MakerDAO has decided to eliminate DAI’s exposure to the USDC, which could cause it to lose its dollar peg.

A few days ago, the U.S. Treasury Department decided to blacklist Tornado Cash, the crypto-currency mixing service. It also imposed criminal penalties on anyone interacting with Ethereum addresses deemed to be involved in illegal activities by OFAC.

As a result of this news Circle, the stablecoin issuing body USDC, has decided to freeze all USD Coin funds belonging to the banned wallets. MakerDAO plans to sell all USDC held as collateral in the protocol.

Rune Christensen co-founder of MakerDAO, weighs in on the decision:

“We will discuss this on the call tonight, but I think we should seriously consider preparing to divest from USD, it is almost inevitable that it will happen and it is only realistic to do so with a huge amount of preparation.”

The main problem is that currently, 60% of outstanding IADs are backed by the USDC. If one were simply to sell them into the market, it would be necessary to burn proportionately all of the IADs that are backed by that particular asset. This is obviously the most unlikely choice, given that these are funds held in users’ portfolios.

In addition, the IAD would instantly lose its peg to the dollar, as more than half of the units in circulation would no longer be collateralized. In this case, the mechanism powered by the Price Stability Module (PSM), which guarantees the dollar peg through the issuance of overcollateralized debt, would be missing.

Currently the overall collateralization ratio for the entire protocol is 144.64%, which is a sign of good health.

According to Makerburn data, DAI backed by stable currencies account for 81.9% of the outstanding supply. This ratio increased in conjunction with the crypto-currency market crash, which saw the share of crypto-collateral replaced in favor of that made up of stablecoin.

One could consider exchanging all units with their corresponding ETH countervalue. However, this would generate severe instability for the DAI, making it too exposed to a volatile asset.

It remains to be seen whether the debt ceiling imposed by the MSP for this guarantee is respected. Indeed, precisely to ensure sufficient diversification within the ecosystem, the community chooses a threshold. This threshold indicates the maximum number of IADs that can be issued for each type of guarantee.

In case of extreme necessity, it is possible to create new wallets that reference the same asset, as is already the case, but with different parameters.

Why does this operation jeopardize the stability of the protocol?

Over-reliance on a single cryptography would generate a stability problem related to the stability of the protocol.

The crypto-currency market is by definition highly volatile, and if the price of ETH were to fall as a result of the transaction, then almost all outstanding IADs would become severely under-collateralized.

This happened with the UST after the collapse of LUNA, it would cause Maker’s stable currency to lose its 1:1 peg to the dollar.

If this happens, it could create a chain reaction within Ethereum’s DeFi ecosystem. The reason for this is that currently DAI is too interconnected with other protocols and its collapse could cause a chain reaction in the Ethereum DeFi ecosystem.

Unsurprisingly, Ethereum co-founder Vitalik Buterin also seems very concerned, to the point of highlighting the potential criticality of this choice:

“This is a risky and terrible idea. A significant drop in the spot price of ETH could see DAI’s collateral become undervalued.”

He is joined by Robert Leshner founder of Compound Finance, who speaks out about the implications this decision could have on the entire DeFi industry:

“Converting DAI into a price elastic asset will ruin it, period.”