Written by Xinxin Cao, working at HashKey Capital Research
Reviewed by Chuanwei Zou, Chief Economist, Wanxiang Blockchain
On February 3, MakerDAO smart contract team proposed a second generation clearing system design (MIP45) and launched an executive vote on April 19 to bring the clearing 2.0 system online. The main purpose of this upgrade is to solve some ineffective links in the current clearing system, and avoid the recurrence of the 2020 312 incident, which led to insolvency due to the failure of clearing. This paper reviews the main modules and functions of the MakerDAO clearing system, summarizes the factors that affect its operational efficiency and the main focus of this update plan.
The main design of the liquidation 1.0 system
MakerDAO implements a mechanism to lend stable coins by over-collateralizing the native digital assets on the chain. The main tasks of the clearing system are twofold.
Monitoring the price movement of the collateral and forcing the closing of the lending position in a timely manner when the liquidation line is triggered, in order to avoid a large amount of bad debt in the system.
Since clearing involves the destruction and issuance of that stablecoin, which is an important source of volatility generated by the market circulation of that stablecoin, the clearing system should also try to maintain the price of the stablecoin to fluctuate in line with the price of the anchor.
Price Stabilization Mechanism of Stablecoin
From January last year to the present, the market value of DAI in circulation has expanded from less than $100 million to $5.2 billion, and its volatility has decreased significantly compared to last year, indicating that the market has formed a relatively strong consensus and recognition of DAI, and the mechanism of the MakerDAO stable coin price has been relatively mature.
Figure 1. MakerDAO supports multi-currency collateralized stablecoin DAI price changes
MakerDAO controls the risk of price de-anchoring by regulating the amount of short-term stablecoins in circulation. By increasing the stabilization rate, it will increase the cost of capital for DAI minters, thereby providing an incentive for them to return DAIs for redemption; increasing the storage interest rate will also attract DAI holders in the market to lock up their DAIs to earn interest income; both of these will reduce the liquidity of DAIs, which has the effect of flattening the spread when their price is at a negative premium to the USD. Both will reduce the liquidity of DAIs, which will have the effect of flattening the spread when their price is at a negative premium to the U.S. dollar.
MakerDAO has been able to expand the size of the DAI issuance by introducing new collateral types to support the DAI. When DAIs ran out of liquidity in the 2020 312 event, MakerDAO introduced USDCs backed by an off-chain fiat reserve as collateral through a community vote to expand DAI liquidity. Currently, the MakerDAO self-developed tool PSM allows for a no-slip exchange between DAI and USDC, supporting more than half of the DAI’s liquidity. Since Coinbase provides a 1-to-1 exchange channel between USDC and USD, investors can arbitrage through PSM and Coinbase when there is a positive or negative premium on DAI, which is useful to maintain the price stability of DAI.
Figure 2. Collateral distribution of MakerDAO stablecoin DAI
In addition, the current storage interest rate for DAI is already as low as 0.01%, partly because the high yields of many other DeFi and revenue mining projects focused on lending are attracting DAI holders to adopt third-party services to gain more DAI appreciation, and partly because the MakerDAO system no longer needs its own savings module to recover over-issued DAIs. The other reason may be that the MakerDAO system no longer needs its own savings module to recycle over-issued DAIs, as the entire DeFi system is now involved in regulating DAI liquidity.
To implement the two main functions of the clearing system, the MakerDAO Clearing 1.0 system builds three English-style auctions via smart contracts and uses incentives to encourage third-party Keepers to participate in the bidding.
MakerDAO’s clearing system is a bit like a system of many parts, the parameters of which need to be decided or updated through the governance system, and it is a big challenge to maintain a decentralized governance system that works well. The governance token MKR is a chip for the voters of the governance system, and the surplus auction mechanism is an incentive for the MKR holders.
MakerDAO’s service of overcollateralizing highly volatile digital assets to mint stablecoins requires a stabilization fee, which can also be thought of as interest on borrowing. This fee is compounded at an annual interest rate determined by a community vote, the time precision of block generation, and overlaid on the total amount of coin that needs to be returned to the stablecoin when the mint redeems the collateral. This portion of the surplus is locked in a cushion vault, which serves as a cushion of priority disposition against the risk of rapid collateral devaluation in the debt auctions that will be mentioned subsequently.
