Almost 50% of All DAI is Locked in Compound As Collateral And This Could Be Problematic

Compound is a DeFi lending and borrowing protocol built on Ethereum. Users can use it to borrow certain ERC-20 tokens by depositing another token as collateral. At the same time, they earn interest in supplying liquidity.

The animation above tracks the total value (in USD) of the different assets supplied and held by the corresponding smart contracts in the protocol, between June and August 2020. At the time of writing, a total of $852.84M are locked on Compound. 

Any cryptocurrency can be supplied to earn interest, but many people choose stablecoins (coins pegged to the US dollar), and/or widely used cryptocurrencies that are not likely to lose value. 

In this way, millions of dollars worth of Ether (ETH), USD Coin (USDC), Tether (USDT), 0x (ZRX), Augur (REP), and MakerDAO’s DAI were locked in Compound these past three months. 

The sudden spike in the total value locked (TVL) noticeable mid-June corresponds with the launch of the COMP token. On June 18th, COMP was given away as an additional reward to suppliers of collateral. 

Today Nearly 50% of DAI’s total circulating supply is locked in Compound 

DAI is a stablecoin that relies on over-collateralization with non-USD crypto assets to maintain its dollar peg. At the time of writing, there is a total of $420M worth of DAI in circulation. $202M are locked on Compound.

Illiquidity has placed strains on DAI’s peg for a while now, with relatively small trading activity significantly disrupting the market. As shown on Black Thursday, a lack of DAI liquidity can have damaging effects on MakerDAO and the broader DeFi ecosystem. 

For example, users may be unable to source DAI to keep their vaults adequately collateralized in the event of violent price movements. Keepers may be unable to acquire DAI to bid on undercollateralized vaults, thus increasing the likelihood of disorderly collateral liquidations or losses, among other negative ramifications.

Further, if the lending and borrowing of DAI on Compound is highly concentrated, i.e. if only a few people own the DAI that’s on the Compound protocol, then that would mean only those few people own nearly half of all DAI tokens. This centralized control over supply would mean a powerful few could overly influence price and further stress the dollar peg. 

Meanwhile, fiat-collateralized stablecoin USDC has only 10% of its supply locked 

USDC has a total circulating supply of $1.14B, $109M of which have been supplied to the Compound protocol. 

USDC is fiat-collateralized, meaning that the tokens are backed by USD held in reserves. The supply of USDC is controlled and issued by Coinbase and Circle through a joint venture. The fact that the USDC supply is controlled by a centralized financial institution instead of the community is proving beneficial for maintaining the stablecoin stable. 

Why this matters 

DAI is the only crypto-backed stablecoin. It is meant to be more decentralized and censorship-resistant than the fiat-collateralized USDC and USDT. But a lack of liquidity could translate into uncertainty around using DAI as a decentralized stablecoin in DeFi protocols. 

Already we’re seeing a lot of DeFi teams express frustration over DAI’s lack of liquidity and stability, with many opting to use USDC instead.

This is likely to damage DAI’s network effects in the long run if nothing is done to address the issue immediately. 

The good news is the MakerDAO community has been taking steps to increase the supply of DAI. Amongst others, Uniswap LP tokens, LINK, and PAX Gold have been brought up as new potential collateral options.

Proposed also was adding a new ETH-DAI vault that would have a lower liquidation ratio (125%/133%) which may drive new demand from Compound/dydx and initiate the generation of a few million DAI.