Now let's talk about a different situation, a liquidation situation. We've just been through an example where the Ether actually appreciated, went up in value. Now let's look at a different scenario. In this scenario, Ether depreciates by 25 percent. That means that the Ether goes from $200 to 150. Let's go through the mechanics of what would happen at 150 value. Now we've minted 500, and the total value of what we've got here is only 750. The over-collateralization is 250 and that's rate at the edge, that is exactly a collateralization ratio of 1.5. Very dangerous to be at that point because just like a one percent or even less, further depreciation in ETH means that the contract is going to be closed out. This is a scenario where some action might need to be taken. Let's assume again that the ETH drops 25 percent from 200 to 150. Vault holder, it's got a number of possible options. The first option, which is analogous to what we would do with a margin call is just to add some more collateral. You could add, let's say 1 ETH to the vault, and then you'd be fine to be above the 1.5. The second option is you've got the 500 DAI, you could just pay back the loan and retrieve the 5 ETH that you put in originally. The third option is that the loan could be liquidated by a keeper. As soon as you go just a little bit below that 1.5 collateralization ratio, that's going to happen and it's going to happen very quickly and that is the job of the keeper that we spent a lot of time talking about in the second course DeFi primitives. The keeper is an external actor that's incented to actually do a liquidation. Let's actually go through a liquidation at the 1.5 or think about it as 1.49. But let's just go through what a liquidation would actually look like. The mechanics are the following: the keeper is actually going into the vault to liquidate 3.33 ETH. Essentially what's happening here is that those ETH are auctioned off and that will generate enough money to pay off the loan of 500. That's the first thing that the keeper does. The keeper also gets a fee for actually doing that. The keeper is incented to do this action, to do the liquidation, to keep the protocol strong and efficient, so the keeper is going to keep a 0.2. What about the vault holder? The vault holder ends up with 1.47 ETH, that's what's left over after paying off the loan and then the fee for the keeper. They get 1.47 ETH which is worth $220 and of course, they've got the original 500 DAI. Overall, what they get is 720. Let's think about that, is interesting. They've got 720, if they didn't go through any of this, if they just had their 5 ETH, or if they decided to pay back the loan and pull out the 5 ETH then the 5 ETH would be worth 750. This is a situation where the loan is over-collateralized. The loan is paid back, and any residual minus the fee to the keeper goes back to the person that made the original deposit of the 5 ETH. This is how a liquidation actually works. There's another layer that's very interesting here in terms of the stabilization of DAI. Why would a DAI be worth a dollar? Well, the most obvious reason is that it is over-collateralized. People believe is worth a dollar because it's more than a dollar in collateral. We know the collateral is risky. We know it's over-collateralized. Anybody can see the degree of over-collateralization. Again, on the Ethereum block-chain , everything is transparent. The other thing that's interesting is there's another stability force that's linked to market actions. In the liquidation, what actually happens here? The keeper goes in, and you remembered they sell 3.33 ETH. You're selling ETH in the market, and DAI are purchased. This actually exerts a positive price pressure on DAI. You can think of the overall scenario here is that the value of the collateral is going down, and people might think, well, maybe if it goes down enough, we're not going to have as much confidence that DAI is worth a dollar. As that collateral gets lower and lower, people will start to discount the DAI. Maybe it's 99, maybe it's 0.98. But with this liquidation, given that you're selling ETH and buying DAI, that actually acts as a counterbalance. There are two levels that actually build in for the stability. A very interesting mechanism. Of course, the key idea here is to maintain the peg. A stable coin, you want to be as stable as possible with respect to the peg DAI set. Ideally, you'd like it at exactly $1 all the time. There will be some fluctuations, 0.995, 1.01. But ideally, you want to maintain that one-to-one peg. Again, various different mechanisms here that are in play in this protocol, and we're going to talk about a number of them here. One is a DAI savings rate. We got a debt ceiling. We got a stability fee. These are parameters that are controlled in the smart contract by the governance of MakerDAO. The governance is the Maker token, MKR. It is in the governance's best interest to keep the DAI as close as possible to the US dollar. The stability fee is basically a variable interest rate that's paid in DAI by vault holders on any debt that they generate. This is, think of it as, an interest rate. This interest rate can be raised or lowered. This will basically incentivize, for example, the repayment of the DAI. If the rate goes up, then you're going to repay. This will basically drive the price towards the peg. The stability fees, fund the DAI savings rate, and this is a variable rate that any DAI holder can earn on their DAI deposit. If you've got DAI, you can actually deposit and earn this variable rate. This DAI savings rate is compounded on a per-block basis. Would just be interesting also because the block happens every, let's say 18 seconds. It's near-continuous compounding. The stability fee is always greater or equal to the savings rate and that is enforced by the smart contract. That is also very important and we'll talk about this later with some other protocols that this makes a lot of sense that the savings rate has to be less than the revenue coming in to actually fund it. There's also a DAI debt ceiling. This is again contract enforced. It is a parameter that's agreed upon that could actually vary through time. Just let me emphasize this. The fundamental nature of the contract, it is set in stone but there are certain parameters that can be buried by the governance and that's what we're talking about right now. This is basically the amount of debt has got a ceiling. This basically allows for more or less supply to meet the current level of demand. If you're at the debt ceiling, then basically it's not possible to mint some more DAI. You're at the ceiling for debt, then people cannot go in and deposit more collateral and mint some more DAI. We have to wait until some of the old debt is paid so this is all paid off. This is another mechanism for stability. There's also liquidation issues. When the position as I showed you goes under the collateralization ratio, there will be a liquidation and there's a liquidation penalty. That penalty is calculated as a percentage of the debt and is deducted from the collateral. Again, this is just one additional mechanism that we'll look at. This all makes sense but the collateral is still very risky. Even with a collateralization ratio of 1.5 or 2.0, it is possible that there could be a huge drop in the value of the collateral. We've seen this historically. In the crypto space, at the end of 2017, cryptos lost 80 percent of their value, which would challenge the collateralization ratio. What happens if there is a sharp drop in the crypto? Basically, there's just not enough collateral to pay back the debt. That's something that we need to worry about. Essentially, what the DAI system has done is to create a second layer of risk management and this has to do with protocol debt. There's going to be a buffer pool. That is going to be helpful in a situation where there's an extreme event and we go into a situation of under collateralization. That's kind of the second layer of risk management is buffer this pool. Ideally, there's enough funds in this buffer to actually cover the under-collateralization. There's actually more. There's a third level. The third level is, well, what happens if you run out of the buffer? You're undercollateralized and you still need to pay back the debt. The way that that happens is with the governance of the MakerDAO.
