DAI’s Systemic Risk: The ‘PSM Freeze’ Scenario

1. Executive Summary

This report analyzes a specific, high-impact, low-probability “Black Swan” event relevant to the DAI stablecoin. The central thesis is that DAI’s “decentralized” and “censorship-resistant” branding ¹ is a token-level feature that masks a catastrophic, systemic dependency at the collateral level.

The protocol’s reliance on Circle’s centralized stablecoin, USDC, to maintain its peg ² creates a hidden “kill switch.” This switch is not held by DAI’s governance, but by Circle and its U.S. regulators.⁴

A single, valid regulatory order from the U.S. Treasury to Circle ⁵ could instruct it to freeze the MakerDAO Peg Stability Module (PSM) wallet addresses.⁶ This action would instantly neutralize the majority of DAI’s collateral. It would also shatter its peg and trigger a catastrophic, undercollateralized system failure. This report details the precise mechanism for this scenario.

2. The Contradiction: Token vs. Collateral

Analysis of the DAI protocol reveals a core contradiction between its technical design and its financial structure.

The Token-Level Reality (A “Decentralized” Façade)

At the smart contract level, DAI’s “censorship-resistant” claim is technically accurate.

• The DAI ERC-20 token contract contains no administrative blacklist or freeze function.⁷
• This is in direct contrast to its centralized competitors, USDT (Tether) and USDC (Circle).
• Both of these issuers retain powerful, token-level administrative controls.⁴
• Both Circle and Tether have a well-documented history of using these blacklist functions at the request of law enforcement to freeze funds in specific user wallets.¹⁰

DAI’s omission of this function is its primary marketing differentiator.

The Collateral-Level Dependency (The PSM)

This token-level decentralization is rendered irrelevant by the protocol’s financial centralization.

• To solve peg volatility, MakerDAO implemented the Peg Stability Module (PSM).³
• The PSM is a smart contract that allows users to mint 1 DAI by depositing 1 USDC, creating a powerful 1:1 arbitrage loop.³
• This mechanism proved so effective that it became the dominant source of DAI’s backing. At its peak, over 60% of the entire DAI supply was collateralized not by decentralized assets like Ethereum, but by USDC held in the PSM.²
• Subsequent “diversification” into Real-World Assets (RWAs) often involved simply moving this USDC from the 0%-yield PSM into yield-bearing, custodial U.S. Treasury bills.¹³

This strategy means the entire DAI protocol is systemically and financially dependent on a centralized, freezable, U.S.-regulated asset (USDC).

3. Black Swan Scenario: The “PSM Freeze”

This dependency creates a catastrophic systemic risk. A regulator, such as the U.S. Treasury’s Office of Foreign Assets Control (OFAC), would not need to target the decentralized MakerDAO protocol directly. They could neutralize it by targeting its centralized point of failure: Circle.

The “kill chain” for this scenario would proceed as follows:

1. The Order: OFAC, citing national security or terrorist financing concerns ⁵, issues a standard, legal order to Circle.¹⁶
2. The Target: The order instructs Circle to add a list of wallet addresses to its USDC token blacklist. This list would contain the smart contract addresses for the MakerDAO Peg Stability Module (PSM) on Ethereum and other chains.
3. The Execution: Circle, as a compliant U.S. entity, executes this order by calling the blacklist(0x...PSM_Address) function on its USDC smart contract.⁴
4. The Instantaneous Effect: The notBlacklisted modifier in the USDC contract would immediately trigger.¹⁷ All USDC held within the MakerDAO PSM—representing 40-60% or more of DAI’s total collateral—is instantly and permanently frozen.² The funds cannot be transferred, swapped, or redeemed.
5. The Peg Break: The 1:1 DAI↔USDC arbitrage ³, the primary mechanism keeping DAI at $1, is instantly broken. Any user trying to redeem 1 DAI for 1 USDC from the PSM will have their transaction fail.
6. The Panic: The market, realizing the majority of DAI’s backing has been rendered valueless, would panic. The DAI peg would catastrophically break, crashing far below $1.
7. The Protocol Response: This event constitutes the exact “serious emergency” that the “last resort” Emergency Shutdown (ES) was designed for.¹⁸ MKR holders would be forced to trigger the ES to halt the protocol.
8. The Catastrophe (Settlement): During the ES settlement, DAI holders are permitted to redeem their tokens for a pro-rata share of the remaining collateral.²⁰ However, the collateral pool is now massively undercollateralized, as its largest asset (USDC) is frozen and worthless.
9. The Outcome: DAI holders would receive a devastating “haircut.” ²¹ They would get back only a fraction of their $1, enforced by the protocol’s own “graceful settlement” rules.²¹

