Will DAI be killed? Understanding the battle between 3 Pool and 4 Pool
DAI is the first decentralized stablecoin to successfully maintain its peg, but it now faces serious threats.Original: Bybit
Compiled by: The Way of DeFi
Summary:
- A Brief History of Stablecoins
- The Rise of DAI
- How DAI Maintains Its Peg
- The Impact of 4pool on DAI
A Brief History of Stablecoins
Stablecoins are now the cornerstone of the decentralized finance (DeFi) economy. Without them, the latter is unlikely to operate in its current form.
While names like USDT and USDC are often mentioned in all conversations surrounding stablecoins, as of the writing of this article, there are actually 75 different stablecoins actively operating within the DeFi ecosystem.
Beyond the sheer number of existing stablecoins, the concept of stablecoins itself is not entirely new. Of course, the concept has only truly exploded in recent years (since 2020), but the idea itself has been explored long before that.
In 1996, E-Gold was established as a digital currency fully backed by gold and silver. In terms of intent and purpose, E-Gold was the first stablecoin in history. In 2006, Liberty Reserve was born as a centralized digital currency service, allowing its users to exchange currency with others under pseudonyms.
As mentioned earlier, it wasn't until 2020 that stablecoins truly began to gain popularity.
Why Did Stablecoins Suddenly Become Popular?
Problems in the Traditional Financial System and the Rise of DeFi
As discussed in this article, the global financial system is the foundation that supports our society, enabling it to function. It represents a universal system that makes the life we know possible; without it, we could not progress or even survive.
How do entities exchange value, and how do we incentivize people to do things in their daily lives that may benefit others more than themselves?
Thus, the financial system is the cornerstone of our lives, and we rely heavily on it.
However, because all financial services within the traditional system depend on some central authority, this centralized "hub-and-spoke" financial system, or "CeFi" for short, indeed carries many risks. These include mismanagement, fraud, and corruption, among others.
Moreover, the Great Depression revealed the fatal flaws of this "hub-and-spoke" structure, where balance sheet issues at several large centralized financial institutions triggered a domino effect that led to economic collapse and the onset of a global recession.
This ultimately gave rise to the DeFi ecosystem, which aims to create an open-source, permissionless, and transparent financial services ecosystem accessible to everyone and operating without any central authority.
With the rise of DeFi, stablecoins naturally saw a resurgence. This is because (as mentioned in our previous articles) stablecoins are price-stable digital assets that behave somewhat like fiat currencies while retaining the liquidity and utility of cryptocurrencies. They are typically pegged to fiat currencies, with the US dollar being the most popular.
Due to the volatility of crypto assets, stablecoins are naturally the best choice for most DeFi protocols as a store of value. Therefore, when users want to swap from one crypto asset to another, they often serve as intermediary assets.
As an intuitive representation of the utility of stablecoins in the DeFi (and even broader cryptocurrency) ecosystem, here is a table we propose:
In summary, stablecoins primarily have four main uses:
- As a store of value, maintaining value against volatility
- Serving as a medium of exchange to facilitate peer-to-peer transactions
- A unit of account with predictable target prices
- A standard for deferred payment of debt
Decentralized Stablecoins
However, the crypto community is never content to stand still. As always, they want more. They believe that leading stablecoins like USDT and USDC are too centralized.
They want a decentralized stablecoin.
The Rise of DAI
In short, DAI is the first decentralized stablecoin to successfully maintain its peg. Before DAI, many others attempted but failed, including Empty Set Dollars (ESD) and Dynamic Set Dollars (DSD), among others.
So how did DAI become the first decentralized stablecoin to successfully maintain its peg?
After its establishment in 2017, DAI adopted a single collateral DAI (SAI) system, where DAI was borrowed using ETH as the only available collateral, and the supply of DAI depended on the total value of the collateral and the collateralization ratio.
As a stablecoin supported by collateralized debt positions (CDPs), the outstanding loans in the DAI economy play a crucial role in DAI's ability to maintain its peg.
When DAI is above the pegged exchange rate, borrowers are incentivized to take out more loans against their collateral and sell DAI on the market. As a result, this increases the circulating supply of DAI, bringing it back to peg.
On the other hand, when DAI is below the peg, borrowers are incentivized to purchase DAI at a discount from the market to cheaply repay their loans. This creates buying pressure for DAI in the market. Additionally, if loans are repaid on Oasis, the returned DAI will no longer be in circulation, further helping DAI maintain its peg.
This virtuous cycle allows DAI to stay pegged. In November 2019, multi-collateral DAI (DAI) was launched. This was an upgrade to SAI, allowing multiple assets to be used as collateral. Theoretically, a diversified asset portfolio should provide better backing for minted DAI while simultaneously strengthening its peg to the US dollar.
Here is an intuitive representation of how DAI works:
The Importance of 3Pool and the Peg Stability Module (PSM) in Maintaining DAI's Peg
However, if we look at DAI's price chart, it is clear that even after the launch of multi-collateral DAI (DAI), DAI still experienced volatility beyond what stablecoins should see.
