Weekly (almost) Narrative on MakerDAO – 03 June 2019
During the course of the last week, the community voted on and reduced the Stability Fee to 17.5% per annum. The community has maintained the polling frequency for another executive vote. At present and pending an executive vote, a further softening of the Stability Fee by an additional 100 bps to 16.5% per annum looks highly probable. The overall price* of DAI has significantly rallied to its soft peg target of 1.0000 and for the most part stuck to the peg. During the last week, the total outstanding DAI has now expanded to just slightly above 81.7mm DAI. This expansion follows the recent contraction to 80,3 mm DAI. The initial contraction is largely attributed to the elevated Stability Fee; however, the subsequent expansion in DAI can be possibly attributed to further willingness by participants to engage with leverage as the core price of ETH has rallied along with the broader crypto market.
The above being said, as the DAI price* continues to hover above the target of 1.0000, we can draw an initial conclusion that most of the market maker inventory has been cleared out; therefore, it is reasonable to believe the supply overhang (e.g. difference between Demand and Supply) has ceased growing and is basically zero. As reported by at least on market maker on the recent governance call, their ability to secure larger batches of inventory is becoming a material challenge.
As the supply overhang has disappeared, a new risk appears that might cause the price of DAI to continue to elevate above 1.0000 (even in the face of a recent Stability Fee decrease). As now, the expected primary sellers of DAI at 1.0000, the market makers (which previously had outlined their desire to sell at 1.0000) no longer have excess inventory. As such, the remaining sellers will not have large inventory to sell which could cause a squeeze on the price upward. This further implies that historic excess inventory was suppressing the price at or slightly below 1.0000.. In the absence of that excess inventory, “true” supply and demand market forces are now at work for price discovery. With one market maker confirming their inventory is on a path of being depleted and the DAI price* is at 1.000, we have at least part of the recipe of a confirmation the Stability Fee should be decreased which is already being voted on with an executive vote.
In parallel to the above, the underlying collateral for SCD (ETH) has surged in value. As such, if the Stability Fee were to be incorrectly positioned, we should see either the DAI outstanding surge upward or downward. As evidenced in the absence of a large change in DAI outstanding, we can deduce the Stability Fee is more or less priced correctly on a blended-average across all CDP holders (on an elasticity of demand to engage in leverage basis).
Further, the average daily maker burned (as calculated) is now right over 50 MKR per day, down from over 60 after the recent Stability Fee decrease. The total MKR in the “burner wallet” has now surpassed 1566 MKR. The P/E ratio has also increased as a result of both price appreciation of MKR along with the earning component bring reduced with the recent decrease in the Stability Fee.
With the upcoming introduction of the DAI Savings Rate, we need to start polling for / forecasting where to start the DAI Savings Rate. As it is strongly recommended to treat the introduction no different than another other new market force, it is strongly advised to roll-out the DAI Savings Rate slowing starting at 100bps. As the DAI Savings Rate should be viewed as a competitor to traditional saving rates or even United States Treasuries, iterations on the increase post DSR launch should be no more than 25 bps at a time.
As further discussed in the governance call, the question arises of the role / capacity / even danger to Maker as realized by the rise in popularity and proliferation of secondary lending markets that utilize DAI.
As DAI can only be minted / drawn or burned / wiped from a CDP contract via Maker smart contract. The cradle and grave of DAI occurs at and with Maker. That said, with the Stability Fee being the only current tool in the tool box to encourage / discourage the issuance of DAI (in a single-collateral world), we are experiencing first hand how to handle a credit bubble when too much DAI was minted for too long as a result of interest rates being set too low. Further, with no good way to remove the DAI from circulation, the only monetary policy left to implement earlier in the year was to increase the stability fee to the point where CDP holders would determine for their own self interest that the cost of borrowing exceeded the benefits and start to unwind their position. During that time, we noticed a lagging DAI price* which was our leading indicator that aggressive monetary policy action was required. Repeatedly we identified that the price* would be at its peg when supply and demand were in harmony. As such and with the price below the peg, there was simply put too much supply with demand lagging behind.
In parallel to those events, “secondary” lending platforms were launching quite frequently and were offering a lower lending rate that Maker (subsidized or not). Initially one would perceive this as a threat to the Maker system, but it is not. Rather, it is and should be viewed as an asset and a tool to help ensure the system stays efficient. The fundamental reason it is not a threat is that regardless of the code used, it cannot cause the creation of DAI or cause the destruction of it. In an extreme risk case, should the secondary lending platforms become so sufficiently large that they choose to issue their own new ERC20 token as a stabile-coin with their own governance, then and only then, would it become a threat.
In the absence of the DAI savings rate for single-collateral DAI, there was no tool that assisted in the “non-painful” way of removing DAI supply. By introducing a secondary market lender that takes existing DAI and allows market participants to borrow DAI at a lower rate (and by presumption pay down their existing CDP), a mini-competitive market was introduced. With the DAI paying down the CDP and being destroyed in the process, we are reducing the outstanding supply. Logic would then dictate with less supply and constant demand, the price would then rise causing the governance to determine to lower the Stability Fee.