4. Conclusion

The true “kill switch” for the DAI protocol is not its own Emergency Shutdown module. It is the blacklist function in Circle’s USDC contract, which can be activated at any time by a U.S. regulatory body.

The protocol’s primary and defining risk is not its potential for illicit use, but its profound systemic fragility. It is a “decentralized” protocol that can be unilaterally neutralized by a centralized counterpart.

Works Cited

1. MakerDAO, The world’s first unbiased currency, N/A, https://makerdao.com/
2. Gate.io, The MakerDAO Endgame Plan, N/A, https://www.gate.com/learn/articles/the-makerdao-endgame-plan/513
3. MakerDAO, MIP29: Peg Stability Module, N/A, https://mips.makerdao.com/mips/details/MIP29
4. John Abraham, Circle (USDC) Blacklist Implementation, Sep 13, 2025, https://medium.com/@j2abro/circle-usdc-blacklist-implementation-8a7bab143a93
5. U.S. Department of the Treasury, 2024 National Terrorist Financing Risk Assessment, 2024,(https://home.treasury.gov/system/files/136/2024-National-Terrorist-Financing-Risk-Assessment.pdf)
6. John Abraham, Circle (USDC) Blacklist Implementation, Sep 13, 2025, https://medium.com/@j2abro/circle-usdc-blacklist-implementation-8a7bab143a93
7. Chainalysis, Stablecoins: The most popular asset, N/A, https://www.chainalysis.com/blog/stablecoins-most-popular-asset/
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9. Bitok, Tether Wallet Blocking Breakdown, N/A, https://bitok.org/blog/tether-wallet-blocking-breakdown-vulnerability-saved-millions
10. The Block, Centre Consortium blacklisted seven USDC addresses Wednesday, 2021, https://www.theblock.co/linked/102761/centre-consortium-blacklisted-seven-usdc-addresses-wednesday
11. The Block, Tether freezes over $1 million USDT in single address, 2022, https://www.theblock.co/post/129133/tether-freezes-over-1-million-usdt-single-address
12. Blockapps, Understanding DAI Collateral Types, N/A, https://blockapps.net/blog/understanding-dai-collateral-types-how-they-impact-stability-and-value-in-the-crypto-market/
13. Blockworks, MakerDAO sees crypto-backed loans flip RWA revenue, Jan 25, 2024, https://blockworks.co/news/makerdao-crypto-backed-loans
14. MakerDAO, MIP120: RWA Vault for USDC from PSM, N/A, https://mips.makerdao.com/mips/details/MIP120
15. Congressional Research Service, Terrorist Financing and Digital Assets, 2024, https://www.congress.gov/crs-product/IF12537
16. Circle, USDC Terms of Use, N/A, https://www.circle.com/legal/usdc-terms
17. LRQA, How Circle banned Tornado Cash users, N/A, https://www.lrqa.com/en/cyber-labs/how-circle-banned-tornado-cash-users/
18. MakerDAO, Emergency Shutdown (ES) CLI, N/A, https://docs.makerdao.com/clis/emergency-shutdown-es-cli
19. MakerDAO, Shutdown, N/A, https://docs.makerdao.com/smart-contract-modules/shutdown
20. MakerDAO, MakerDAO Whitepaper, N/A, https://makerdao.com/whitepaper/
21. MakerDAO, End Detailed Documentation, N/A, https://docs.makerdao.com/smart-contract-modules/shutdown/end-detailed-documentation