Image credit: Marvel Studios/Disney
Among crypto protocols, MakerDAO generates the 4th highest fees (after only Bitcoin, Ethereum, and Uniswap). Despite that, MKR, its governance token, has a market cap of a mere US$1.8bn making it the 46th largest protocol by market cap.
MKR has a narrative problem. If the market can be convinced to look more favorably towards the protocol, it will enjoy a higher P/E ratio, raising MKR price without increasing revenues or profitability. In this note, you’ll learn of several initiatives designed to get investors more excited about Maker so they’re willing to give it a higher P/E.
What is Maker Protocol?
Maker Protocol is a 2-token, decentralized stablecoin project, where MKR is the Governance Token and Dai is the crypto-collateralized Stablecoin pegged to the US$.
How does it work?
When you take a loan from a bank, you deposit collateral (say an apartment) and receive money (US$ or any other fiat currency) in your bank account. When you return the loan amount, you get your apartment back.
Maker works similarly. You deposit collateral (cryptocurrencies) and receive a loan in the form of Dai (US$ pegged stablecoin). When you return the Dai, you get your cryptocurrencies back.
Note that the money you receive in both loans, US$ in the bank loan and Dai in the Maker loan, is literally created out of thin air. That money doesn’t exist before you take the loan.
The difference between the two is that fiat loans are managed by banks while Dai loans are executed automatically through smart contracts on the blockchain.
How is peg stability maintained?
Loans denominated in US$ enjoy high demand because US$ is among the most reliable fiat currencies in the world. To ensure that loans issued in Dai also have high demand, the 1:1peg to US$ must be reliably maintained. The protocol has several levers to ensure peg stability.
Over-Collateralization — For every 1 Dai loan, one must deposit more than 1 US$ of collateral. The more volatile the collateral, the higher the over-collateralization ratio.Automatic Liquidation — If the collateral value falls and is not topped up in time, smart contracts automatically sell the collateral to cover the loan.Dai Savings Rate (DSR) — Any spare Dai that users are not immediately applying to a use case can be deposited within Maker to earn a DSR. If the Dai value is falling, the DSR can be raised to increase Dai demand and vice versa.Stability Fees — Maker charges interest called Stability Fees on Dai loans. This fee can be adjusted to manipulate Dai’s supply. If Dai trades below $1, the protocol will raise the Stability Fee to disincentivize users from borrowing and creating Dai. This will result in reducing Dai’s supply and push the price back up to its $1 peg. If Dai trades above $1, the protocol will lower Stability Fees to incentivize more borrowing and Dai creation. This will increase Dai’s supply pushing the price back down to its $1 peg.Dai Direct Deposit Module (D3M) — It isn’t sufficient to control the Stability fees. The market borrow rate of Dai should also be in line with the Stability Fees. Otherwise, borrowers can borrow Dai at a rate different from the Stability fees through lending protocols like Aave and Compound. The borrowing rate in these lending protocols is a function of Dai liquidity in these protocols. The borrowing rate is high if there’s too little Dai available to borrow and vice versa. The D3M mints Dai and deposits them in Aave or Compound (in exchange for aDai and cDai tokens) if the borrow rate is higher than the target borrow rate, and withdraws Dai from Aave and Compound if the borrow rate is lower than the target borrow rate. (This mechanism looks like financial chicanery given the circular logic that Dai is backed by aDai and aDai is backed by Dai)Peg Stability Mechanism (PSM) — PSM is a special vault through which users can swap Dai for USD-pegged stablecoins like USDC and vice-versa at a 1:1 ratio. Traders using this mechanism in volatile markets bring prices back in line. If Dai de-pegs to the downside, arbitrageurs buy Dai in the market for say $0.97, swap it for USDC at $1 through the PSM, and lock in a profit of 3 cents. If Dai de-pegs to the upside, arbitrageurs swap USDC for Dai through the PSM, sell Dai in the market for say $1.03, and pocket the 3 cents profit.Surplus Buffer — MakerDAO sets aside some of its revenues to build a Surplus Buffer that can be utilized for stabilization purposes when required. For example, in volatile markets when liquidations cannot be executed on time and Vault values fall below the outstanding Dai loan amounts, it can be used to cover the difference.
Blockchain-Native Stablecoin
Using the above model, Dai firmly established itself as the largest blockchain-native, crypto-collateralized stablecoin.
Fiat-collateralized stablecoins like USDC and USDT are run by centralized institutions susceptible to censorship, and hold reserve assets off-chain that require attestation by trusted auditors. Maker is less susceptible to censorship and full information on reserve assets was publicly available on-chain at any time, thus removing the need for auditors.
