky and terrible idea. If ETH drops a lot, value of collateral would go way down but CDPs would not get liquidated, so the whole system would risk becoming a fractional reserve.”

-Vitalik Buterin, founder of Ethereum

A Fractional reserve is a system in which only a fraction of deposits are backed by actual cash on hand and available for withdrawal.

What Vitalik is referring to is that, having so much collateral depending on ETH would cause, in the event of a price slippage, the value of the collateral to fall far below the actual value of the minted DAI, making only a part of that DAI actually backed by assets, and available for withdrawal.

Alternatively, some have called for the diversification towards RWAs (Real World Assets).

For example, in July, Maker launched a 100 million DAI vault for the 151-year-old Pennsylvanian lender, Huntingdon Valley Bank, and provided it with 30 million DAI loans. The subsidiary of the French bank Societe Generale was also endowed with a 30 million DAI loan.

Some claim diversified RWAs were the objective since the beginning, but many disagree with the proposition, arguing that USDC was essentially an RWAs in itself.

Consequently, it isn’t clear how MakerDAO is going to handle this issue.

The issue with DeFi

A lot of discussions have been around lately with regards to how decentralized DeFi protocols truly are.

For instance, although I have to clarify that I can’t confirm the veracity of this claim, some argue that the vast majority of MKR — the governance token of MakerDAO — are owned by a small subset of people, so although all decisions are put into a vote, chances are that those people will decide for the rest of the community.

Censorship resistance must be addressed

Making sure the decentralized protocols are censorship-resistant (can’t be shutdown or censored by governments or developers) has been one of the landmark features — or aspirations, it seems — of DeFi and the crypto space in general.

Despite this, news regarding many protocols have generated in the space a sense that crypto is far more centralized than it seems, and that DeFi protocols can be easily shutdown if they fail to meet OFAC conditions.

Several acts of censorship have occurred lately in Aave or DyDx, which again puts in jeopardy the claim for decentralization.

In my opinion, crypto is pointless without proper — and proven — decentralization, so not only we can create trustless, censorship-resistant financial markets, but also we can guarantee that no government or law will deny us the right to financial freedom.

However, my vision looks more naive by the day…

I hope I’m wrong.

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