When the net surplus (net of debt) of the MakerDAO system exceeds a certain threshold (e.g., 500K DAI, which is also determined through MakerDAO’s governance system), a surplus auction is opened. This determination step can be calculated by synchronizing the latest status data from anyone initiating an on-chain transaction. When the first bid is initiated, the auction begins and a fixed amount of surplus (e.g., 50,000 DAI, as determined by governance) is available for bidding in batches of bidders in descending order of the MKR they are willing to pay, with the system requiring each bid to be at least a certain percentage above the previous bid.
Figure 3. Flowchart of smart contract invocation for participating in surplus auctions (from MakerDAO doc)
At the same time, the system specifies the total duration of each auction and the maximum time interval for accepting new bids, and if the total duration or the maximum time interval is exceeded, the auction ends. The MKRs paid by the bidders are destroyed, thus shrinking the supply of MKRs and raising their prices; the bidders themselves are able to liquidate the MKRs at a favorable price.
Collateral Auction (Collateral Auction)
The governance system determines the liquidation line indicator for each overcollateralized asset, and when the ratio of collateral to lending falls below the liquidation line, anyone can initiate a transaction for a collateral auction and start a round of auctions. The auction process is similar to a surplus auction, with bidders bidding from low to high by the amount of DAI they are willing to pay for a fixed amount of collateral until the time limit is exceeded. This auction continues until the debit amount and liquidation penalty are covered by the remaining collateral, with the liquidation penalty being a reward paid to the Keeper for successful bidding. When there is not enough collateral left to cover the set size, a reverse auction is opened and bidders bid from high to low based on how much collateral they are willing to accept for a fixed DAI.
In extreme cases, the market value of collateral may fall below the borrowed amount due to Keeper’s reluctance to accept collateral assets with high downside risk, etc., creating systematic debt. To deal with this situation, the debt is first covered by the balance of the buffer vault; if it is not available or insufficient, and the system’s debt exceeds a certain threshold, the system will initiate a Debt Auction, where the auctioneer bids for a freshly minted MKR with DAI.
312 Event Analysis
In practice, the above system failed to withstand the stress test of the market and the clearing engine failed and created over $5.4 million in debt during the market crash on March 12, 2020. The main causes were
Transaction congestion: The rapid drop of collateral price in a short period of time will trigger a large number of clearing transactions, which will compete with other transactions for block recording space. The above auction mechanism of collateral auction requiring multiple rounds of bidding and selling collateral in batches is inherently very inefficient and redundant, and the efficiency problem is further highlighted in the case of congested transactions in Ether. It’s not surprising that Keeper will end up with zero payment.
Insufficient incentive: In addition, Keeper can calculate the break-even point through transaction fees, current market selling price, and clearing penalty income, and the higher fee cost and the expected downward price of collateral will depress Keeper’s clearing enthusiasm. When the liquidation price of collateral falls below the break-even point, Keeper’s willingness to participate in auctions may plummet. The clearing system is also very unresponsive to updates and cannot adjust the parameters that motivate Keepers to participate in auctions in a timely manner.
DAI liquidity is depleted: As collateral sells off in the market, it exacerbates the downward pressure on its price, which may generate more bad debts, and investors prefer to hold stablecoins in the event of a crash, the liquidity of DAI available for liquidation in the market plummets, resulting in a very high positive premium, and there is not enough DAI in the market for liquidation, which further raises the cost for Keeper to use This further increases the cost for Keeper to use DAI for liquidation.
Faced with this situation, MakerDAO stimulated more DAIs to flow into the market by lowering the storage rate of DAIs to 0; lowering the borrowing rate of DAIs to incentivize investors to mint more DAIs; and introducing USDCs as a new collateral species, which was very attractive to investors holding USDCs at the time because the collateral The introduction of USDC as a new collateral was very attractive to investors who held USDC at the time, because the DAI obtained from USDC could be sold in the market at a positive premium; these were all emergency measures to deal with the problem of depleted DAI liquidity.
Once the DAI liquidity problem was alleviated, the debt auction for the MakerDAO liquidation system was opened and new MKR tokens were issued to raise enough DAI for the system to cover the losses and eventually survive the crisis.
Figure 4. DAI price K-line as of March 12, 2020 (from MakerDAO blog)
The planned upgrade of the Clearing 2.0 system
The core goal of the clearing 2.0 upgrade plan is to connect the clearing system to the entire DAI liquidity market on Ether, increasing the DAI liquidity available for large-scale clearing, and improving the auction system to make it more efficient with a lower threshold.
Prior to this, MakerDAO implemented a clearing 1.2 system upgrade on August 31, 2020, in preparation for the clearing 2.0 system upgrade. In response to extreme market conditions where a large number of bad debts need to be cleared at any given moment and there are not enough Keepers to bid and not enough DAIs on hand, the Clearing 1.2 upgrade allows the governance system to reduce the volume of liquidation at any given moment by limiting the number of auctions that can be started simultaneously and the total amount of collateral to be auctioned at any given moment. Keepers can choose to enter auctions at different points in time and improve their capital utilization (recycling collateral into DAI for multiple rounds of auctions).
Among the planned upgrades to the Clearing 2.0 system are the following major improvements.
Changing from English to Dutch auctions
In the original system, English auctions not only required multiple rounds of bids, but the DAI of Keeper bids would be locked until they were raised by other Keepers or the auction ended. The Clearing 2.0 system replaces the British auction with a Dutch auction, where bidders can send their bids at a psychological price level and settle in a timely manner, with a set decreasing time function from a price starting point. In addition, the system will set a time limit for the Dutch auction process, and the auction will be restarted if the time taken and the price drop exceeds the threshold.
Removal of Keeper Entry Threshold
In the original British auction, there was a capital threshold for Keeper. In the improvement plan, collateral is no longer offered in batches of a fixed quantity, and in Dutch auctions, any number of Keepers can purchase a portion of the collateral at an accepted offer.
Support for Lightning Loans
The Clearing 2.0 system supports flash lending under the condition that it supports just-in-time settlement. Keepers who do not hold DAI themselves can flow collateral to an external DEX or other agreement to convert to DAI and return to MakerDAO in a single transaction, significantly reducing Keeper liquidity costs.
Incentives for Keepers
In the original system design, there was an incentive for the first Keeper to participate in the auction, but after the 312 event, it was not beneficial to the system to incentivize Keepers to participate in the earliest liquidation. In the update plan, it is proposed to adjust the allocation of incentive funds for incentive recipients and different types of collateral, aiming to provide more incentives for liquidation behaviors that reduce system risk, such as allocating more incentive funds for collateral types with high bad debt sizes, and using incentives to compensate for Keeper losses in situations that are not conducive to attracting Keepers to come to liquidation.
In addition, MakerDAO may also integrate external resources with abundant liquidity, such as DEX and aggregation protocols, to increase the competitiveness of Keeper bidding and to expose the entire clearing system to more market liquidity.
Reflections and Summary
MakerDAO’s Clearing 1.0 system is a regulator of three English auctions that attract external Keepers to spontaneously participate as collateral, stabilize coins, and govern token liquidity. The main reasons for the failure to withstand the stress test in the 2020 312 crash were block congestion, depleted DAI liquidity, and insufficient incentives to attract Keeper participation in extreme cases. While the governance system mitigated DAI liquidity depletion with emergency adjustments to risk parameters and closed funding holes with debt auctions, the community has suggested additional improvements to the long-term functioning of the clearing system.
The Clearing 2.0 system upgrade plan, which recently went to a ballot, improves a number of areas, notably by changing from English to Dutch auctions, increasing auction efficiency and lowering the barrier to entry for Keepers; and by supporting flash lending so that Keepers can clear liquid assets in the DeFi market, further reducing their liquidity costs; and The upgrade plan also proposes to design mechanisms to provide different incentives for different situations affecting the system risk factor.
MakerDAO’s response to this year’s 519 crash was significantly different from the 312 event, and DAI prices were relatively more stable during this time, which may be related to MakerDAO’s expansion of the collateral asset classes, especially USDC, which is also a stablecoin.
The clearing system designed by MakerDAO is more complex than the other two lending products, Aave and Compound, which provide more freedom to the Keeper in the clearing process, as the Keeper can send clearing transactions at any time by listening to the prophecy machine quotes without having to participate in the auction process set by the system, which may be related to the fact that MakerDAO itself This may be related to the fact that MakerDAO itself has a slow update rate (at least 1 hour).
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/hashkey-cao-xinxin-an-analysis-of-the-makerdao-clearing-system-and-its-update-plan/
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