# 2 | MakerDAO Deep Dive: Is Anybody in DeFi Thinking About Credit Risk?
Simple answer: that person should be you
This is another issue of Dirt Roads. No financial reports or marketing material dress downs, no investment advice, just deep reflections on the important stuff happening at the back end of banking. The time you dedicate to read, think, and share, is precious to me, I won’t make abuse of it.
MakerDAO: Decentralising Fractional Banking
MakerDAO was born in 2014 as a Decentralised Autonomous Organisation (DAO). Based on the Ethereum blockchain, it simply enabled users to create (crypto)currency. MakerDAO, or more simply Maker, had the undeniable merit to try to revolutionise fractional banking. With more than 5b of USD-equivalent tokens outstanding in the form of Dai (Maker’s USD-pegged stablecoin) Maker is so far the most successful experiment in decentralising (part of) the job of a traditional banks.
The post below is intended as a deep dive on credit risk in the context of DeFi:
Let’s Talk Risk —protocol mechanism and high level scenario analysis
And So What —link between credit risk and valuation
Who Cares — actors and incentives
Let’s Talk Risk
In a piece on MakerDAO and decentralised banking I have argued that an investor in the MKR token (i.e. the token entitled to governance and implicit financial rights over the protocol) runs a few risks: protocol risk, credit risk, currency stability risk, and regulatory risk.
Let’s assume that the protocol, and the underlying technologies it relies on, works as expected, that the Dai stablecoin succeeds in maintaining the soft-peg with the dollar, and that the FED and other regulators don’t mind. That’s a big assumption, but it is helpful in letting us focus on one single element of the equation at the time. What remains is credit risk, i.e. the risk that one or more of the collaterals used as guarantee to issue deposits in Dai would see their value significantly reduced. How resilient is the Maker protocol to sustain a shock in the value of those collaterals? What are the underlying support mechanisms put in place by its governance structure? And how did Maker behave during its short lifespan?
Investopedia definition of credit risk → “Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection.”
MakerDAO take on credit risk → “[…] Traditionally, this would be a credit risk premium attached to the borrower’s credit quality but in this system, the credit risk is shifted entirely to the collateral. The traditional method would have a liquidity preference fee, which creates a higher compensation for more extended loans. In the MakerDAO system, this does not apply because loans facilities are open-ended. To summarize, the credit stability fee simplistically can be seen as the sum of the inflation rate, operational cost premium, and credit insurance premium.”
How Does Maker Work: the Base Case
A vault is created by locking authorised collateral in a smart contract. The collateral-to-debt ratio remains above the liquidation ratio until the full debt (in Dai) is repaid (including a stability fee), unlocking the collateral and emptying the vault. The stability fee flows into a surplus fund and all is good. If the surplus fund exceeds the target size, a surplus auction is triggered to buy and burn MKR tokens (something similar to a buyback of shares).
How many MKR tokens are around? The supply of MKR tokens was initially set at 1 million. After circa 1 year, the protocol started to burn MKR (meaning accrued fees exceeded the target surplus). In March 2020, however, the protocol had to resort to debt auctions (see below) to face the fall in collateral value and support the Dai peg; newly minted tokens exceeded by c. 6k those burned until that time, a dilution of c. 2% — since then, MKR has gone back to burn tokens and has resisted well to the turmoil of April and May 2021. Currently, MKR tokens out of circulation amount to c. 9k (what was burned), plus 84k (treasury tokens gifted to the protocol by the dissolving foundation).
The Liquidation Case
A vault is created by locking authorised collateral. The collateral-to-debt ratio falls below the liquidation ratio, triggering a collateral auction, attempting to sell the minimum amount of collateral needed to cover the outstanding debt (including a stability fee and a liquidation penalty). If this is achieved, the vault is emptied.
In the example below, a BAL (Balancer) vault was liquidated. Thanks to over-collateralisation (Maker’s first line of defence), only 68% of the tokens had to be liquidated to cover debt and penalty. The liquidation price was USD 21.14, meaning that the vault owner was forced to crystallise the price drop on two thirds of its exposure — but the lender position was protected and Maker made money. The auction lasted 45 minutes.
In case the proceeds from the collateral auction are insufficient, the surplus fund is drawn to fill the gap. In case the surplus fund is also insufficient, a debt auction is triggered to sell newly minted MKR tokens (something similar to a rights issue) and fill the gap — these are the liquidation expenses we see in the chart below.
Putting it in old school banking analyst terms, along its life the Maker protocol made extraordinary (beyond what required by its own governance to run the business) profits, and distributed those to existing MKR token holders in the form of token burning. Even considering the impact of March 2020, Maker’s risk policy held pretty well through standard turbulence.
The Token Blowup/ Total Devastation Case
Maker’s history, however, is short-lived and, as usual, it is all good until it’s not.
At the time of writing, Maker aimed to keep a surplus of c. 46m — expenses are paid out of the surplus, and additional collected fees are used to burn MKR tokens as explained above. Maker’s top collateral exposure, USDC, was 2.8b (with 4.0b already authorised). Second exposure in size was ETH with 1.3b, BTC exposure was 230m.
Indirect exposure to single counterparts’s risks (operating, protocol, regulatory risk) is therefore huge, and structurally under-provisioned. Maker’s surplus fund would be wiped out 30 times over in case one of those tokens is put out of business. Effectively, the fund wouldn’t cover any of the top 5 collateral exposures. I will not list here the number of crypto-tokens historically gone out of business, but we are in the thousands. Auctions, however, are executed within the hour in normal market condition; with few and standardised exposure vs. on-chain collaterals, as well as programmatic credit recovery, the notion of credit risk blends with those of market volatility and liquidity.
