Science of DAI

3.5 billion Google searches are made every day & 20% of them are the items that’ve never searched before. This leaves us with 700M things that people are asking for the 1st time. This is the opportunity generated EVERY DAY!

Same goes in the crypto world where no project is 100% perfect and the imperfections engenders new opportunities. Let’s talk about one problem, which is more than a bottle neck for crypto to go global as a medium of exchange and store of value. Crypto volatility. This is something that has also been the reason for the risk in crypto investment. Suppose you borrow in Bitcoin and the current market value of the coin is let’s say $10k. You are expected to return the loaned Bitcoin after couple of weeks and you find the market value of the coin soared to $12k or dropped to $9k while returning the loan. This volatility makes the scope of the project limited. The figure shows the fluctuation in one day value of Bitcoin.

These are the imperfections that make it hard to deal in crypto but have given rise to coins which tend to maintain its value over time called Stablecoin. This concept is called Collateralized Debt Position or CDP-a financial cryptocurrency concept & has been in development by MarkerDAO project which is offering DAI as a possible solution to coup volatility in crypto. Stablecoin like DAI is a crypto that is pegged into currency (USD or GBP) or assets. They could be both centralized as well as decentralized. I have written pretty detailed guide over the top and could be read here Stablecoins – A Complete Guide

DAI is the first decentralized stable coin that is based on Ethereum Blockchain. It is actually a very great source of stability and since it is backed in excess by collateral all the time, so you do not have to worry about fluctuation in the value of your coin. The coin is actually pegged into USD and the value is pretty much stable due to that reason. Being pegged into USD means the value of DAI is pegged by the regulatory authority to the value of the dollar. The table below depicts the DAI price chart (DAI to UST).

We have around 87 million DAI in circulation in the crypto market right now. In an analysis, DeFi Plus calls MakerDAO the most popular decentralized finance app in crypto space. The token’s value is however supported by as much as $300 million worth of ether locked in the system of MarkerDAO.

But this is after a long four months that DAI started maintaining a consistent dollar valuation. The famous data scientist Alex Svanevik in an interview in May 2019 had said that there has been a surge in trading prices of DAI on the leading Coinbase from $0.95 on 8th of April to between $0.98-$1 range in May and June. He further added that this may be considered “super close to the $1 peg”. Today on Aug 26th, it was trading at a value above $1 as visible from the table given below.

To this rise in the value of the coin, the COO of RealTPlatform David Hoffman quoted that DAI could be moving to a “whole new phase”.

How does Marker System Work?

There are many operational mechanisms which make sure DAI stays relative to USD. This is made possible by the smart contract platform that is offered by Maker on Ethereum blockchain and which through a series of dynamic feedback system or CDP stabilizes and backs DAI. Through CDP, user can generate DAI by depositing some asset into the smart contract. Suppose you have ETH or any asset and you want to create DAI. Simply deposit your asset or ETH to smart contract for loan and once the CDP holds your deposited asset, you can easily generate DAI equal to the value of the asset in USD.

You may use DAI in any way possible like any other currency. The best part is when you are returning the loan, you would have to return the same DAI borrowed plus some interest on the DAI. Suppose the value of the asset (ETH in our case) was $100 at the time of depositing the asset, and you borrowed 100 DAI. This is called collateralization ratio which refers to the amount of Dai that you can create relative to the ETH you put in the smart contract. While returning the loan, you have to return 100 DAI plus some interest on DAI to get back your ETH. This means the graph for the loan you take in DAI stays horizontal to the x-axis that is you would have to pay the same dollar amount plus some interest on the DAI borrowed.

The concept of interest in stable coin is pretty interesting and has given rise to a sought of price war between companies offering stablecoins.

The problem with non-stablecoins is volatility. You just cannot be sure about the dollar amount that you would have to return if you borrow in NonStableCoin or any asset with high volatility. You could end up owing 2x than your initial loan.

What happens when the value of asset (ETH) collateralized fluctuates?

So there could be both rise and fall in the value of asset deposited into the smart contract. The rise in the value of the asset results in more stability of DAI, the fall is however gloomier.

When the value of the asset deposited into smart contract goes up, DAI becomes stronger resulting in further collateralization of the system. There are other ways that contribute to increased stability. This happens when demand for DAI rise than the supply of the coin. The simple demand law of economics 101 holds here. Moreover, there is a concept called Target Rate Feedback Mechanism under which Market incentivize the creation of DAI for users if the price of the coin should trade above $1.

Fall in the value of the asset deposited into the smart contract makes problems. The value of DAI falls below $1 and the system could possibly collapse if the value of ETH held as collateral falls below the value of the amount of DAI it is backing. Such a situation is tackled by Marker by liquidating CDPs & by auctioning off the ETH deposited into the smart contract. ETH in CDP is auctioned off until there is enough DAI available to pay back what was lost from CDP. In simple words, CDP is liquidated in case of insufficient collateral.

Target Rate Feedback Mechanism:

However Marker is very able to maintain stability and keep DAI stable through a mechanism called TRFM. Target Rate Feedback Mechanism TRFM is an automatic mechanism which is employed by DAI to maintain stability. As 1 DAI has a target price of 1 USD, the change that is needed in the price of DAI overtime to approach this target price during market ups and downs is determined by the Target Rate. The onset of TRFM breaks the fixed peg ratio ie 1DAI/$1USD but it is important to push back the price of DAI where it needs to be. So when the target price of DAI is less than one USD, an increase in TRFM occurs which pushes up the price of DAI again to the value where it should be. When this happens, the generation of ADI through CDP gets more expensive.

This rise in the value simultaneously increase the demand for DAI and cause the users who hodl DAI gain profits. The rise in demand for DAI and the reduced supply in the market as users try to buy from the market and borrow from CDPs eventually pushes up the price of DAI to reach its target price.

Moreover, there are certain dynamics that determine the TRFM and TR. In most cases, it is the market forces in the form of demand for and supply of DAI that determine both TRFM and TR. In addition, the sensitivity parameter of the TRFM could also be set by the Marker voters which in turn determine the degree of response of TRFM whenever the target price of DAI deviates from the value it needs to be at.

A Sensitivity Parameter of “10% in 15 min” means that the Target Rate can change the price of DAI in the market to a maximum of 10% only in 15 minutes. This makes the max hourly change by TRFM in price of DAI as much as 40% per hour.

One might also argue why is the change restricted to only 40% per hour and not more than this. SO this restriction is important to control the system in case of hack. The restriction actually provides the time to trigger a global settlement in case there is hack that grants attacker control over the Oracles. It is due to this reason that the SP is set to a max of 10% in 15 minutes by Marker Voters.

Global Settlement:

So despite so much development and improvement in programing in the blockchain space, one cannot overlook the prevalent cyber threats and hacks that often cost companies millions of dollar. The recent hack of Binance is the perfect example when more than 7k Bitcoins were transferred from the exchange which cost more than $40M to the exchange. To keep the system secure and escape such a scenario, Marker has developed a process called global settlement. In case there is a hack that grants the hacker control over the Oracles, triggering the global settlement freezes the system. This means the owners and users of DAI and CDP get the exact value of the asset they have deposited into the smart contract. So if I have 110 DAI and 1 ETH = $110, I can exchange my 110 DAI for one ETH through a smart contract. THe whole process if fully decentralized.

So who triggers the global settlement?

Selected and trusted individuals have access to the global settlement keys and it is they who trigger the global settlement.

One might think it makes the system centralized. No, this does not make it centralized because triggering the global settlement just freezes the system and it does not give the individuals having GSK (global settlement keys) the option to interact with the system on your behalf and hence cannot steal your DAI or ETH. It just end up exposing you again to the volatility of your asset (collateral).

Importance of global settlement:

Global Settlement plays important role in the equilibrium price of DAI. To understand this, let’s assume a situation in which intrinsic demand for DAI is zero. The only value of DAI would come from its future claim on ETH collateral. AS a result, the market value of 1DAI would be equal to the probability of GS. This means if the aggregate expectations of having a GS is 90%, the equilibrium price of DAI would be $0.9 USD and would be stable at the value provided the aggregate expectation of having a GS stays 90% without any fluctuation. The stability will results in demand for DAI and hence a price rise to its target price as long as supply of DAI to the market stays below the demand for DAI. So the probability of GS is vital to the equilibrium market value of DAI.

Benefits of using DAI:

There are many benefits which makes it a game changer.

  • It is equal to $1 USD with negligible fluctuations.
  • It could be traded freely like any ERC20 token.
  • If you have an Ethereum wallet, you can accept, own and transfer DAI without getting a third party involved in the process and it therefor cuts the cost of transactions. DAI makes it free to transfer your dollars across border without any fees.
  • It is fully decentralized and hence no government bogy or regulatory authority can control it.
  • It is secure, transparent and resilient.

