2

The answer here is not very useful so I'm asking again. It doesn't matter if you describe the mechanism with the current or future version of MKR.

If the price of DAI on the open market deviates from $1, the supply of DAI has to be altered to bring the price back. How exactly is this done in a decentralized and autonomous way?

The obvious way to me is to lower or raise the interest rates on CDPs thereby making it more or less attractive to open and close them. This would give a perfect feedback mechanism that keeps DAI pegged at an arbitrary price of $1. But I don't think this is actually how the system works in reality.

So here's my question: Assume DAI goes up to $1.10. I do not assume a priori that the price will fall back to $1 anytime soon (if you assume this, then it becomes a self fulfilling prophecy). What is the mechanism that increases the supply of DAI?

2

Any peg (such as a stablecoin) relies on two mechanism to actually stay stable:

  1. Trust. All value is based on belief. If people believe that the coin's value is equal to $1, it is. And if people believe that most people believe that it's worth $1, they are also likely to believe it. It's a self-sustaining cycle of trust and belief.

  2. Large buy and sell orders above and below the $1.00 price maintained by a large organization and/or by people trying to make a profit if the price fluctuates. For example, there might be a huge stack of sell orders at $1.01 and a huge stack of buy orders at $0.99. The fact that people can see these buy and sell orders on exchanges further enhances the trust in the peg.

If you know that people believe that it 'should be' worth $1.00, you are economically incentivized to participate in maintaining the peg by placing a buy order at $0.99 and a sell order at $1.01. You can make a small profit if the price goes up and down a bit. This is 'decentralized and autonomous' in the sense of many different people placing these orders because of their own trust in the peg and the resulting incentive.

Most decentralized and autonomous systems are based on human incentives. For example, Ethereum miners could choose to not mine any transactions any more. However, they are economically incentivized not to do so because they would lose the transaction fees and they would reduce the value of ETH itself.

Related anecdote: When the UK entered the European exchange rate mechanism, the British government tried to peg their Pound to the German Mark. Billionaire George Soros managed to break the peg by selling huge amounts of Pounds. This selling started to exhaust the stack of buy orders, which scared other traders and caused even more selling. The British central bank simply had not allocated enough funds to buy all the pounds that were being dumped and the peg broke.

  • @user1936752 Ah sorry, I forgot about the decentralized and autonomous part of the question. I have added to the answer – Jesse Busman Dec 7 '18 at 14:32
  • Sorry, just edited my comment as you posted! But both 1. and 2. seem essentially the same as a self fulfilling prophecy - it becomes true because the majority of actors in the system believe it to be true (not necessarily a bad thing, just clarifying). Isn't varying the interest rate a more obvious solution? – user1936752 Dec 7 '18 at 14:34
  • @user1936752 Sorry, I don't understand. How exactly would that help maintain the peg between DAI and USD? – Jesse Busman Dec 7 '18 at 14:37
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    @user1936752 Ah, I see. I don't think it's a certainty that the interest rate will always directly cause the amount of new CDP's, especially in the current volatile early-adopter market. Also, it's not at all easy to program such a relation. The smart contract would have to detect a change in price, which is extremely difficult because the price is always almost exactly $1.00 and different exchanges can have different prices. You would have to base very large interest rate changes on very small and very frequent price fluctuations. This can cause instability and mistrust. – Jesse Busman Dec 7 '18 at 14:45
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    @user1936752 I think your system could be stable under the right conditions, but because of unreliable price information and a volatile environment it's not practical right now. Feel free to disagree though :) – Jesse Busman Dec 7 '18 at 14:47

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