Weekly Narrative on MakerDAO – 31 March 2019
Last week, the community continued to monitor the 400 bps increase in the Stability Fee from the prior week, bringing the current Stability Fee to 7.5% per annum. General concern continues to permeate as the price of DAI* still remains below its soft peg target of 1.0000 . Further, market makers as well as MakerDAO’s internal trading desk confirm that inventory levels remain materially elevated. The community has elected to continue to pursue a rate tightening policy to reduce excess liquidity in the market and remains vigilant in doing so. While the DAI price* initially indicated a reversal after the Stability Fee change and thus an upward trend, it has been noted the price is continuing to struggle and has retreated just below $0.97 .
During the course of the previous week, the outstanding DAI supply decreased by approximately $7mm DAI, representing nearly ~8% of the total outstanding DAI. This new Stability Fee caused many CDP holders to unwind their position. It is however widely believed the majority of the DAI burning was the result of a few large CDP holders. Even with the new Stability Fee, some new CDPs were still minting new DAI. It should be noted that Stability Fee changes take time for the market to absorb the new cost imposed on debt holders.
Calculating the current outstanding DAI demand is and will be the “new” scientific challenge. The ramifications of computing such a value will however, prove to be challenging and incredibly powerful as tools and algorithms are optimized with time to more accurately determine the Demand side. At present, we must resort to an educated guess and crude equations to estimate the current Demand, which must be less than the outstanding DAI of ~$88mm and more than 0. It has been estimated in the past to be closer to $70mm; however, it must be noted that with the objective to use the scientific method, this number is purely an indicative value. Several parties from the community have elected and volunteered to allocate resources to start estimating the Demand side with more accuracy.
As the Supply side can be determined by a query to the Blockchain, once the Demand side can be Determined within a reasonable level of statistical variance, the community will be able to more effectively recommend and implement Stability Fee modifications.
Once the DAI Savings Rate is implemented, the Community will be able to implement policies that both directly impede / discourage the supply increase from DAI as well and encourage the long-term holding of DAI (thus stimulating demand) or the reverse. By derivative, the foregoing will cause / market force incentivize Supply and Demand to match. In doing so, the DAI price will become more ever-more rigid as the DAI Savings Rate component of the Stability Fee may be modified by the community. This market price rigidity is essential for the community to truly accept DAI for further geometric adoption.
Further it is expected that the DAI Savings Rate will absorb market shocks as there will be a source of Demand uncorrelated to market activities. If we exclude the systemic risk of the blockchain (and possible code defects) and assume the community will be ever-vigilant to push DAI to a 1.00000 peg, then the implementation of the DAI Savings Rate may be viewed by some as access to raw uncorrelated risk-free Alpha. With this assumption, excess swings in DAI Savings Rate should be discouraged and viewed in the same light as implementing swings in the single-collateral DAI Stability Fee.
Given the observed impacts of the Stability Fee on the price, prudence and monitoring are advised. As the overall objective is to bring supply and demand into balance (which may be observed via the price* being as close to 1.0000 as possible), it is critically important to engage pragmatically and not overshoot any new rate change adjustments.
As empirically perceived, a credit bubble of DAI continues to persist after a period of low credit with lagging demand. As the Maker community is committed to a soft-peg for DAI and using market forces related to the Stability Fee to cause the enforcement of such policy, it is expected that the community will continue to tighten its policy. When the credit bubble does start the materially shrink, it is expected to see a sustained contraction of outstanding DAI (and by derivative the soft-peg should be restored), as we will have then sufficiently passed rate sensitivity elasticity of 1. When this event occurs, it will be critically important to monitor and possibly soften the monetary policy accordingly based on the then market conditions with an attempt to restore demand unit-elasticity.
As the current outstanding DAI is now below $89mm, the community should start a discussion to form rough consensus around a new debt ceiling as it is a question of when / not if the total outstanding DAI reaches the $100mm level. While not expected, a sudden increase in the underlying collateral would allow more DAI to be minted while being away from their respective liquidation price. In short, while not an urgent issue, it remains an outstanding and important issue to address. While not catastrophic if the debt ceiling is temporarily hit provided we are in an oversupplied DAI market, it would however start to artificially increase the price. Such prices increases should instead be caused by raw economic forces of supply and demand.
Observe the market price* and compare the supply numbers from Maker’s internal trade desk (and any other trade desks) for another week. In parallel, prepare the community for a continual series of 50bps rate increases to continue to tighten the perceived supply demand imbalance. Further, it is recommended to continue these rate increases on a predictable and well-communicated cadence until such time as we see the excess liquidity begin and continue to contract. Once we are able to effectively value the demand side, it is expected to see a trend when / where supply and demand would match.
Start a post-mortem on what might have caused such a credit bubble with emphasis on what changes might be recommended in the future to make such credit bubble more difficult to create.
Once Multi-Collateral DAI is implemented which would also allow the introduction of the DAI Savings Rate, the Community and the Foundation must estimate of what portion of the Stability Fee should be allocated to directly encourage DAI demand and be mindful to not overshoot. While tempting, the notion that all or even half of the Stability Fee must be allocated DAI Saving Rate to encourage the two to “meet in the middle” must be resisted. It is an ever present test of the collective patience of the community to move the needle pragmatically. Therefore it is recommended to implement no more than 100bps of the Stability Fee to the DAI Savings Rate as the market impact on implementing raw uncorrelated risk-free Alpha is unknown but expected to stimulate Demand.
* – price being determined by USD fiat offramp via USDC – DAI (at pro.coinbase.com)
(If you would like to collaborate in the creation of this narrative, please contact me directly.)