Intersection of TradFi and DeFi : a glimpse into the future !
Maker DAO is an OG of DeFi. While other stable coin ecosystems are blowing up (first in a good way and later in a bad way) Maker DAO and $DAI are chugging along with few major headlines. Recently Maker DAO has captured our attention again because of an announcement of partnering with a traditional financial institution. But what is “collateral integration” and how is it relevant to Maker’s Tokenomics?
We are taking a deep dive to better understand Maker DAO and its Tokenomics. We are looking for the context and motivation of Maker to partner with a TradFi bank. What impact, if any, will this have on $MKR and $DAI?
What is Maker DAO and how does it lend
Maker is a permissionless, multi asset, overcollateralized lending platform responsible for the creation of $DAI, the first decentralized stablecoin, built on Ethereum. Many consider Maker to be amongst the first DeFi projects. The way the $DAI stablecoin is different from USDT, USDC, or other algo based coins, is that it works on the principle of being overcollateralized and allowing permissionless access to anyone who wants to borrow against their collateral.
What is permissionless lending? Maker operates vaults and smart contracts that automate the lending process. There is no credit check, no KYC, any other form of qualification of borrowers is also missing. The only thing required to initiate a loan on Maker is collateral to secure your loan. The collateral secures the loan so the user can stay completely anonymous.
What is overcollateralization? For every $DAI that’s borrowed by a user, the user has to offer more collateral than the value of the loan. There is a minimum required ratio between the USD value of your deposited collateral and the amount of $DAI minted as a loan against it. Multiple assets like Eth, wStETH, wBTC, Eth LPs etc. are approved to be posted as collateral.
Lets understand this with an example:
- You open an ETH-A Vault with 10 ETH. Its current market value is let’s say $10,000 (at approx. 1000 $ ETH price)
- You mint 5000 $DAI. Your current collateralization ratio is 200%
- Assuming the Liquidation Ratio of ETH-A is 145%. If your collateralization ratio falls below 145%, your Vault will be liquidated
- To reach a collateralization ratio of 145%, the ETH price would have to fall below $725. (5000*1.45/10)
- At that point you will get liquidated. To avoid that, prior to the liquidation point you can either repay your loan or post additional collateral to lower the liquidation point
Maker leverages a native token, MKR, which is used as a governance and utility token to vote on new upgrades to the platform. So there are t 2 tokens: the US Dollar stable coin $DAI and the governance token $MKR.
The 2 Token economy of Maker DAO: $MKR and $DAI
Expand the diagram here
Let’s see how $DAI lending operations work:
- Vaults: Maker DAO enables borrowing on the Blockchain through Vaults earlier called Collateralized Debt Positions (CDPs). When a user opens a Vault they can borrow Maker’s decentralized stable coin, $DAI, by depositing collateral.
- Stability Fees: The Stability Fee is a variable-rate fee continuously added to a Vault owner’s generated $DAI balance. It’s the interest you owe for borrowing $DAI just like how one pays interest for taking a loan from a bank. The Stability Fee parameter has a lower bound of 0%, it cannot be negative.
- DSR: The $DAI Savings Rate (DSR) allows any $DAI holder to earn savings automatically by locking their $DAI into the DSR contract in the Maker Protocol. In simple terms you get paid interest for locking $DAI just like how one (used to) get interest by depositing money in a bank.
- Liquidation Penalty: Liquidation Penalty is a fee paid by Vault owners when the value of their collateral reaches the Vault’s Liquidation Price. This is in addition to the Stability Fees they have to pay for their loan position. (Liquidation fees historically have been in the 13–16% range.)
- Unlike a bank that pays/charges interest monthly in Maker DAO it is compounded per second.
- If the Stability Fee is set to 2%, it will accumulate at 1.0000000006279371924910298109948% per second.
- At the end of year one, the user will owe exactly 2% on the principal.
- Assuming the user borrows 100 $DAI, at the end of year one they would owe 102.00 $DAI. At the end of year two, they would owe 104.04.
The Stability fees and DSR are set by the community. This is one of the utilities of $MKR.