Real-World Assets to address scalability challenges
Dai has proved itself a reliable stablecoin that historically maintained the peg to US$ remarkably well. It however found itself unable to scale beyond a point. At the time of writing, it has a market cap of just over US$5bn. The main reason is that there are limited high-quality crypto assets available to offer as collateral to create Dai.
To gain scale, MakerDAO decided to accept Real World Assets (RWAs) as collateral. The total crypto market cap is $2.4 trillion. This is minuscule compared to US Treasuries ($27 trillion), US Money Market Funds ($6.4 trillion), US Bond Market ($51 trillion), Global Bond Market ($126 trillion), and Global Equities Markets ($126 trillion). The amount of Dai that can be minted therefore can increase exponentially.
During the Gold standard when money had to be backed by gold, only a limited quantity of money could be printed. Later when money was allowed to be backed by treasuries, HQLAs, education, property etc, the supply of money increased.
Today, MakerDAO has exposure to short-term US Treasuries and Private debt.
RWAs brought several positives:
Scalability — This was introduced around the time of crypto winter when the value of crypto collateral had fallen dramatically. Without RWAs, Dai’s market cap would have dropped even more.New revenue stream — Unlike USDC, RWAs bear yield which is deposited into the protocol and contributes to the Stability Fees. In May, RWAs contributed 34% of all Stability Fees generated.Protocol resilience — In bear markets with high interest rates, the loan composition can have a higher weightage of RWAs. In bull markets with low interest rates, the loan composition can have a higher weightage of crypto.
There are some negatives too:
No longer crypto-native — The move to RWAs is disappointing for those who relied on Dai as a stable crypto asset that isn’t backed by government and tradfi issued paper, cannot be censored, and doesn’t require trusted centralized intermediaries like auditors.Limitations of traditional financial infrastructure — Maker now relies on legacy financial infra and traditional market operating hours for minting and redemption which unlike crypto is not real-time. It remains to be seen if Maker can keep the risk of a bank run at bay if redemptions cannot be processed in minutes. One would think that any de-peg will be corrected as arbitrageurs jump in knowing that the token will re-peg once collateral assets like T-Bills are sold.In the past, Maker only had to worry about solvency but now it’ll also have to worry about liquidity.
So what’s next for Maker?
Despite expanding to RWAs, Dai still hasn’t been able to scale to the size of leading fiat-collateralised stablecoins. Slow and steady growth is good but money benefits from network effects.
Metcalfe’s law says that the value of a telecom network is proportional to the square of the connected users. This should be as true for monetary networks.
Endgame
Maker is embarking on a major re-haul that will bring a new brand, a new stablecoin, a new governance token, a new website, a new app, and a dramatic change in governance architecture. This re-haul is called “Endgame”. Maker may not be recovering from a catastrophic “Infinity War” but there’s a clear sense of urgency to avoid a calamity.
“Endgame” will see Maker transition from a conservative Central Bank to an Early-Stage Venture Fund incubating new protocols.
It’ll continue to issue Dai backed by collateral, both crypto and RWAs. But now, it’ll incorporate an added incentive to hold Dai and MKR by dangling the carrot of tokens in the SubDAOs it incubates.
First, let’s start with the easy fixes recommended in Endgame.
Rebranding — DAI and Maker are horrible names for a stablecoin and Defi protocol. The former sounds like Death and the latter is confusing invoking images of Homemakers, Troublemakers, and Pacemakers. Endgame will introduce new branding.NewStableToken and NewGovToken — The protocol will launch a NewStableToken (NST) and NewGovToken (NGT). Old and new tokens will be easily exchangeable. 1MKR will be equal to 24,000 NGT. I suspect that the team would prefer to have only 1 set of tokens but is not phasing out old tokens to avoid stress to current users holding Dai and MKR. To me, new tokens are an unnecessary complication. Rebranding would have been sufficient.New Website and Apps– The protocol will launch a more user-friendly website and app and simplify access to DSR and token farming.Launch on L2s and deployment of own L1 — MakerDAO will launch on L2s (Arbitrum, Optimism, Base), and Solana, and eventually deploy on a standalone L1 of its own.
5. SubDAOs — The most important change proposed in Endgame
Philosophically, crypto believes in decentralization. However, decentralization is difficult to implement in practice. When many people are involved, decision-making slows down. Maker found itself in exactly such a situation. The DAO structure was paralyzing decision making and important proposals were getting rejected. Endgame proposes simplifying decisions taken at the center and moving the more innovative and risky decisions to the edges.