Source: from Messari
It wasn't until the deployment of 3pool on Curve Finance that we began to see DAI's volatility being managed more effectively.
Next, the Peg Stability Module (PSM) was launched in December 2020. Since then, DAI has been able to maintain its peg to the US dollar within a very small deviation range.
From these observations, we might attribute DAI's success in maintaining its peg to the deployment of 3pool on Curve Finance and PSM, rather than because it is backed by alternative cryptocurrencies like ETH or WBTC.
To further substantiate this claim, let's look at two other decentralized stablecoins, TerraUSD (UST) and Frax (FRAX), the latter of which is partially backed by collateral and partially by algorithms. On the other hand, UST was fully algorithmic and had no collateral or treasury backing it until recently.
The above situation, combined with the fact that FRAX and UST are the two largest contributors to the 3pool TVL (which we will explore in more depth later), reveals that 3pool and the substantial bribes (that FRAX and UST use to incentivize deep liquidity in these pools) are indeed key factors in FRAX and UST's ability to maintain their pegs.
Source: from Sébastien Derivaux's Crypto 101
Key Assumption #1
Given the above logic, we can make a key assumption here: DAI's success as a stablecoin largely depends on 3pool and PSM.
So, Is DAI Really a Decentralized Stablecoin?
With the key assumption above, it is clear that we need to better understand how 3pool and PSM work to assess whether DAI can truly be considered a decentralized stablecoin.
3pool
3pool is a liquidity pool on Curve Finance composed of DAI, USDC, and USDT. As of the writing of this article, the pool's TVL is $3.54 billion based on the following composition:
Source: Curve Finance
In summary, it is evident that DAI's deep liquidity with USDT and USDC undoubtedly plays a role in helping DAI maintain its peg. Additionally, Curve Finance is an automated market maker (AMM) that provides an efficient way to exchange tokens with low slippage and fees, which is another factor we cannot underestimate in maintaining DAI's peg.
Essentially, DAI is directly pegged to USDC and USDT through 3pool.
MakerDAO's PSM
In addition to 3pool, as mentioned earlier, MakerDAO also deployed PSM to help DAI maintain its peg.
In short, PSM allows borrowers to mint DAI using USDC as collateral at a 100% collateralization ratio without incurring any fees. For PSM, similar to the case with 3pool, MakerDAO essentially directly pegs DAI to USDC.
As of the writing of this article, over half (specifically 52%) of DAI is backed by USDC through PSM.
Source: MakerBurn
Key Assumption #2
From the above, we can derive another key assumption: since DAI uses USDC and USDT as a life support form to maintain its close peg to the US dollar, it can be considered a sort of proxy for USDC and USDT.
Will 4pool End DAI?
This leads us to the most important question we need to address today—will DAI die at the hands of 4pool?
With recent announcements and updates, 4pool is well-positioned to become the preferred stablecoin pool on Curve Finance, surpassing 3pool.
As of the writing of this article, 3pool consists of 34 assets on Curve Finance, with a TVL of $6.51 billion.
Source: Curve Finance
It is important to note that as the two largest contributors to the TVL of 3pool, Frax and UST will become part of 4pool.
This means that 4pool is essentially a vampire attack medium on 3pool, as FRAX/3 Crv and UST/3 Crv account for 65% of the TVL of all pools merged with 3 Crv. What could happen is that once 4pool is deployed, UST and FRAX may first withdraw their TVL from 3pool.
If this occurs, we will certainly see more projects from 3pool following in the footsteps of UST and FRAX, as it is expected that UST, FRAX, and other members of the 4pool gang will provide incentives in the form of bribes.
Let's take it a step further. If BadgerDAO, OlympusDAO, and Tokemak also join Frax and UST in the 4pool, then the total CVX held by this group would account for over 62% of all vlCVX held by DAOs.
With such firepower to influence the governance voting process on Curve through Convex Finance, it is very reasonable to believe that this vampire attack on 3pool is likely to succeed.
Furthermore, to further substantiate our argument that liquidity will flow from 3pool to 4pool, Terraform Labs (TFL) and FRAX have been two major bribery contributors to Votium for some time now. This does not seem likely to change anytime soon.
Since September 2021, Frax and TFL have provided a total of $55.4 million and $23.2 million in bribes, respectively. Therefore, this could lead to the remaining tokens initially merged with 3pool switching to 4pool.
Key Assumption #3 and Conclusion
From this, we can logically make a final key assumption that 3pool may lose its status as the foundational stablecoin pool in the DeFi ecosystem.
Consequently, following the logic of all the key assumptions we listed above—since 3pool is an important factor in considering DAI's peg stability, this could lead to negative cascading effects, significantly impacting the strength of DAI's peg.
How all this will unfold remains to be seen, but at least in the coming months, we all need to carefully monitor developments in this area.
In summary, do you think the stablecoin veteran DAI is heading towards extinction? Or how will MakerDAO respond next?
