This is a follow-up from an earlier post, “Stablecoins are doomed to fail,” from December 10th. I’ll keep this one short.
Long have I been a critic of the “stablecoin” concept – the techno-magical idea that a cryptocurrency can tell the market what its price should be, rather than the market determining what a cryptocurrency’s price should be (the usual way these things work).
My first encounter with stablecoins was with the Bitshares/BitUSD scheme in 2014. I pilloried it. Following which it fell on its face 100 hours after launch.
In October, I moved on to point out how harebrained a new scheme called Basecoin was. This scheme is similar to Bitshares, only with different names and slightly different functionality for the various moving parts. Incredibly, this profoundly ill-considered project attracted investment from A16Z, a smattering of new cryptocurrency-only VCs and Bain Capital Ventures.
Then, last month, after a developer from the “MakerDAO” team told a reporter that the fact I hadn’t commented on their “Dai” stablecoin project “spoke volumes” about its legitimacy and quality, I wrote a brief post in the space of 20 minutes pointing out that I thought “Dai”, too, was a bunch of twaddle.
The nice thing about predicting the demise of a stablecoin is that, in any free (i.e. unmanipulated) market, you are 100% guaranteed to be right. You just need to wait for your day to arrive.
Today is that day.
1. What I said about MakerDAO
Four weeks ago, I wrote:
Having taken fifteen minutes to review the MakerDAO paper, the Dai system is at its core a very simple cryptocurrency-collateralised derivative contract, with a lot of intermediate steps to confuse its buyers of the facts that (a) that contract is massively overcollateralized in the underlying cryptocurrency (which is Ethereum by default) and (b) in the event of an Ethereum black swan event the value of the underlying collateral, and therefore the value of the stablecoin, will also be wiped out.
Speaking generally, the system requires someone who wishes to obtain $100 worth of Dai to post, say, $150 Ethers’ worth of collateral. This, of course, is insane, because it would be easier for the user to simply go to Coinbase and sell his Ether for actual dollars, and he’d have $50 worth of Eth left over to go spend on other things.
The system also assumes that overcollateralising will protect the value of the Dai. Not so; it simply increases a Dai holder’s exposure to the price of the underlying Ether. If Ether gets wiped out, the Dai collateral will be worthless, so the user will have lost $150 in an effort to create $100.
2. What MakerDAO said about me
Cryptocurrency projects don’t like being criticized.
Well, nobody likes being criticized. But cryptocurrency projects in particular, with their communities of thousands of financially invested scheme participants eager for the value of their investment to rise, are known to dislike it a great deal. A sample:
The problem with Preston’s brash, hyperbolic, stance is that it favors showmanship over facts. While it may be great for increasing clicks he has backed himself into a corner of never being able to admit he groks it even when he does.
Saying something will eventually fail is the safe position of never having to be wrong with the chance of maybe being right some day.
if you didn’t spend enough time to understand this point, you end up saying incorrect things like “[issuing DAI] is insane, because it would be easier for the user to simply go to Coinbase and sell his Ether for actual dollars, and he’d have $50 worth of Eth left over” – selling ether directly for fiat or DAI, and opening a CDP, expose you to completely different “risk profiles” (margin long vs closing a regular long position).
It’s not true that the system “only works if the price of Ether goes up”. The whitepaper specifically discusses what happens if the collateral starts losing value, with different “lines of defence” that need to be used depending roughly on how fast it loses value – liquidating CDPs, then minting MKR, then the foundation.
“Read the white paper, bro.” Cute.
3. What happens when reality strikes
This was the dream:
“Always maintain.” Strong language there.
The language sets the standard to which this stablecoin project must be held. For Dai to live up to its promise, a person seeking to redeem 1 Dai for money or money’s worth should reasonably expect to be able to convert it for $1, every single time, without exception.
Even if the marketing were more nuanced, we would do well to remember that near-perfection is also the standard in the grown-up world of finance which many of these crypto projects aspire to supplant.
If a money market fund’s investment income is less than its expenses, it breaks the buck (something that has only happened once in the United States in the last 47 years). If a bank can’t satisfy depositor withdrawals, it collapses. If an SPV can’t redeem bonds that have matured, it defaults. If a company cannot satisfy its debts as they fall due, it is insolvent.
If a stablecoin can’t hold its peg, all the time, every time, it’s simply not a stable coin. It is a mere aspiration of stability, clothed in technobabble, that has broken the buck, and a stablecoin’s users – if stability is indeed what they seek – would be better off just withdrawing cash, depositing money in a FDIC-insured bank or making an investment in a money market fund.
For Dai, then, this is reality:
The markets are crashing and, as this marmot predicted, Dai is trading at $0.80 on the dollar. It dipped to as low as $0.72.
The coin launched on December 30th. It lasted a grand total of 12 days before breaking. This is better than Bitshares’ BitUSD, whose freshman attempt lasted just over four days. TBD: whether Basecoin can set a new record by making it two whole weeks.
Rather speaks for itself, doesn’t it.
Why this happened, we cannot say. The coin, my friend Rick Dudley points out, remained over-collateralized despite the fact that the value of the collateral dropped 12.5% overnight. This lends itself to the suggestion that not only are stablecoins super inefficient from a cost of capital perspective, but also that stablecoins are not “stable” at all.
Rather, this episode suggests that, like markets for every other security in human history, stablecoins are not closed systems and are therefore subject to the vagaries of supply and demand and contagion from the wider markets beyond. In this instance, one market circumstance which might have caused the seemingly irrational selloff could have been a Dai holder getting margin called with respect to some other, unrelated, exposure and needing to liquidate his or her Dai at a loss then and there in order to cover.
If we were talking about any other security traded by grown-ups, mind you, we would not need to have this discussion, as the point would be taken as read by everyone, including the interns. Yet this point does not appear to be something that the existing stablecoin projects, the VCs investing in them, or the media covering them have considered at all.
It may be that this “stablecoin” will recover when the market recovers, or when those with an interest in seeing the project succeed deploy Ether to ensure its price reaches the “correct level.” A return to dollar “parity” for Dai should not surprise us. Stablecoins work as long as the price of the underlying collateral rises, or as long as traders with a financial interest in the coins’ success have sufficient firepower to paint the tape or otherwise subsidize their differences of opinion with the market.
It is not reasonable to assume Ether’s price can or will rise forever, or that the MakerDAO people have infinite financial resources. Eternal inflation works in cosmology. It does not work in economics.
The teachable moment here is the same as the teachable moment from Bitshares back in 2014. When you make a “coin” which is in form and substance a repackaged exposure to another underlying cryptocurrency, as Dai is simply repackaged Ether, and Basecoin is simply an abstraction of demand for “Base bonds,” and peg that exposure to some meatspace asset like an ounce of gold or a U.S. dollar, a sudden move against the underlying collateral – in this case, 12% – can trigger a sell-off that breaks that peg, and breaks it hard.
Which means that despite all the marketing budget and smooth pitchmen dedicated to this folly, if we’re being responsible and/or honest with ourselves, maybe we should think twice before we use “stable” and “coin” in the same document, let alone the same word.
At this juncture, all I’ve left to say is:
Postscript, 17 January
Remember what I wrote a week ago?
It may be that this “stablecoin” will recover when the market recovers, or when those with an interest in seeing the project succeed deploy Ether to ensure its price reaches the “correct level.”
Welp, it turns out that was a pretty good guess: