If Maker governance can rally around any singular point, it has been using market forces to align the DAI price to its current target reference currency, the US Dollar.
During a large portion of 2019, we saw SAI used primary as a leverage tool to acquire more ETH thus causing a surge in demand as excessive SAI minting pushed the SAI price below the reference price of $1.00
To combat this issue and due to a lack of other collateral outside of ETH and a lack of incentive tools, like the DSR, the Stability Fees were continually raised until the benefits to mint SAI were outpaced by the costs to do so. Thus folks started to repay their SAI loans and peg stability was restored.
Fast forward almost a year, multi-collateral DAI has since launched and now has many collaterals helping to control the DAI price (though it should be noted that virtually all of them are correlated, less stablecoins. Then “yield farming” came around and created organic demand for DAI outside of singular historic token leverage. Further, one can also imagine that some token holders are mindful about ETH price volatility and thus do not mint even though right now it has no economic cost to do so. .The result has been a stubbornly elevated DAI price above $1.00 now for months.
Unlike its 2019 counterpart where raising the rates upward was a solution, MKR governance has now found itself needing to reduce all costs (to basically zero) to encourage minting of DAI to excessive levels to again break the back of a price above the peg. Thankfully, since the multi-collateral DAI launch, governance on-boarded stablecoins that can help provide market support for the peg during these turbulent times.
Still, using stablecoins is only a temporary patch. Even stablecoins have an upper issuance limit (when, of course, DAI has no limit) and have other properties that do not make them long-term ideal solutions.
If we view the pressure between two bodies of water (think of a dam), we are now rapidly experiencing the time when that pressure is approaching a maximum sustainable amount. Further, the water level on one side is slowly rising to what is rapidly approaching critical levels (and we do not want the dam break). We need to implement the equivalent of turbulent waters on one side with a “negative-edge” pool on the other. By doing so, real world assets then absorb the shocks from the system and calm the waters. This happens by allowing the DAI to flow over into capital sinks by basically removing the reflections.
So what can we do?
Currently, virtually all collateral types have almost a negligible cost to mint DAI to increase the amount outstanding. Further, the notion of negative interest rates has also been floated within the community. I personally believe using negative interest rates would be the wrong direction.
I am currently advocating for real-world assets as a collateral add-on within the Maker protocol using a combination of a Delaware Trust and a Revolving credit facility agreement and use an external lender (legal entity) to deploy capital into a specific “pre-approved” forms of collateral with credit quality standing by the deal. Starting with, commercial real-estate (single-tenant Triple / Double Net, credit tenant leases). From my lens, when implemented correctly and safely, real world assets are an absolutely essential “overflow valve” for the community and DAI ecosystem as a whole.
Excluding the tenant selection for Credit Tenant Leases as well as the scope in general, there are three fundamental levers that MKR governance can pull.
- Risk Premium
- Debt Ceiling
- Debt to Equity ratio / equity requirements that must be maintained when closing a deal
For any off-chain Lender, provided there is no material change to the tenants financial health (which absolutely should be reviewed at least annually by risk-teams to ensure all risks are priced correctly), the Risk Premium for the revolving credit facility agreement + trust structure shouldn’t really change more than a few bps here and there. The equity requirement is the shock absorber that allows the cost of capital to be quite inexpensive given the credit quality.
However to change the incentives of the off-chain Lender, the community should fundamentally rely on the other two metrics to encourage or discourage lending behaviors.
- Debt Ceiling - To control the maximum risk and generally ensue the lender doesn’t mint too much DAI too quickly.
- Debt-to-Equity ratio / Equity requirement - No question, the more influential lever will be the revolving credit facility agreement requirement of a certain equity contribution per transaction (It is important to note that in this construct the equity requirement must move first before the DAI facility). As the Lender runs its operations, the “business” of raising capital (ie Preferred Equity) is a necessary and time consuming one. That said, should the community want to encourage the Lender to deploy capital on an accelerated path, the MKR community need only lower the equity requirement per transaction, thus reducing the capital raise burden allowing LendCo to further leverage the existing equity already raised.
Depending on the severity of the peg dislocation (eg 1.01 vs 1.08) and as an example only and if the situation is dire, MKR governance could reduce the equity requirement and simultaneously increase the debt ceiling to allow LendCo to rapidly expand its lending. This would be increased DAI minting that would be sold for USD to cause the needed downward pressure on the DAI price. These levers directly control the motivation and behavior for a Lender and should be used cautiously.