This is the beauty of blockchain and it has actually taken the economics and commerce to a whole new level.

2019-09-19T19:05:59+00:00September 19th, 2019|

Happy 10th Birthday to Bitcoin Genesis Block !

Today is the 10th anniversary of bitcoin Genesis block!!! Here is the screen shot

The first Bitcoin block of 50 bitcoins was mined on January 3rd, 2009 12:15 PM CST with the following hash.

0x000000000019d6689c085ae165831e934ff763ae46a2a6c172b3f1b60a8ce26f

Here is the link to 1st transaction

Bitcoin Genesis Block

Concept of Bitcoin was introduced by a pseudo entity Satoshi Nakamoto through a white paper on 31st October 2008. This genesis block was mined on the principles laid out in that white paper

On 3rd Jan’09, The London Times ran a cover story entitled “Chancellor on Brink of Second Bailout for Banks”. This title was quoted and embedded into the very first transaction ever to be included in the new Bitcoin blockchain, by Satoshi Nakamoto.  The block containing this transaction is called “The Genesis Block”

The London Times – 3rd Jan’09

This note has been interpreted as both a timestamp and a comment on the instability caused by fractional reserve banking.

First recipient of the bitcoin transaction was Hal Finney, a cyberpunk who created the first reusable proof of work system ( RPOW) in 2004. He was probably the first person to download the software upon release & was transferred the first set of 10 bitcoins from Satoshi on 12th Jan’09. This was the first ever transfer that took place on bitcoin network.

Bitcoin has sparked a movement or a strong debate in existence of programmable money that leads to open & financial financial system.

It’s been a roller coaster ride. I got involved 7 years ago & thought late to the party. 10 years since first bitcoin transaction & I still think we’re early to the party

Industry has been growing daily defying any resistance internally & externally. This is probably the most undisputed financial technology innovation till date. It’s not just the tech, but combines economical, financial, political & philosophical movement.

Biggest strength of bitcoin is that it’s running now for 10 years in a row with 100% uptime, without a single fraudulent transaction that exists today & not deviating from its original monetary issuance schedule. Only 20% more bitcoins will be issued over next 10 years. In comparison, we’ve no clue how much of government issued fiat will exist even in next 12 months. I am really a fan of the transparency, where I can predict with a very high degree of certainty that every 10 mins, a bitcoin block will be created.

So unless the bitcoin network disappear which I find slightly hard to believe at-least over next 10 years or governments start putting a check on their money printing press, there will be a serious competition for storage of value. I suspect majority of the governments will give up on their currency & adopt another currency. It’s similar to languages where major languages have a network effect. With every passing day, confidence is bitcoin is growing & the pedigree that bitcoin has achieved over it’s competitors is unprecedented

Though we’re very far from where we should be, today’s the day to celebrate the bitcoin genesis block’s 10th birthday. Looking forward

#Happy10thGenesisBlock

2019-01-03T17:15:30+00:00January 3rd, 2019|

Stablecoins – A Complete Guide

Preface

Bitcoins was a hope of beacon in the world of crazy inflation that’s impacting every one. Since bitcoin isn’t tied to any country monetary policy it’s only worth what believe it to be worth it. Though it has consistency outperformed every legacy asset on a longer time horizon, it’s still far from mass adoption and one the major reason is price fluctuation.

Here are some of the bitcoin price crashes

Bitcoin historical correction

2017 was the craziest year for cryptocurrencies where we saw crazy gains of 10,000X but 2018 wiped off everything. This led to party moment for few but a nightmare for many.  Fingers on the argument that bitcoin as a storage of value were raised & classic example of tulip mania was back in the market. It’s hard to argue with the pessimists because bitcoins doesn’t have any underlying fundamentals behind it. More & more negative media however has attached a taboo towards this revolutionary technology through which money can be programmed.While I personally have seen crashes multiple times over last 7 years, it’s tough to see market take a toll like this. Overall I am bullish on the cryptocurrencies however sanity has to prevail. It’s hard to deny the advantages cryptocurrencies provide but price volatility is keeping them off field for many serious players. While it’s exciting to see the upside swings, not everyone has an investor mindset. Since majority of the countries regulations are hostile towards cryptocurrencies, volatility keeps the institutional investors further away.  There has been one thing certain about bitcoins & that’s volatility. There are many funny memes & jokes around but the following one is my favourite

A boy asked his bitcoin-investing dad for 1 bitcoin for his birthday.

