Weekly Narrative on MakerDAO – 26 April 2019
Weekly Narrative on MakerDAO – 26 April 2019
General:
Last week, the community voted on and implemented an additional 300bps increase in the Stability Fee bringing the new fee to 14.5% per annum. The community has also stepped-up the polling frequency for another executive vote. At present and pending an executive vote to implement a new fee structure, the Stability Fee looks to be increased by an additional 200 bps. General concern continues to permeate as the price* of DAI still remains below its soft peg target of 1.0000 now moving into month number three. During the last week, the total outstanding DAI has now contracted just slightly above 86mm DAI which demonstrates the previous increase in the Stability Fee had the net one week contraction of ~3mm DAI. That said, it is impossible to determine if the supply contraction was due to the Stability Fee increase from the last week or the one before, etc. While the average price* still remains below 1.0000 it should be pointed out that thin trading volume exists on Coinbase Pro (with a ~$120,000 theoretical purchase, DAI would be trading at 0.99 to 1.00 USD).
The above being said, as the price continues to lag below the target of 1.0000 and the overall supply has slightly contracted; therefore, it is reasonable to believe the supply overhang (e.g. difference between Demand and Supply) has ceased growing and is contracting. A removal of the excess Supply is still needed. During a historic call, it was estimated the total Demand was around 70-75mm. As such if the current decline continues in a linear fashion, it could be estimated the Supply will brought into harmony with Demand in approximately five weeks.
As the community cadence is up which is an excellent sign, prudence and restraint are needed to keep the vigilance but remove the intensity of upcoming changes. Further, we need to start the poll to take our foot off the throttle and include Stability Fee reductions as possible candidate(s). When the credit bubble does “pop”, we are going to need to poll & vote to decrease the fee urgently. A “pop” would be determined by large CDPs deciding to wipe millions of DAI instead of a few thousand.
Demand:
We need to start the research for the Stability Fee impact on Demand and then expand that research into its fundamental parts of DAI Saving Rate and the Stability Fee overall (w/ specific emphasis on determining when the partial derivative of profit with respective to stability fee equal zero). By doing so, we will be tweak these metrics to forecast expected Demand increases and Supply decreases for when future credit bubbles occur.
With the upcoming introduction of the DAI Savings Rate, it is strongly recommended to treat and celebrate its introduction no different that if a government authority were to receive a new drug that would cure cancer in all its forms. There is wisdom in a slow roll-out to curtail and fully understand its market force and possible unintended consequences. It can be theorized that its introduction and thus access to true raw alpha will be a potent tool to cause demand creation. Further, for each DAI acquired below the 1.0000 peg the yield-to-maturity is also enhanced, thus making discounted DAI an interesting possible investment.
However today, as empirically perceived, the DAI credit bubble continues to persist after a period of low credit with lagging demand. It is expected that the community will continue to tighten its policy until such time as the supply begins to have a continual supply contraction. The point (via the Stability Fee) in which unit-elasticity is exceeded must be determined. Once crossed, it is imperative to loosen the monetary policy to avoid an accelerated contraction of DAI (e.g. a death spiral). The aggressive policy to remove supply via substantial rate increases includes systemic risk. This risk is somewhat hedged provided the community accepts a “loosening when determined” policy. It was also mentioned the possible usage of global settlement, to in-effect, reset the clock and start-over (thus causing the clearing of the excess supply).
Many have indicated a somewhat lukewarm concern about overshooting. While the nature of policy will cause the voting community to almost always over and then undershoot, in this case when the stability fee is elevated to such levels, the concerns become amplified for an overshoot. Should a scenario exist where we see a material (almost severe) contraction in DAI outstanding and therefore the DAI price increased above 1.0000 (let’s for the sake of the argument state 1.05), as a community we are making the assumption that by lowering the Stability Fee to a historic value (that caused DAI creation) that it would cause CDP participants to mint DAI again over a period of time. That argument in an efficient market may be true; however, this is far from an efficient market. Further, in the absence of that DAI creation, the price would then materially be above 1.0000 thus causing the community to vote on decreasing the stability fee further to find the point where DAI minting would occur again. Fundamentally the point here is that making the assumption that the Stability Fee can be lowered quick enough to make up for the supply differential is unproven, therefore caution is advised.
As the Stability Fee has been increased to combat excess Supply, politics has started to inject itself with theories as to the motivation surrounding such increases (e.g. Maker holders are voting exclusively to enrich themselves). Such commentary is used to try to force MKR holders to defend their position of increasing the Stability Fee by demanding a party prove a negative instead of using scientific arguments. The DAI Saving Rate implementation will be the ultimate demonstration of the above fallacy, as MKR holder will be quite literally handing over value that is presently used in Single-Collateral DAI for a buy-burn structure to those that lock-up DAI with the DAI Savings Rate.
The “culprits” in this scenario are those that continue to borrow at elevated rates (and thereby mint new DAI). As CDP holders are expected to act selfishly and thus in their best interest, a party that decides to mint DAI at these rates must only be willing to do so if it serves his / her interests. Therefore his / her reward (or trade) must be generating in excess of the Stability Fee costs. As such, on a blended-basis, we are still in pursuit of the optimal Stability Fee. What is needed right now is the controlled reduction in Supply.