Real world assets can start to be on-boarded in 90d from today if the community rallies behind the notion that this asset class is essential to a healthy balance of uncorrelated asset classes and a community approved capital sink for excess DAI.
As MKR is fundamentally a REPO facility that underwrites / insures a collateral type by minting MKR if needed as the last resort, today MKR is in an uncomfortable position of taking on significant risk without appropriate compensation. When implemented correctly and safely, real world assets (emphasis on Credit Tenant Leases to start) have much less risk than all collateral types on Maker today (and should be priced as such). In doing so, some existing collateral types could then be priced in accordance with their actual risk as real world assets are on-boarded. Where historically this could cause the peg to break upward, with real world assets being used as excess capital-sink, we now will have that escape / overflow valve and an economically motivated party to issue DAI in bulk and keep it in USD while the peg is higher than 1. Further, the Lender is then motivated to repay debt with the peg is lower than 1, thus also becoming a liquidity provider. Credit Tenant Leases present an interesting angle as they look and smell like debt (with credit quality backing the rental stream), but they are treated as real-estate.
It is essential that the first real world asset Lender ensure a clean path to the collateral with liens that are enforceable in a Court of law in the event of a MKR governance decision to liquidate the Vault for that DAI loan. Once off chain, the only recourse MKR has is the law in the jurisdiction that govern the agreements.
Further, it is important the Lender deploy “small bites” of capital and not be too ambitious with its lending operations until it has an established flow (both directions). Of course, situations may dictate otherwise (e.g. the DAI peg is above 1). The higher the peg, the more aggressive the community should encourage and incentivize off-chain lenders to deploy capital using market forces. Further, the MKR community is recommended to use capital sinks that might need to hold that capital for years (or have the Lender continually recycle that capital off-chain). Point being, the credit quality of the underlying asset for off-chain matters. That said, no mass capital deployment of DAI at one time should be deployed until the USD < — > DAI market is more mature and liquid (e.g. the system today can withstand several million DAI market OTC order; however, under no circumstance should the Lender be deploying capital into assets that do not have a robust secondary market or are in bites so large that any liquidation would move the market).
This will change the world?
Yes. Once real world assets as a collateral pack are added to DAI, the blockchain ecosystem will finally have pierced the crypto bubble to the real world with an umbilical connection between them. This means for the first time (and with scale) the efficiencies around crypto (specifically lending) will compete in the real world. In this regard, real world assets are the ultimate layer-2 tech possible for DAI. Period. By competing with real world established players, MKR should maintain a cost advantage compared to its analog peer. Successfully putting together a structure that allows capital to be moved off-chain is the first step to leveraging the efficiencies created by MakerDAO.
Today, yield farming has created a “buzz” that has resulted in unexpected demand for DAI. That said, we do not know how long Yield Farming will last. Regardless, demand is still demand (and that is a wonderful challenge and an unprecedented opportunity to which the community needs to take advantage of the situation).
What to expect.
After real world assets are on-boarded, we should expect a period of “leveling” as excess DAI capital (DAI above 1) will overflow into the real world (this could take months!). From there, MKR governance can incrementally price the risk premiums on existing collateral with risk solely in mind, not monetary policy. Thereafter, the DSR can be increased to allow for true organic core demand for DAI that will compete head-on with global savings rates (with full awareness that most globally are near zero). Those in DeFi will stay in DeFi, but the demand wave of DAI is coming, and we need a capital sink. Urgently!
Real world assets as collateral is a natural progression and a complement to the existing DAI collateral. In many ways, it is an evolved symbiotic relationship, as both truly need the other, even as neither realizes yet.
Can we fix the peg in 90days?
Well, that is a tall order. However the better question is, can we put things in place that use market forces to encourage the behavior of market participants to resolve the peg issue? Absolutely.
Defending the peg to its target reference is the calling. Real world assets are the critical path to do that by being an overflow valve to deploy excess DAI into community-approved risk adjusted capital sinks. As a community, let’s do our homework to ensure any implementations approved are safe and give full protections for MKR holders (e.g. a nuclear liquidation scenario doesn’t leave MKR holding the bag; there must be legal recourse to recover proceeds). Unfortunately, given the market conditions and the trajectory of DAI demand, time is not on our side to deploy this. This needs a fired-up community and engaged to get this across the line.
Let’s Go !!
I am presently advancing a real world assets structure for consideration by the MKR community. Regardless, the points above hold true for any real world assets onboarded correctly and safely.