Dad: What? $15,554??? $14,354 is a lot of money! What do you need $16,782 for anyway?


Bitcoin trader

There is an interesting case of token velocity which is super high when someone is using it as the currency and doesn’t want to hold. In case of cryptocurrencies, if you’re holding for long you’ll get a HODLER ( Hold On for Dear Life). HODLERS are generally regarded as highly respectable in the industry because they’re considered to be in for the long vision rather than flipping. Everyone loves to HODL, however the scary swings aren’t for the faint hearts. 

Read more on HODL here

Welcome Stable Coin which does take care of the volatility problem by being pegged to a fixed value such as fiat or commodity. This is the answer to every day users who don’t want to be exposed to price movements. It does fulfil the basic functionalities of money which are

  1. Means of exchange  
  2. Unit of Account
  3. Storage of value

Transaction in cryptocurrencies have been complicated due to fluctuations & stable coins are supposed to put a stop to that. It’s almost impossible to transact in exact amount. Stable coin prime job is to protect the immutability of the transaction value. This also makes a strong case for cryptocurrencies and graduates it into a mature storage of value. 2018 has been a good year for stable coins which mushroom growth of stable coin provider. Everyone have their own way of approaching the solution but majorly they can be divided into two which are further subdivided into two. The two solutions are first divided by the way they’re designed and then by the virtue of their functionality. Overall they serve the same purpose, provide stability in the price of the user-desired assets.

There are two major types of stable coins philosophies

#1 – Centralized

#2 – Decentralized

Centralized coins are the one where there is a centralized entity keeping possession of the assets while in decentralized case, it’s generally a smart contract stabilizing the value.

Centralized

Centralized coins are issued through a financial institute who has the custody of the asset backing them. There are two major types of assets which are considered colletral while issuing stable coin

  1. Fiat
  2. Commodities

Fiat backed

This is the most common type of coin where the stable coin is issued against fiat currency by a centralized financial institute. Here are the features of fiat-backed stable

  • It’s value is pegged to a fiat currency such as USD in a fixed ratio such as 1 stablecoin would be equal to 1 USD. USD is the most common pair but other pairs are also available.
  • Financial institutes at any time is in the possession of the fiat currency backing the coin.
  • Transaction may run off-chain or it’s own private or dedicated public chain
  • Total collateral should be equivalent to circulating supply at any given time.

Technical wise, this is the most simplest way to issue a stable coins since the financial institutes just issues coins based on the amount they’ve. They are tradeable on exchanges and redeemable by issuing financial institutes. Trust in the entity backing is super important. Financial institutes does have an incentive in increasing the fiat backing because they can earn interest on the money without any risk. Even at 2% interest for 1 billion deposit, they’re earning 20M/year risk free. Cash handling cost is much lower than this making it a cash cow the financial institute. Cost involved are generally occured by the financial institutes anyways. We’ll see more and more financial institutes issuing similar kind of stable coins.Due to centralized nature, if the financial institute backing the coin has any problem, it’ll have directly impact on the the stable coin issued by them.

Commodities backed

Similar to fiat, there are stable coins which value is pegged to commodities they’re backed by. Most popular form of commodity is gold followed by silver, but we’ll be able to see other precious metals & petroleum based coins as well.

  • It’s value is pegged to an asset such as gold in a fixed ratio such as 1 stablecoin is equal to .01 ounce of gold. Gold is the most popular but silver and other exotic commodities are also being issued.
  • Financial institutes at any time is in the possession of the commodities  backing the coin.
  • Transaction may run off-chain or it’s own private or dedicated public chain
  • Total collateral should be equivalent to circulating supply at any given time.

Technical wise, it isn’t difficult either but the fluctuating price of underlying asset does require financial management and generally the storage cost is higher as compared to fiat. Commodities which are generally supported by stablecoins has to be fluid and tradeable on exchanges. They are tradeable on exchanges and redeemable by issuing financial institutes. Trust in the entity backing is super important. Having higher deposit strengthen the balance sheet which empowers the financial institute be leverage. Similar to fiat-backed stable coins, we’ll see more of commodity based coins as well.

