In-depth analysis of MakerDAO: Can Maker effectively affect market interest rates?

Article translation: Block unicorn

Article translation: Block unicorn

The time we share is precious to me and I will not abuse it. Owning a time machine would just be the most useless reason for me. Betting on the market and getting crazy rich is not one of these reasons, I actually try to ban myself from trading in the present to enjoy the infinite wisdom that comes from being able to look into the future. The truth is, it's impossible to stay calm and focus on small gains if you have that kind of power, and the risk of having someone's asset base explode with the confidence of a full horizon is real. At some point, great power becomes very destructive. You can't control it, it's in every comic book.

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no matter what the cost

On November 2, Maker opened up its direct deposit DAI module (or D3M) on the AAVE v2 money market, with an initial debt ceiling of 10 million DAI. In the eyes of AAVE's borrowers, the D3M vault is nothing more than a semi-transparent additional source of available DAI. However, in the eyes of Maker, it is much more than that.

MakerDAO's governance controls two main parameters when managing D3M:The maximum debt ceiling and the target borrowing rate, the latter should be kept in mind.If the equilibrium borrowing rate observed by AAVE is higher than the target, Maker will mint more DAI and put it on the market to reduce it; if such a rate is instead lower than the target, Maker will redeem liquidity in an attempt to restore it. The similarity to how central banks affect market rates is clear: instead of directly adjusting the rate handle on some dashboard, central banks state clearly what they will do to control rates, which is often enough. By announcing (mandating) a target rate that borrowers should pay, and declaring that they intend to do everything in their power to meet such a pledge, central banks hope to influence expectations so strongly that they don't even have to pull the trigger. In finance or the distribution of money in general.

On July 26, 2012, Mario Draghi made history. His speech as ECB President at the Global Investment Conference in London will forever prove... the power of power. The stability of the entire Eurozone was discussed by various practitioners, sometimes with good intentions and sometimes with malice, when The Man dropped two almost random closing remarks:

But I want to tell you another piece of information.

Within our mandate, the ECB is prepared to do whatever it takes to protect the euro. Believe me, this is enough.

Every word in those two sentences deserves the scrutiny of Dante’s Divine Comedy—excuse my patriotism. Does Maker's D3M have the same impact? Is Maker self-fulfilling when it announces the target interest rate that borrowers should pay when claiming DAI on AAVE? There are two elements that make the achievement of self-actualization a reality: competence and credibility. The market needs to believe that Maker can influence interest rates, but Maker needs to do so effectively. In the medium term, the former is more important than the latter: without the ability to do something effectively, market players will find a crack and look for the jugular.

Can Maker effectively influence market interest rates?AAVE's D3M debt ceiling was initially set at 10 million DAI, which was increased to 50 million DAI a week ago, out of a total lending market of 1.74 billion DAI - or < 3%. Nonetheless, the observed variable borrowing rate (APY) is currently at 3.99%, which is right at Maker's target level. Could Maker have such a powerful impact on interest rates, even with a small footprint? As expected, the answer is no. AAVE's interest rates are not set by market forces, as happens in the world of animal spirits, but rather are parameterized and manage liquidity based on an interest rate curve controlled by AAVE governance risk. The inflection point of this curve is exactly at 3.99%.