Each time the Stability Fee is reduced, the overall net benefit of refinancing and outstanding CDP is reduced. This process will continue until such time as the “true” market demand matches the outstanding supply. Put another way, the supply will be reduced to the point of true demand. This is market efficiency, and that is a wonderful thing. The DAI savings rate in MCD will have the same impact, but its ability will be much sharper and more quickly felt as a random user won’t have a large CDP position to move / reduce the DAI supply that may or may not have a tax consequence. Rather than random user will simply desire to purchase 1 DAI and place it in a savings contract.
In the same manner that algorithmic stock market traders help make the price more efficient (which is a good thing), they also then make the market so efficient that they put themselves out of business as the volume of trades has to constantly increase to capture an ever decreasing margin per transaction.
The same will be seen for the secondary lending markets. They will have a place, but their roles will need to morph in the face of the DSR release which will accomplish the same overall objectives and do so much faster. Areas that we can expect to see their business model morph will be in the areas that (at present) maker has expressed no interest to pursue (e.g. term loans and more specifically term repos and term reverse repos). In this space they will not be viewed as theoretical competitors but rather building on a collaborative layer above that is essential to building the foundation.
We have seen the above work in real time during the last few months when demand lagged behind supply. However let’s discuss what happens when Demand exceeds supply and what we should expect for the secondary lending markets. In that scenario, the DAI price would be above 1.0000 which would stimulate CDP holders to mint / draw DAI. Further, governance actions would logically reduce the Stability Fee to encourage the issuance of new supply. So where does that leave secondary lenders? Each time the Stability Fee is decreased, their market usage will be reduced. Taking that to the extreme case of the Stability Fee being set to zero, the secondary lenders will simply get eviscerated.
As discussed prior, if we forecast a world in 60 months where the overall stability fee would be 200 bps and 150 bps of that would be the DSR leaving ~50 bps of VaR maker stability fee / insurance, secondary lending markets competing to be an efficiency tool appears on the surface that with the DSR value above the VaR MKR value, why would someone borrow and lend money on a secondary market? Put another way, if we follow the corollary that Maker is basically a central bank with a retail / commercial book of business, how does a retail / commercial bank fit in when borrowers can just go directly to the source of capital? The answer is the only way they survive is when there is an inefficient market and the rates do not reflect an efficient equilibrium between supply and demand (for that given point in time). When they are in harmony, the market window disappears.
The point in general is that secondary lending market for now may just be a short-term phenomenon unless their business model morphs as outlined above.
It is expected that the DAI Savings Rate contract will be an essential metric to gauge and estimate demand changes. As such, it is essential for future PID algorithm optimization to gather as much demand side information as possible, hence the logic to start slow and iteratively determine the market correlation and sensitivity.
In a continuation of the general theme, it is recommended to establish a workgroup to start the logic on a Machine Learning PID Control System** tool to help with signaling. Each time we add a new collateral asset that will have its own Stability Fee, the ML PID must be adapted to handle the new input (and associated data). Compute any market correlation, and recommend the changes to each SF and DSR in general. As the DAI Savings Rate will be uniquitious across all collateral types, it will be the unifying metric. As such, when MCD is launched, it is recommended to add only one other asset class and focus on getting the governance process and the DAI Savings Rate as a tool. While everyone will want to use Maker for a credit facility for his asset, the prudent move is lock down on the fundamentals of governance of the DSR and handing one additional asset aside from ETH. Thereafter, adding new collateral types will be an incremental and accretive process. This ML PID initiative is no small project but is essential to helping to identify any systemic correlation risks that are possible to be inadvertently overlooked.
Therefore, if not already done, it is recommended to put a team together (probably needs to be grant sponsored) to spearhead this ML PID endeavor. Of course, in this space, the well-placed paranoia about how a system can be gamed remains. For the team that assembles the algorithm, they will be privy to “almost” inside information. Therefore any such actions / recommendation must either be done with extreme privacy / secrecy or complete transparency.
Capturing and feeding in such data and then determining the best DAI Savings Rate and Stability Fee overall becomes a perpetual iterative feedback control engineering challenge. There will be input variables that we cannot conceive right now. Removing the human emotion side of how to keep the Stability Fee low per asset is important to long-term acceptance and price stability of DAI as we navigate our way to general acceptance. Following on, the concept of general acceptance is also a bit of a misnomer, replacing the USD is not needed per say. What is needed is a hyper efficient fixed rate commission to exchange DAI for USD and replace credit facilities worldwide with a more efficient tool that utilizing a synthetic USD pegged asset, DAI.
- * – price being determined by USD fiat offramp via USDC – DAI (at pro.coinbase.com)
- ** – 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.
Top 250 MKR holders = 688348.024
1d 🔺: -230.452
1wk 🔺: 4437.506
Live STBLTY Fee: P/E (dilut.) 50.66 – P/E (w/o dev. fund) 37.54
FCST 50bps STBLTY Fee (VaR MKR burn portion): P/E (dilut.) 1775.82 – P/E (w/o dev. fund) 1323.80