MKR holders are able to stake their MKR tokens in order to vote on proposed changes to the Maker Protocol — as well as ensure the efficiency, transparency, and stability of $DAI.
To understand the full utility of MKR we need to explore Maker DAO’s Auctions first.
Maker DAO Surplus, Collateral and Debt auctions
Vaults are created in Maker to hold collateral and generate $DAI whenever a borrower interacts with the Maker protocol. $DAI is accrued through stability fees collected from Vaults. Whenever the net surplus from stability fees reaches a certain limit, the surplus $DAI is auctioned off on a DEX to external actors. The maker system takes this $DAI and purchases MKR through smart contracts and burns it, thereby reducing the amount of MKR in circulation. Since the entire process is executed via smart contracts, no human intervention is needed to see this process through. This process is called a Surplus Auction. (In this phase Maker DAO shows a lot of lending income.)
When a Vault is liquidated because the collateral value has fallen below the liquidation point then a Collateral Auction is hosted. The protocol keeps the principal plus stability fees plus liquidation penalty and returns the leftover collateral to the borrower. In this phase Maker DAO has both lending income and liquidation income.
Finally, if the value of the collateral falls to a point where it can’t cover the protocol debt plus fees then a debt auction is conducted. This happens when the collateral price drops sharply or no one wants to buy the collateral. The first course of action is to cover this debt using surplus from stability fees, if there is any surplus to cover it. If there is not, then the system initiates a Debt Auction, whereby the winning bidder pays $DAI to cover the outstanding debt and in return receives an amount of newly minted $MKR, increasing the amount of $MKR in circulation.
In summary, the different auctions are the main processes through which $MKR and $DAI are minted and burned. Surplus Auction and Collateral Auction burn $DAI, Debt Auctions mint $DAI.
The below diagram illustrates the Net burned MKR ((Total burned — Total minted)) on a quarterly basis.
Relationship between $DAI and $MKR Tokens
Maker DAO is a lending institution, like a Bank. Any bank needs to find good customers which repay interest and principal on time, to lend. Loans lead to interest creation, called stability fees in the case of Maker. These stability fees accumulated by the DAO are used to buy and burn $MKR.
Better $DAI lending decisions -> higher stability fees generated -> more $MKR bought and burned -> reduction of $MKR in circulation -> appreciation in $MKR price.
Better lending decisions and more demand for loans leads to a better $MKR price for $MKR holders.
Poor decisions in the $DAI lending system -> losses incurred by the system -> additional $MKR minted to cover the losses -> increase in $MKR in circulation -> depreciation of $MKR prices.
When mistakes or unforeseen circumstances happen, the Maker portfolio becomes undercollateralized. To cover the loss new $MKR tokens are minted, which leads to price erosion of $MKR tokens.
How is the $DAI/Dollar peg maintained?
Strategy 1 : Use DSR to increase and decrease the attractiveness of borrowing $DAI, thus controlling the liquidity of $DAI and maintaining the peg.
Remember, the DSR is the “$DAI Savings Rate”. It is the interest you get paid for locking $DAI.
When the market price of $DAI deviates from the Target Price due to changing market dynamics, $MKR holders can mitigate the price instability by voting to modify the DSR accordingly:
- If the market price of $DAI is above 1 USD, $MKR holders can choose to gradually decrease the DSR, which will reduce demand and should reduce the market price of $DAI toward the 1 USD Target Price.
- If the market price of $DAI is below 1 USD, $MKR holders can choose to gradually increase the DSR, which will stimulate demand and should increase the market price of $DAI toward the 1 USD Target Price.
Example: Data on CoinGecko shows that on March 13 2020 $DAI was at an all time high value of $1.22 leading up to the events of Black Thursday. See below how the DSR was changed during that time period to bring back the $DAI to peg.
Strategy 2: Peg Stability Module (PSM)
Given the existence of a USDC-backed PSM, a user would be able to swap 100 USDC for 100 $DAI (minus fees) using the USDC-backed PSM without taking on any debt or needing to manage a Maker vault. From a user’s perspective it works like an automated market maker with a liquidity pool behind it even though the PSM works differently under the hood.
