The once-symbiotic relationship between decentralized stablecoin issuer MakerDAO and lending protocol Aave is fraying. 

As new innovations are being tested within the decentralized finance (DeFi) sector, tension has started building up. The perceived risk of these innovations puts the two major protocols at a crossroads.

At the center of the controversy is a controversial stablecoin mirroring what’s known as a “basis trade” and Maker’s Direct Deposit Dai Module (D3M), Ethena’s USDe.

MakerDAO launched its Dai (DAI) token in 2017 as an overcollateralized decentralized stablecoin backed by Ether (ETH). Users had to mint tokens on the MakerDAO platform by locking up ETH.

In November 2019, Maker launched multicollateral DAI, allowing DAI to be backed by multiple cryptocurrencies, including centralized stablecoins like USD Coin (USDC).

Aave (formerly known as ETHLend) launched around the same time as a peer-to-peer cryptocurrency lending platform and integrated DAI as collateral on its platform from an early stage.

Both platforms collaborated throughout the 2021 DeFi boom. The launch of D3M, in cooperation with Aave, allowed Maker to directly interact with its secondary market by actively enforcing a maximum variable borrow rate.

Things took a turn during the 2022 bear market as the collapse of then-major DeFi protocols and major cryptocurrency lending firms, as well as the banking crisis that led to the collapse of Credit Suisse, put unprecedented pressure on these protocols.

Alarm bells ring as stablecoins depeg

The 2022 bear market was marked by a series of bankruptcies and high-profile collapses, starting with the Terra ecosystem in May. Terra collapsed after its algorithmic stablecoin lost its peg.

The collapse saw Terra (LUNA), previously a top 10 cryptocurrency with a market capitalization of over $40 billion, become nearly worthless in days as it entered a “death spiral” that led to the minting of trillions of tokens.

The collapse of the Terra ecosystem had cascading effects that ultimately led to the collapse of lending platforms Celsius and BlockFi, among others. As a result, MakerDAO voted to temporarily cut off Aave’s D3M in a bid to protect itself.

The bear market later saw the centralized stablecoin USDC briefly lose its peg after the now-defunct Silicon Valley Bank collapsed with $3.3 billion of the stablecoin’s reserves held there. The peg was restored only after regulators stepped in to ensure that depositors were made whole.

That depeg rang alarm bells for MakerDAO, which shortly after requested an “urgent executive proposal to mitigate risks to the protocol” to address its then over $3.1 billion exposure to USDC. At the time, Maker also moved to eliminate its exposure to Aave, stating its “overall risk-reward of depositing funds into the D3M are not favorable under current conditions.”

Speaking to Cointelegraph, Becky Sarwate, head of communications at cryptocurrency exchange Cex.io, said that the decentralized autonomous organization’s (DAO) next move was then to purchase real-world assets in the form of U.S. Treasurys to “strengthen market confidence in DAI by bringing the network’s value composition into greater harmony.”

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Indeed, real-world assets, including U.S. Treasurys and short-term loans, currently represent a large portion of DAI’s backing, making up 20% of all generated stability fees in March.

According to Sarwate, the protocol has since moved to extend its credit back into stablecoins. This decision has worried some market participants, especially given its new exposure to what some deem a risky stablecoin mirroring a hedge fund trade.

Tensions rise between MakerDAO and Aave

MakerDAO and Aave became more direct competitors over time. In early 2023, MakerDAO introduced Spark Protocol, a fork of Aave’s version 3 that allows users to borrow, lend and stake DAI directly. This fork is linked to Maker’s D3M, effectively offering DAI users an Aave competitor.

Later that year, Aave launched GHO, an algorithmic stablecoin pegged to the U.S. dollar. It described it as a “decentralized, overcollateralized” asset backed by a “multitude” of digital assets, including Ether — effectively making GHO a competitor to DAI.

Market data suggests neither platform was successful enough to threaten its competitor. Spark Protocol currently has around $2.4 billion in total value locked, down from a peak of over $4 billion, while Aave has over $10.6 billion locked on its smart contracts across 12 chains.

On the other hand, DAI’s circulating supply is over $5 billion, dwarfing GHO’s near $50 million.

The tension between these two protocols surged in early April 2024 after AaveDAO debated limiting the amount of MakerDAO’s DAI stablecoin allowed as collateral on its lending platform, potentially completely removing it.

While the case was ultimately settled with a loan-to-value reduction of 12%, Aave Chain initiative founder Marc Zeller had proposed to altogether remove DAI as collateral on Aave, which now stands as decentralized finance’s leading lending platform with over $10 billion in total value locked.

The smaller-than-expected reduction came after a detailed analysis from Chaos Labs called for a more conservative approach. Cex.io’s Sarwate says:

“In many ways, Aave was put in a very difficult position, as on the one hand MakerDAO extended DAI’s line of credit from 100 million to a possible short-term ceiling of 1 billion tokens, which introduces significant risk.”

She added that this risk was compounded by the organization’s decision to put some of the newly minted DAI into Ethena’s synthetic dollar USDe. This algorithmic stablecoin has sparked skepticism in the market as it aims to replicate a common hedge fund strategy.

Boiling point

MakerDAO’s indirect exposure to USDe, coupled with the extended line of credit, was seemingly a boiling point for the Aave community, with the stablecoin being particularly controversial.

Ethena’s USDe essentially takes advantage of price differences between spot and futures markets to generate yield through what’s known as the cash-and-carry trade. It works with a Staked Ether (stETH) position and a corresponding short position on ETH, hedging that exposure to the cryptocurrency.