Decentralized Stablecoins

Decentralized coins are not controlled by a single entity but more by code that stabilizes the value. There are multiple 3rd parties who have to participate in order for the value to be stable.

Decentralized stable coin

Cryptocurrency backed

Most common form of decentralized stable coin are backed by cryptocurrency. There isn’t major difference between cryptocurrency and fiat backed stable coins in terms of logic but due to nature of the transaction everything is done through smart contract & is on-chain. User put up their funds as collateral which is generally significantly higher than the stablecoin issued to cover up in case there is a flash crash. Despite higher loan to value, there are still liquidation events which even has more impact on the price and has lead to black swan events.

Here are some of characteristics of stablecoins

  • Value is pegged to fiat but it’s pegged by a cryptocurrency
  • No centralized body is in control of collateral but it’s locked through smart contract & is executed on-chain
  • There are additional supplementary instruments and concept of oracle which keeps the price stable. These oracles have act more like a bounty hunter which is looking for liquidations and make a small profits whenever it is able to execute properly

Though it’s very similar to any centralized stablecoins in terms of mechanics, risks are far higher. Biggest risk is code exploitation which can lead to collapse of entire system. Though there are constant audits, but still history is full of breaches and hacks. Here the stakes are much much higher. Smart contract doesn’t execute by itself but requires a third party execution so the system has to rely on them. If they fail to act in time, liquidations might not happen in time destroying the peg value.  Easiest option is to have a very high value of collateral with respect to loan however it may make tit unattractive since investors are looking to leverage up not the other way around.

Seigniorage (algorithmic)

They’re similar to a Decentralized Autonomous Organization ( DAO) which controls issuance and pricing, which are referred to as seigniorage-style (or algorithmic) stablecoins. They’re completely digitalized and non-dependent on any collateral whatsoever. Supply, demand & target price is controlled by the code which makes it truly decentralized and no regulatory oversight. Both of these features increases its ability to scale as compared to counter part solutions since there are not any additional collateral requirement with supply increase

Here are the major features

  • Full decentralized,
  • High scalable,
  • Executed on-chain,
  • Cheaper to maintain the price immutability due to lack of collateral requirement

It operates on the basic principle of supply and demand where coins are issued if there is enough demand & destroyed if the demand drops. This issuance and destruction keeps the price stable. Generally if the price goes down. Bonds are issued and if the price goes up seigniorage shares are issued. This is most exciting form of stablecoins but haven’t been in production yet.

There are also creative proposals on how to achieve stability while keeping the decentralization property and it’s a work in progress.

Concerns:

  1. Stable coins aren’t stable

There hasn’t been a single example of stable coin that have been successful at keeping the exact peg for extended period of time. Multiple times they’re traded few percent above or below their actual value. Theoretically they’re great but they’re prone to market fluctuations as well. In one case, value of a stable coin has dropped by 70%.

  1. Do they bring stability ?

Bitcoin does have a connection with alternative coins when it comes to price movement so generally the overall market doesn’t move much with respect to  each other. Bear and bull markets are correlated. Stable coins adds a different dimension to market pricing where people can bring in fiat and take a short/long position making the market extremely unstable. So with stable coins, the term shouldn’t confused with the fact that it’ll bring stability to the market. It just keeps the value stable for the holder of that specific coin

    3.  Vulnerable

It is a new concept and haven’t been tested over long period. There are chances that one of them will break causing a spiral downward market crash. It has happened in the past but they were not as popular at that time having minimal impact. Even decentralized coins are prone to hacks Stable coins generally require us to trust a central third party. In case of centralized coins, there are always risk of custodial going illiquid.


Pursuit to perfection

Cryptocurrencies basic moto is decentralization but there isn’t a fool proof system to get  a perfect solution. We’re far from perfection but we have came a long way. Stable coins are on the rise with over 2 dozens companies working on the solutions. Every has a unique approach and hopefully we’ll have a perfect solution soon. Stable coins are the holy grail of crypto and is a necessity piece in the puzzle. With extreme volatility in cryptocurrencies, it would encourage people to get in and out of the market whenever they want. None of the solutions are reliable so they’ should be only treated as an ad hoc solution. Right now it’s limited to startups, but bigger financial institutes will move into the game and I won’t be surprised if countries start issuing their own digital currencies on the principle of cryptography. Rome wasn’t built in a day & future won’t be either. It’s an evolution towards better & better

2018-12-17T04:38:56+00:00December 19th, 2018|