The question therefore becomes: what would happen to the MKR token if one of its biggest collateral exposures would entirely go out of business? MKR token market cap is currently USD 2.4b, close to the protocol’s exposure to Coinbase USDC stablecoin. USDC blowup would require, assuming unrealistically that there’s no further turbulence in the market, a full recapitalisation of the protocol and dilution of token holders. It is true that credit risk underlying stablecoins like USDC is very low, but concentration and counterparty risk must be taken into account. From Maker’s website (emphasis is mine):
“The event of a Collateral asset losing all value is considered a Black Swan, which is defined as unprecedented, unexpected, and catastrophic. This makes it very difficult to predict the likelihood and severity of existential threats to the system. There is no guarantee that MKR Dilution will always be sufficient.
MKR Dilution can recapitalize the system to a certain limit. The severity of the situation is important to consider. If the severity of the situation is high enough, then it may be viable for MKR holders to execute an Emergency Shutdown which would result in Dai being a pro-rata claim on the Maker Protocols Collateral portfolio.”
That’s a proper blowup. Things will be different when Maker’s exposure will be less concentrated along a list of token exposures, but the protocol needs to get there first. As things stand today, it would be fair to say that Maker does not have a credit risk policy at all, and that the surplus fund is merely functional to keep Dai stability and smooth operations. Its success, like that of the whole DeFi industry and that of many other innovations, will be path dependent.
And So What?
Maker has no shock absorption capacity. By design. Maker protocol’s book value of equity is currently 40.3m. This amount represents the surplus fund (38.6m) plus some kind of operating capital. Maker doesn’t have, very differently from a traditional bank, any concept of regulatory equity capital to sustain unexpected extraordinary losses — the Common Equity Tier 1 capital for banks analysts out there. In this, decentralised banking is very different from traditional banking: its proposition is to rely on MKR token holders as lenders of last resort in the same way banks do with their shareholders and, ultimately, with the central bank. At current prices, MKR token valuation sits at a 60x price-to-book ratio, an irrelevant number.
But Maker is valued for profitability and growth, and it’s delivering both. Maker’s earnings, on the other side, are projected at c. 100m for 2021 — although that number swings by a lot, and at current prices that’s a 23x price-to-earnings ratio, which doesn’t seem outrageous when we are dealing with its YoY growth and profitability — 2021 perspective profits are 30x (not %!) of 2021’s beginning equity book value, and 4.5% earning ratio vs. the current market prices. This is not a post dedicated to valuation, but this order of magnitude must be highlighted.
This post is about risk, not valuation, and we should stick to it. But here’s my take on the link between risk and valuation. Thanks to the massive operating leverage guaranteed by the protocol (costs are negligible at 800k a year — try to compare it to the cost-to-income ratio of a bank) and to an ultra-thin equity base to cover unexpected losses, Maker shows spectacular profitability even in a phase of explosive growth. But it is all good, until it’s not. Maker’s current credit risk and provisioning policy is in no way ready to sustain existential threats to any of its underlying collateral exposures. A bet on MKR, in other words, is a levered bet on one of its top 10 token exposures. Investors in the MKR token should take this in consideration.
Who Cares?
DeFi is not for everyone. Most people want to sleep well with the often excessive trust on a system that is protecting them and their belongings. This is not what DeFi and Maker are promising.
MKR token holders bear ultimate governance responsibility. As we describe above, Maker doesn’t have a credit risk policy; as a MKR token holder you should be the one doing the math. And rightly so, MKR token holders are the central pillar of protocol governance, they should be incentivised to stay involved and guarantee protocol sustainability and efficiency — that’s why they should get compensated
Dai holders have ultimate trust in MKR token holders. So far there is no external regulator guaranteeing stability of the Dai, trusting the Dai peg means trusting that Maker, and ultimately MKR holders, will do a good job. That’s why lending Dai yields 2.45% on protocols like Compound, while lending USD yields zero — the FED is still a more trustable counterparty
Vault owners are short volatility. Vault owners can use their tokens as collateral in exchange for a stability fee but offer at the same time a backstop to volatility. A sudden drop in the value of the collateral would trigger immediate liquidation and force the vault owner to crystallise a loss. Over-collateralisation mitigates also this phenomenon, but in a market as volatile as crypto it might not a good position to be in
Incentives among those actors are aligned:
MKR token holders want (1) the Maker protocol to remain in existence, (2) to maximise token value through deflation — i.e. token burning using protocol profits, (3) while reducing risk of dilution — i.e. risk of having to mint fresh MKR tokens in order to cover extraordinary losses
Dai holders are passive users of the protocol, they just want the Dai (and therefore Maker) to remain in existence — their incentives are aligned with those of MKR token holders
Vault owners want to access as much Dai as possible at good rates — in line with the profit maximisation incentive of MKR token holders, but at the same time don’t want to crystallise drops in collateral value — in line with MKR token holders’ intention to reduce risk of dilution
All agents know they are running a risk that is proportionally higher than what they would run in the traditional financial system, but the promise of extraordinary efficiency and returns, together with an innate attraction for innovation, seem to more than compensate this additional risk.
We will keep watching.