MakerDAO will be reorganized into a series of SubDAOs, autonomous organizations with their own tokens and workforce. Maker will focus on governance and Dai distribution, and not take business decisions directly. Business decisions will be taken by the SubDAOs. SubDAOs will be more flexible and innovative while being aligned to Maker through a tailored incentive structure.
Maker will thus be similar to Early-Stage Investment firms that incubate new protocols. In addition to capital, it will guide its portfolio of companies through operational and legal support, and access to talent, infrastructure, and network.
Spark — The first SubDAO launched is Spark, Maker’s money market protocol. Spark does everything that Maker Protocol currently does, and more. In addition to Dai loans backed by crypto-collateral (similar to Maker Protocol), it also offers loans in other tokens (similar to Aave). Spark also accepts Real-World Assets as collateral.
MKR Tokenomics
So far, value has accrued to MKR holders from (a) Interest on DAI lending, (b) revenues from Vault liquidations, and © Supply reduction with the burning of MKR using surplus capital. This model will change dramatically.
Sagittarius Engine — Endgame introduces the Sagittarius Lock-State Engine, a new feature to incentivize long-term holding of NGT (MKR). Holders who lock NGT (MKR) in the Sagittarius Engine will receive:
30% of all surplus income generated by Maker Protocol30% of SubDAO tokens earmarked for yield-farming. The 1st SubDAO token is Spark’s SPK.
SubDAO Tokens — SubDAOs will issue tokens. While the exact issuance structure cannot be known for all future tokens, Spark’s SPK serves as a good template.
Spark will yield 4bn SPK tokens over 10 years as per the below schedule:
In Year 1, of the 1 bn tokens, 700 mn will be distributed to NST (Dai) holders and 300 mn tokens to users who lock NGT (MKR) in the Sagittarius Engine.
Indulging in some back-of-the-envelope calculations- If 5 SubDAO tokens are launched and each reaches a market cap of US$ 1 bn, that adds up to US$ 5 bn. 30% of this (US$ 1.5 bn) will be allocated to MKR locked in the Sagittarius Engine. At the time of writing, the market cap of MKR is US$ 1.8bn. This means that those who lock tokens in the Sagittarius Engine could make ~100% returns just from SubDAO token allocations.
In the longer run, holding MKR tokens will be like owning a stake in a traditional Early Stage Investment Fund. Traditionally, 30–50% of portfolio companies of VC funds completely fail, 30–50% give mediocre returns of 1–3x, and 10–20% are “home runs” giving 10x, 50x, or even 100x returns. If Endgame is successful, the portfolio of SubDAOs it incubates might have a similar return profile.
Withdrawals from the Sagittarius Engine are disincentivized — Withdrawing deposits from it invokes an exit fee of 15% of the deposit principal. This exit fee is burnt.
MKR deposited in the Sagittarius Engine can be used to take out Dai loans. These loans will get liquidated immediately if the collateralization ratio falls below 200% or if the collateralization ratio is below 300% for more than 7 continuous days.
Elixir and SubElixir
Endgame Tokenomics is designed to keep value within the Maker Ecosystem through the use of 2 Liquidity Pool tokens, Elixir and SubElixir:
Elixir — A Uniswap V2 LP token consisting of 50% MKR and 50% DaiSubElixir — A set of Uniswap V2 LP tokens consisting of 50% MKR and 50% particular SubDAO token
Maker Core will emit 2 billion NGT (83k MKR) every year. A portion of this will be distributed among SubDAOs based on Elixir holdings. The higher the amount of Elixir locked, the higher the allocation of newly emitted NGTs (MKRs). SubDAOs are therefore incentivized to hold Elixir, and that increases demand for MKR and DAI.
Newly emitted MKR enters either of the above 2 pools depending on whether the SubDAO token is under-valued or over-valued.
If the SubDAO token is undervalued — Maker Core will accumulate SubElixir tokens. This will create demand for SubDAO tokens and thus increase their price. If the SubDAO tokens do well, Maker Core will benefit in 2 ways. (A) The value of the SubElixir tokens they own will rise and (B) The SubElixir LP will rebalance and increase demand for MKR.If the SubDAO token is overvalued — Maker Core will accumulate Elixir tokens and transfer them to the SubDAO. Accumulating Elixir increases demand for MKR and DAI benefiting the Maker Core.
If the market value of locked Elixir is higher than the market cap of SubDAO tokens, Elixir can be used to burn a small quantity of SubDAO tokens to reduce supply and increase per unit value.