So, who is deciding the market rate, Maker or AAVE?Such a question is, fundamentally, a question of power. The story has similarities to Jack Ma's Yu'e Bao fund. Launched by Alibaba in 2013 as a retention tool that lets customers keep change in mobile wallets, Yu'e Bao grew into the world's largest money market fund in early 2018. That was before the Chinese government started pressuring the fund and the group as a whole to shrink in size and influence. Such a large pool of funds could create systemic liquidity risk within the monetary system and in effect shift some currency bargaining power from sovereign issuers to intermediaries. The Chinese government doesn't want that. In the case of Maker and AAVE, it could be argued that the latter retains the greatest control over the monetary system. Not only does it rely on DAI, but it is one of the largest liquidity pools in the DAI market. Maker acts as a stabilizer rather than a market maker through D3M. As an asymmetric stabilizer considering the size of the program - with D3M, at least on AAVE it is impossible to take enough liquidity out of the system and affect the rate when it is below the target. Obviously, D3M is also an additional source of profit for the protocol, and a way to further expand the currency's footprint during bull markets. But their ability to maintain a stable footprint during a storm will be limited. At least at this size. As an asymmetric stabilizer considering the size of the program - with D3M, at least on AAVE it is impossible to take enough liquidity out of the system and affect the rate when it is below the target. Obviously, D3M is also an additional source of profit for the protocol, and a way to further expand the currency's footprint during bull markets.

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Where is your DAI?

D3M only tells part of the story, as it is not currently the main channel for minting and distributing DAI for Maker. Of >9b DAI currently outstanding, c. 450 million (or 5%) actually sits in AAVE's v1 and v2 liquidity vaults - more on Compound. The choice between borrowing DAI at its primary source (Maker) or in the secondary market is a choice of opportunity. Even though uneven collateral requirements and liquidation mechanisms make direct comparisons difficult, Maker has the ability to affect the entire currency stack by shaking its foundations, i.e. setting stability rates and other parameters on its collateral vaults.

Both Maker and AAVE are virtual places where someone can ask for money, but a deeper, fundamental difference emerges that will ultimately determine where each protocol sits in the stack. In pure DeFi style, it's about the transparency of composability leading to vertical specialization. When it comes to AAVE vs. Maker, while they may be doing the same thing in the eyes of the end user, how they do it determines their interrelationship. Even in the real world, lending is not a monopoly. In theory you could build an entity with a banking license along the way and have direct access to free central bank liquidity to fund your mortgage and avoid bank spreads, but why would you? There are costs and there are pains. That's why you have commercial banks and money market funds, and that's why you have decentralized liquidity protocols. As part of D3M's risk assessment, Maker's Risk Core department has done a great job outlining the differences between AAVE and Maker - if you have time, you should definitely read it.

Does this mean that Maker is the almighty emperor of its monetary system? There is a trap, and that trap is the peg (anchor). The requirement for DAI to be pegged to the U.S. dollar limits Maker’s ability to fully control its monetary policy. In monetary policy, it's known as the currency trilemma: When you have a fixed exchange rate, it's impossible to have a fully sovereign monetary policy and free-flowing capital markets at the same time. In times of stress, some things need to give way. In the long run, the most common is the nail (anchor) itself.

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Project Real World Sandbox

The story does not stop in the world of smart contracts. We can call it DeFi, blockchain-based finance, value networks, liquidity laws, but one thing should be clear to builders, users, and investors—although the roles are no longer clearly distinct: blockchains are nothing more than an infrastructure layer. As for all the infrastructure, there's a lot of value in what you can build on top of them. From a more practical standpoint, there is no reason why the entire lending and financial intermediation sector should not start migrating to it. Apart from many vested interests, of course.

Project Real-World Sandbox → MakerThe use of DAI has been opened up against off-chain assets, but its efforts have been timid. It may be premature, but times have changed and I believe the day has come to turn Maker's vision into stone and refine all onboarding and management processes. It is for this reason that I have accepted a grant to help usher in the era of the Great Migration.

The extension of Maker to non-blockchain use cases is the ultimate weapon in supporting the sustainable development of DAI, but it also brings a new set of challenges. These challenges raise broader questions about what Maker's role is in the broader monetary and lending system, as reflected in Societe Generale's recent filing and Rune Christensen's call to action in proposing Maker as a sustainable financing engine. It's my opinion (and I've said it many times on DR elsewhere) that Maker's position should not differ too much from that of a central bank in a dollar or euro sovereign system. Rather than profit maximization, Maker aims to achieve sustainable growth in the monetary base and velocity of money, with the goal of being the lender of last resort with the highest collateral quality, leaving the rest of the value chain to attack other parts of the risk spectrum.

