Ethereum Price: $142.97
Ethereum Price (BTC): 0.017682BTC
ETH Locked in DeFi: 3.09M (2.83% of circulating supply)
Market Cap: $15.62B
ETH Network Dominance*: 67.41%
7 Day Candle**: $141.01 / $148.19 / $135.00 $142.97

Since the Dai Savings Rate (DSR) launched in November 2019, providing interest on Dai stablecoin deposits, its rate has increased twice, moving from 2% to 4% and then, last week, to 6%.

The returns from DSR are paid with every Ethereum block (~15 seconds) and the full principal can be withdrawn at any time without penalties. In a world where rock bottom and even negative interest rates have crippled savings accounts, a 6% rate on dollar-pegged deposits could not have come at a better time.

How is MakerDAO able to offer a 6% rate?

MakerDAO, the governing structure behind the Dai stablecoin, has a single goal – maintain Dai’s dollar peg. To maintain this peg, MakerDAO token (MKR) holders vote on proposals to amend risk parameters that relate to the demand and supply of Dai.

On the demand side, MakerDAO can increase or decrease the DSR. A higher savings rate would attract more demand for Dai, thus increasing its price.

On the supply side, MakerDAO can increase or decrease the Stability Fee (SF), a fee applied to those in the system who create (borrow) Dai. A higher stability fee would increase the cost of borrowing Dai, incentivizing borrowers to pay back their Dai loan – burning it in the process and reducing supply.

There are other parameters that MakerDAO can control including the Liquidation Fee and Collaterization Ratio, however none have such a direct impact on maintaining the DAI-USD peg.

With these mechanisms in place and with MakerDAO having been effective at maintaining this peg. It now begs the question, how high can the Dai Savings Rate go?

What’s stopping the DSR from increasing further?

As with any economic system (particularly a new one), it’s best not to make large sweeping changes overnight. Instead, MakerDAO has adopted a strategy of testing small changes and iterating on those changes with regularity.

So long as each increase to the DSR comes with a stable peg over the following weeks, there is arguably no reason to halt the increments. At some point however, there will be some limiting factors that make further increases undesirable.

Liquidity

A DSR that is too high may find Dai struggling with liquidity. Take a very large rate for instance, let’s say 20% annually; Dai could lose its ability to function as a stable medium of exchange as investors buy the token in droves to lock it in the DSR contract.

Interestingly, with the creation of Dai derivatives like Chai, this may not be such a problem as holders of Chai are able to make a claim on the underlying Dai without needing to lock tokens in the DSR contract. #moneylego

Counter-Balance

The Dai Savings Rate has a counter-balancing mechanism that can be used to negate the price effects of an increase or decrease in the DSR – the stability fee. The demand (price increase) generated by a 20% DSR could theoretically be balanced with a low Stability Fee, incentivizing the creation of Dai and increasing supply (price decrease).

Or could it? A low SF would indeed incentivize the creation of Dai, increasing its supply and helping to reduce the upward price pressure of a high DSR, however it opens up a new problem.

A low SF and high DSR would motivate an enormous creation of Dai as each Dai created could be immediately locked in the savings contract at a profit. There would be no limit to the amount of Dai created and the price would drift from its 1 dollar peg.

Instead, MakerDAO is taking the approach of ensuring that the DSR and SF do not move too far from one another (both are currently 6%). With this in mind, a 20% DSR would require a somewhat equal ~20% SF, but such a high Stability Fee would dramatically decrease the Dai supply as loans became too expensive and were paid back.

As discussed last week, Dai creators are typically looking to leverage their ETH position by using their new Dai to buy more ETH. The lower the Stability Fee, the lower the risk of this type of leverage. At a 6% SF an individual may feel confident in outperforming this rate with a greater than 6% increase in the price of ETH. At 20% however, it would be hard to remain as confident.

Where will the DSR stabilize?

I don’t think we’ve seen the end of the DSR increases. An maximally high DSR is desirable so long as the dollar peg is maintained. A savings account that pays 8% or more will certainly grab the attention of mainstream media, increasing awareness and earning Maker a great deal of press in the process.

It’s also possible that, as the market turns more bullish (which it seems to be doing), MakerDAO can justify a greater Stability Fee and therefore a higher DSR.

It’s possible that by the end of Q1 2020, DAI holders will be able to take home 8% p.a. on their holdings.

What does this mean for the price of Ethereum?

If the Dai Savings Rate is able to attract mainstream headlines then we can expect a surge in demand for Dai as retail (who are stuck with 1-2% savings accounts) begin allocating funds to the DSR.

This demand would place upwards pressure on the price of DAI and will need to be stymied by either reducing the DSR or the Stability Fee (or a combination of both).

Should the DSR remain roughly the same, DAI creation will need to go into overdrive through a reduced Stability Fee. DAI creation requires ETH as collateral (or BAT, but let’s be real). For this reason, ETH may be bought up to generate “cheap DAI”, increasing its price as a result.

Ethereum, which forms the basis of many DeFi applications including Maker, was coined by Ryan Sean Adams as providing “economic bandwidth” for this new system. The bandwidth, which Adams refers to, is in the value of ETH; if DeFi applications and instruments like Dai are to be highly liquid, they require a high market value (bandwidth) of the underlying asset, ETH.

Consider this, there are currently ~110 million ETH tokens in circulation. Theoretically then, and at a price of $143, an upper limit of $15.73 billion dollar-pegged DAI could be created. Realistically, ETH is used for a plethora of other applications and not all ETH could ever be used to create DAI. However, this idea of “economic bandwidth” can hopefully now be seen more clearly. For Dai to be successful (along with the many other DeFi applications available now and in the future), ETH must be valuable enough to sustain the economic bandwidth demanded by users.

This bandwidth pressure could be alleviated somewhat by the introduction of BTC on Ethereum (or the additional of other collateral types like BAT), allowing developers to use tokens other than ETH as the base for their DeFi applications. However, ETH itself is inherently the most secure asset of the Ethereum blockchain and, for that reason, has a natural and permanent advantage over competing assets.

Disclaimer: DSR deposits are not protected by any financial regulator. Use at your own risk.

– Nick, Owner EthereumPrice.org

* calculated as: (ETH Market Cap / Ethereum Network Market Cap)
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