MKR Smart Burn Engine — As of now, surplus Dai held by Maker Core is used to purchase MKR tokens which are burnt. With Endgame, when Maker Core’s surplus exceeds 50 million Dai, the surplus will be used to swap Dai for MKR in the Elixir pool. The MKR bought this way will then be burnt. This will ideally be done when MKR is trading below fair price.
The final effect of the above is:
Dai Demand and Tokenomics
Dai supply is created when someone borrows them into existence. But once Dai has been created, what would someone do with it? Demand for DAI comes from:
SubDAO token farming — SubDAO tokens will be allocated to those who hold Dai. If 5 SubDAOs are launched and reach a market cap of $1bn each, that adds up to $5bn of total market cap. 70% of this (US$ 3.5bn) will be distributed among Dai farmers. With Dai currently at a market cap of a little over US$ 5bn, that is a return of 70% if the entire Dai supply is allocated to farming SubDAO tokens.SubDAOs create demand for DAI — SubDAOs receive a share of MKR emissions based on their Elixir holdings. The creation of Elixir tokens creates demand for both MKR and Dai.Dai Savings Rate (DSR) — Those wanting to earn DSR returns will hold Dai.Arbitrage — Arbitrageurs can make money by trading Dai when it deviates from the peg.
Concerns
I can’t help but think that Endgame is “Clever” rather than “Innovative”. Instead of having to do the hard job of running a useful protocol, Maker will pivot to a model of distributing capital to new teams that will do the hard job of building useful protocols.
Sustaining interest in NGT (MKR) and NST (Dai) — If the reason to hold NGT (MKR) and NST (Dai) is SubDAO token farming, then a regular supply of promising SubDAOs will be required. SubDAO token emissions are front-loaded. In each of the 1st and 2nd years, a SubDAO will emit 8x the tokens it emits between the 7th and 10th years each. Once most of the tokens have been farmed, sophisticated farmers might lose interest and leave the Maker Ecosystem for more attractive token farming opportunities. In short, token farming does not give you sticky customers.
Few SubDAOs will be successful — Much is being said about Spark’s success. Note that Spark is essentially a combination of Maker’s and Aave’s proven models. Building a crypto protocol is hard as is clear from the fact that only a handful of successful protocols currently exist, and Spark is a combination of 2 of them. It is over-optimistic to believe that Spark’s success will be replicated by a majority of future SubDAOs.
Is Dai Stability not a priority? An excerpt from Maker Endgame Documentation says that “Maker Governance may now opt to interrupt the automatic use of MKR as a backstop for Dai value in the event of bad debt in the Maker Protocol. Instead, Maker Governance may choose to modify Dai’s Target Price”. What this means is that in the past, MKR was used to stabilize Dai. This practice may be stopped and Dai’s peg to US$ will no longer be sacrosanct.
=> In my opinion, nothing within the Maker ecosystem will have any value if Dai’s 1:1 peg to the US$ breaks.
Doubts regarding sustaining Dai Demand — When analyzing Dai use cases, one can criticize it for excess financialization i.e. there aren’t enough real use cases that would create sustainable, long-term demand. It hasn’t been integrated into as many L2s, it isn’t as accessible in exchanges, there are no token pairs denominated in Dai in DeFi or CeFi, it is not being used for real-world purchases, it hasn’t been integrated into payment products like Paypal and Credit Cards.
Riskier model — When SubDAOs borrow from Maker, as long as they’re borrowing against quality collateral and safe collateralization ratios, it should be fine. But if borrowing terms are relaxed where say Dai is issued against SubDAO tokens and the SubDAO business is in trouble, a bad debt could start a contagion that impacts the entire ecosystem. One will already be able to borrow Dai against MKR in the Sagittarius Engine. This itself could have implications for MKR and Dai’s stability.
Conclusion
In conclusion, I want to make two points:
Governments and Central Banks working on stablecoin regulation insist that stablecoins maintain the 1:1 peg to the underlying fiat, at all times. This is essential for monetary stability and consumer protection. Endgame will make Dai issuance more risky and one can expect more frequent peg slippage, both to the upside and downside. Slippage means Dai is less useful for payments and less acceptable to regulators. This however does not mean that it is not useful. It simply means that it is useful to a different target segment. The ideal target segment for Dai is traders and speculators.Warren Buffet has often spoken about how capital allocation is a significant part of a CEO’s job and newly appointed CEOs have no experience in this task. If Maker climbs this steep learning curve in identifying good teams and enabling them to build sustainable businesses, Endgame “could” be a big success.
MakerDAO’s journey from “Central Bank” to “Early Stage Investor” was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.