Trust is the most important asset → MakerAs a community, the power of being able to mint money at extremely low cost should not be underestimated; this is a testament to the trust the wider DeFi ecosystem has in Maker's governance principles and collateral quality. This trust should not be compromised in any way. I think Maker should focus more on expanding the collateral footprint rather than putting in collateral that generates higher returns. In fact, I think Maker should act as a super senior, programmatic, highest quality collateral (i.e. PD 1Y < 1%) lender in passive partnerships with established and active intermediaries. I also strongly believe that with a clear vision of what Maker wants to do, this appetite will fulfill itself, just like what happens in the modern central banking world.

A multi-level organizational setup → MakerNot a rigid and politicized institution, it's a DAO. DAOs are complex animals whose decisions are made in a less structured way. It takes a while to get used to. Developing an internal process that will help advance Maker's role as a top lender will be a challenging task. For this reason, we considered a multi-tier setup consisting of multiple control layers with no single point of failure:

1. MKR token holders: retain all executive rights that may or may not be financed through DAI minting.

2. Compliance unit: Codifies and updates the core principles, and controls the controllers (ie the portfolio unit).

3. Portfolio Units: Deal directly with counterparties to try to negotiate the best credit scheme for MKR token holders to vote.

4. Legal Support Department: Act as the DAO's internal legal counsel, hire external counsel and review documents.

5. Maker community: constantly challenge and provide opinions.

The Future of Decentralized Onboarding →It is not impossible to decentralize some or most of the analytics functions to parties outside the DAO. Such external underwriters may place MKR tokens as on-chain security or first loss capital in support of their formal endorsement of credit applications. While decision-making power will remain in the hands of MKR holders, the advisory underwriting process may also be pushed outside.

Financial Manifesto for the Real World →The credit process described above must remain stable without becoming onerous or cumbersome. Such a framework should attract increasingly high-quality intermediaries that are ready to go through the approval process to broker large flows of funds, while remaining flexible and less punitive in terms of requirements, rigidity and waiting times. All of the above core principles should be clearly defined and maintained in a manifesto that should be voted on-chain. However, such a declaration should not become a comprehensive civil code, but should be intended to serve as a constitutional declaration for the common law legal system. As with every common law system, judicial precedent (in this case applications granted or denied) will serve as Maker's evolving code of conduct.

Maker is the strongest ramp for institutions willing to enter DeFi

Many might argue that it is a waste of time to develop a mental model of how the bridge between TradFi and DeFi would work, especially when real-world assets represent only a small fraction of Maker's total exposure. I disagree. strong.

First, I don't like the real-world definition because several of the more complex funding use cases should be handled with a similar level of scrutiny, even if those use cases themselves exist on-chain. More structured use cases, from inside or outside the blockchain infrastructure, could significantly reduce the correlation issues that affect Maker and other cryptocurrency lenders and limit their scalability.

Second, I believe that a strong mental model can serve as a strong roadmap to translate some of the frameworks that exist in the field of legal contracts directly into the framework of smart contracts. It can save us a lot of time and credit loss.

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here's your chance

To me, blockchain is more like a sovereign state than a technology platform. Thanks to its ability to combine the fungibility of information with the inevitability of law enforcement, a large part of the social contract underpinning the modern state could be replicated in blockchain technology. Ethereum or Terra may not be America's version of crypto, but they can definitely be Singapore's or London's version of crypto, trusted centers for the secure exchange of financial value. The race will be to transform into a relevant and diverse country fast enough to outweigh the need to move away from the dollar peg. Adding real-world assets can speed up the process. By bringing in international businesses operating in multiple jurisdictions with multiple sources and uses of capital, DAI can become a truly international commercial currency and be of reference value for globalized industries. I know it's dreaming big, but history tells us that often big may not be big enough.