How exactly does DAI maintain the dollar peg? CDP borrowers can buy DAI if the price is below $1 to close the CDP and get their ETH back. For example, let us consider a case where you might borrow 100 DAI tokens by depositing $200 worth ETH in a CDP (200% collateralization). In order to close the CDP and get back your ETH, you will have to payback the borrowed DAI and also pay the accrued stability fees for the tenure. If the price of DAI is trading below $1, say 98c, borrowers can buy DAI from the market for less than a dollar each and redeem their ETH from the CDPs, thereby making a profit of 2%. In cases where the price of DAI is above $1, say $1.02, users are incentivized to borrow DAI by collateralizing ETH and sell the borrowed DAI on the market for a 2% profit. These potential arbitrage
opportunities are expected to keep the peg as close to a dollar as possible.
However, when DAI is persistently trading above or below its $1 peg, the MKR ecosystem makes changes to the protocol to incentivize users to restore the price to $1 again. Stability fees is one parameter that can be tweaked to increase or decrease the supply of DAI, akin to how central banks use interest rates to infuse or suck liquidity out of the system. When there is too much liquidity in the system, increasing the stability rate will make borrowing DAI more expensive and incentivizes users to payback loans faster. This results in liquidity shrinking and the price of DAI going up.
When DAI was faced with the problem of trading below its peg, the Maker governance body (a loose affiliation of early stakeholders) brought forth a proposal to increase the stability fees from 0.5% to 1.5%. This was voted in by MKR holders with the aim of reducing the overall liquidity of DAI, albeit for a short while. However, DAI prices very soon readjusted to the new normal and started trading at a slight discount again. This led to new proposals for further rate hikes, which resulted in the stability fee increasing from 1.5% to 7.5%, across three successive hikes. Ideally, a high stability fees of 7.5% should deter users from borrowing new DAI and increasing supply, but it failed to have an impact on DAI’s price. DAI’s price seemingly moved closer to $1 after increasing the stability rate to 7.5%, but the price retracted back when the prices of ETH surged in the mini rally a few days ago. In a bullish ETH environment, traders are incentivized to borrow more DAI as it allows them to gain leveraged exposure to ETH. DAI liquidity is more likely to contract when the stability fees are high enough and offset the profit potential from a leveraged ETH position. In order to counter this, MKR has announced another rate hike, this time to 11.5%.
We are just scratching the surface here with this line of reasoning. There are angles to be explored around velocity of DAI, total secondary DAI trade volume to primary issuance, and other such concepts that lend themselves directly from traditional macroeconomics and monetary policy. It will be interesting to whether the rate hike to 11.5% will finally lead to price stability, especially when previous attempts at stabilizing the prices have been proven futile. Moreover, if the impending rate hike is not sufficient to maintain the peg, Maker could be forced to look for alternatives such as imposing a temporary supply constraint on DAI issuance to rein in the surging demand for DAI tokens.