The Peg stability module is a special type of vault that allows users to swap collateral for $DAI rather than borrowing $DAI against collateral. The PSM was created to help keep the $DAI peg close to $1 during times where $DAI demand is higher than $DAI supply. The PSM operates similar to a regular Maker vault but doesn’t charge a stability fee (fee is set to 0%) and has a liquidation ratio of 100%. Users are not borrowing $DAI but swapping it for USDC (or whatever stable coin is part of that PSM) thus artificially controlling demand for $DAI and hence restoring its peg.
The PSM should only be used to absorb short term deviations. Longer term, the system is supposed to adjust the supply and demand of $DAI using rate adjustments.
How Maker DAO generates revenue
The protocol’s revenues are derived from three main sources:
- Lending income: Interest revenues from overcollateralized loans (Stability Fees)
- Liquidation Income: Liquidation revenues from fees charged on liquidated vaults
- Trading Fees: Stablecoin trading fees from the Price Stability Module (PSM)
A look at this chart breaks up the revenue distribution over time.
To sum up the overview of Maker, let’s look at the 3 main activities of the protocol:
- Normal debt process where loan is offered against Collateral
- Normal debt repayment process where borrower pays back the debt along with accrued stability fees leading to the protocol earning a lending income
- Finally, a liquidation scenario where debt is liquidated and protocol liquidates the collateral, recovering the principal lent, stability fees and a liquidation fees. The remaining value of the collateral is returned back to the borrower.
Why Maker DAO is interacting with Real World Assets (RWA)
In spite of its solid reputation, Maker has come under fire of late for not being aggressive enough. Terra, a late entrant onto the scene (Maker debuted in 2014 and $DAI arrived in 2017), was almost double of $DAI market cap in March 2022 (a few weeks before it imploded). For reference, the market cap of USDT was $80.8 billion, USDC was $52.4 billion, Terra was $15.8 billion, and $DAI was $9.3 billion in March 2022.
$DAI community was forced to take some measures to remain relevant in the changing stable coin environment. Of the multiple initiatives the community took to increase $DAI adoption, the most notable one was onboarding more real world assets (RWA) as collateral. What that means is that Maker will now accept RWA as collateral in addition to the approved Crypto based collateral list.
How could this improve Maker’s fortune?
By adding RWA as a collateral, Maker would increase the types of collateral against which $DAI can be borrowed on the platform. That would translate into new loans originating from the platform. As we have established earlier: new loans translate into collection of more fees, which results in reduced availability of $MKR, which may lead to higher market value of $MKR.
As part of the RWA effort, Maker has struck a deal with Huntingdon Valley Bank (HVB). Maker is extending a credit line of 100 Mn to HVB through which it will co-invest along with HVB. In TradFi terms one could equate it to co-lending. Since it is not possible for Maker to qualify every retail loan proposal (remember it’s a permissionless protocol unlike TradFi), the credit due diligence is done by HVB and selected borrowers are lent to from the HVB-Maker pool of capital.
The announcement of the final deal structure was also made on Twitter recently. A snapshot of this announcement is what we started the note with, and hence it’s quite apt that we conclude the note with the same.
Slow and steady wins the race: How Maker DAO is in a position to partner with TradFi
Lending along with TradFi is a Trillion dollar opportunity. More importantly, it opens up new vistas for integrating DeFi and TradFi. Rather than being a competitor to traditional finance this is a great experiment to explore how DeFi can actually synergize support and grow TradFi.
The HVB loan is expected to be delivered over the next 12–18 months. Maker given its permissionless overcollateralized model is in the pole position to lead this market. Since the HVB partnership Maker seems to be getting multiple proposals to finance which creates both an opportunity and a massive responsibility on the community, to decide wisely.
With Luna’s implosion and subsequent fall of the algo stablecoin narrative, Maker has some breathing space to deliver results. Looking back 5 years from now, if executed well, this might very well turn out to be the defining moment for DeFi.