The trade is essentially market neutral and generates yield through the staked ETH and the funding rates perpetual futures contracts charge traders with open positions. This helps align the perpetual futures contract’s price with the underlying cryptocurrency’s spot price.

When there’s more buying demand, the funding rate is positive, and those with long positions pay short sellers, while when supply outstrips demand, the opposite happens. Since Ethena’s launch, funding rates have mostly been positive, allowing USDe holders to earn double-digit yields through what has been a “delta neutral” trade.

Critics, however, have argued that the stablecoin can become under-collateralized during a cryptocurrency bear market in which the price of perpetual ETH futures contracts drops below the spot price of ETH, which would turn funding rates against USDe holders.

The founder of decentralized finance protocol Yearn.finance, Andre Cronje, has suggested on social media that things are now going well and funding rates are positive, but he added that “eventually that turns, funding becomes negative, margin/collateral gets liquidated, and you have an unbacked asset.”

Cronje noted other risks, including external risks related to the oracle used to keep stETH pegged to ETH, exchange custody risks and potential spread risks.

Evgeny Gaevoy, CEO of cryptocurrency market maker Wintermute, mentioned on social media platform X that key risks were related to execution and custody.

Sarwate said, “If USDe were to go into freefall, it could push DAI toward a similar tipping point.”

She added: “On the other hand, Aave choosing to remove DAI completely could run the risk of exacerbating such potential underlying conditions. When not approached thoughtfully, delistings can be turbulent and fracture communities that once enjoyed a freer range of motion.”

John Lo, a former key contributor at popular decentralized exchange SushiSwap and now head of digital assets at cryptocurrency fund Recharge Capital, told Cointelegraph that Aave’s move to reduce the loan-to-value ratio was prudent but noted that “removing DAI as collateral completely would be extreme.”

Lo called for more research on the limits of the D3M module and “its ability to be utilized as a flash loan vector — as rapidly inflating the price on any oracles poses a risk to all lending protocols.” Flash loans are loans taken and repaid within a single transaction.

He said the risk of flash loans being used to manipulate oracles to mint more tokens should always be evaluated. The minting of tokens — as mentioned above — was part of Terra’s death spiral.

The ghost of stablecoin’s past

On Aave’s proposal to drop the loan-to-value for DAI, Aave Chan founder Mark Zeller references the Aave protocol’s “previous experience” with the “consequences of reckless minting policies” on a smaller scale, such as that of Angle’s agEUR, a stablecoin pegged to the euro minted into Euler that was hacked within a week.

Lo said Ethena’s USDe stablecoin is “centralized, and therefore, there exists a slight security risk in the ability to mint more USDe at will,” a risk that could be “potentially offset by USDe’s reputational constraints.” He added that the most important risk was cascading liquidations and slippage incurred from growing redemptions in a bank run scenario.

He explained that runaway redemptions during low or negative funding rates “would force exists from short perpetual future positions,” and slippage could be incurred “at size if ETH and BTC prices are increasing during that time.”

On top of that, Lo added that slippage incurred on selling staked ETH over low liquidity should also be considered, as even a 5% decrease in a stablecoin’s net asset value “is enough to trigger a crisis in confidence.”

Cex.io’s Sarwate commented that to some in the cryptocurrency space, “USDe’s yield structure raises specters of stablecoin’s past” and pointed out that USDe’s popularity is but one of the factors at play

“This is leading some critics to recall the old adage about the downstream effects of burning twice as bright should the network’s delicate balance start to wobble. While high returns can be cause for excitement, negative effects could domino across all vested chains if conditions on the core asset falter,” she added.

Lo, on the other hand, revealed he doesn’t believe USDe poses “unique risks to DeFi,” as it is a “size-constrained tokenized delta neutral strategy that has been commonly deployed by funds.”

According to Lo, various similar tokenized projects should start appearing in the future, and a larger question to ask is whether USDe itself will continue to be attractive for users once perpetual funding rates fall and potentially turn negative, which could affect USDe’s on-chain liquidity.

“Many tokens and stablecoin have low liquidity on-chain, and the risk that arises in that scenario is economic exploits, in particular, oracle price manipulation as a result; however, I don’t believe these would cause systemic risks in the way Luna and its UST mechanism functioned,” he said.

Nevertheless, the former SushiSwap contributor saw a silver lining in the rising tensions between both protocols and the controversy surrounding USDe, noting that the discussions and attention on these issues are getting “shows governance at DAI is alive and well and most importantly widely known.”

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To him, this activity should be seen as the “number one signal of confidence in a decentralized protocol,” and while mitigations will ultimately be implemented, one can ask how much in governance “is related to security and how much is to prevent competition for established incumbents.”

What’s “generally lacking in crypto,” he said, are “consolidated independent reviews of collateral risks and asset risk,” something he believes the ecosystem would greatly benefit from.

MakerDAO and Aave’s latest spat was seemingly resolved with Chaos Labs’ analysis of DAI for the Aave DAO, leading to the 12% loan-to-value reduction. On social media, Zeller concluded the matter with a simple “DAI stays in Aave, we move on. Onwards.”

Whether Ethena’s USDe will ultimately collapse, fall behind competition or suffer some other fate is unclear, but with the presence of Spark Protocol and Aave’s GHO, what is likely is that these two protocols will eventually bump into each other down the road again.