All participants want the rate to come down and have supply and demand be in harmony. Today they are not. It is conceivable they will not until the DAI Saving Rate is implemented. Please don’t rely on a “cheap” rate from Maker any time in the near future.
Debt Ceiling:
Many of the discussions in the last week circulated around using the debt ceiling as a policy tool to help establish DAI back to 1.0000 . While this would help produce a short-term solution, it would also start to insert a new level of complexity (and thereby uncertainty) and should be discouraged (mostly surrounding how to unwind using the debt ceiling as a policy tool, e.g. all at once? throttled?). The ideal solution is to set the Stability Fee (and the “coming soon” Dai Savings Rate) to the optimal rates and use purely market forces to stabilize the system. As outlined in the call, should we see a surge in the value of the underlying collateral, as the system presently does not have the tools to allow the throttling of newly issued DAI, the only way to discourage the creation of that DAI will be via increasing the economic costs (the borrowing rate) to mint DAI.
Recommendations:
During a recent call, some advocated for a global settlement. While possible, it is discouraged primarily for the reasoning of “why today and why not tomorrow”. If we can gather valuable data today, we could always conduct a settlement tomorrow; of course, when tomorrow comes we repeat the previous sentence. Supply is continuing to come down. On the assumption the most recently polled increase of an additional 200 bps passes and is implemented thus bringing the overall Stability Fee to 16.5% per annum, it is recommended to monitor the system and stand down on further rate increases until the ecosystem as a whole has had the opportunity to truly digest the material Stability Fee increases. With the supply recently declining, the risk associated with further increases to directly cause supply destruction instead of inhibiting supply growth is not justified.
While unpopular, going through a credit bubble and contraction is healthy market activity. From a governance perspective, many critical items were learned along the way. Specifically, six months ago, no one would have estimated the Stability Fee would rise (or better stated be able to rise) to ~15% per annum without causing an absolute collapse in supply. The community has received a crash-course education (“learn by burn”) in the risk-tolerances and appetite for risk from the singular collateral in this project. While the underlying price of ether has appreciated, we have yet to see the market impact should we return to the bull (insane) market conditions of the fall of 2017.
It is further recommended to keep a rolling vote & poll to continue the communication to the community related to Stability Fee changes. Further, while not implemented yet, we should start the polling to form rough consensus on what portion (e.g. how many bps) of the Stability Fee to allocate to the DAI Savings Rate. As we do not yet know the full extend of the DAI Savings Rate on demand; although solidly believed to be a potent tool, it is recommended to start at no more than 100bps and only increase in 25bps increments. Gathering demand side data is essential for future PID algorithm optimization. It is expected that the DAI Savings Rate contract will be an essential metric to gauge and estimate demand changes.
Further, when Multi-Collateral DAI is released, it is recommended for each of the risk teams to evaluate the concept of throttling newly issued DAI (on a hourly / daily / weekly / monthly basis) until such time as each collateral class has reached a threshold of stability via a frequently updated per collateral debt ceiling. This throttling might also occur via different Stability Fee percentages tied to a specific collateral type. This serves the dual purpose of not allowing too much DAI to be minted and potentially move the overall DAI price off its peg, but also limiting the maximum amount of risk exposure any one given Maker Risk team should be allowed to embrace on behalf of the MKR token holders as a whole.
In a continuation of last week’s narrative, it is recommended to establish a workgroup to start the logic on a PID Control System*** tool to help with signaling. As outlined prior, it can be reasonably forecasted that over a period of time upcoming to see that control system move from signaling humans that vote to one where the PID tool would implement those changes and have humans vote on the tuning variable or to veto all-together. What becomes interesting is not only the frequency of when that PID tool should be run (e.g. weekly? daily? hourly?) but also if we should run the optimization when DAI is being minted or destroyed. A solid argument could be made that the DAI minting and destruction process can directly cause price change in the market and are likely targets for when the control inputs to the system could be modified. Further, minting 3000 DAI has a clearly different impact on the market than minting 3mm DAI, especially if the intent of such DAI minting is to sell for a FIAT off-ramp, thus degrading the DAI price. Therefore in a multi-collateral dai world, it is recommended to include whether or not the intention of the collateral used on or off-chain as a metric of consideration (e.g. lending against real-estate).
Similar to an old engineering school project of having an autonomous car follow a while line, we need to consider the inputs to the system allow for such a PID tool (e.g. DAI price oracles, overall supply, current stability fee, current DAI Savings Rate, arc point elasticity on demand & supply, and the stated objective for overall SF and MKR risk-premium to name a few). For sure there will be more as we develop the overall logic. This style tool will have profound impacts with the long-term ramifications (positive) when the tool will make counteracting market decisions as the community votes and monitors.
- – price being determined by USD fiat offramp via USDC – DAI (at pro.coinbase.com)
** – feedback inputs would be DAI Savings Rate balance / Overall Supply Balance / computation of arc point elasticity for each / others
*** – PID (proportional / integral / derivative) Control System. It is expected that the DAI Savings Rate will be a potent (and more so than the Stability Fee impact on Supply) tool, as such it will be supply leaning (much like an autonomous car that has an alignment issue and drifts to the right, the control system for Maker will unlikely be symmetric between supply and demand).
NOTE: Not a part of the Maker foundation, just my $0.02 and not intended as advice in any capacity.