MakerDAO (MKR) Review

An independent review of MakerDAO (MKR)

Weak liquidity and restrictive system parameters point to further downside for MakerDAO

Company Overview

MakerDAO (Decentralized Autonomous Organization) is headquartered in California and was established in 2015. The main vision is to minimise asset volatility through the creation of its stable coin, DAI, allowing anyone equal access to financial services that includes loan offerings. DAI can only be issued through a Collateralised Debt Position (CDP), where ETH is locked up as collateral via a smart contract, in return for a stability fee. In short, a user could collateralise an asset to borrow in DAI.

MakerDAO’s (Maker) token, MKR, on the other hand, is both a utility and governance token, where the former is required to pay fees for using the platform, and the latter entitles holders to vote on certain changes to the system such as stability fees, the debt ceiling, etc. Maker’s structure is touted as one of the most well-thought concepts backed by sound game theory dynamics, which result in DAI being distinctly different from other stable coins as it is truly decentralised and not backed by physical USD stored in a bank account. We further explain several features below:

•MKR - The primary token governing DAI’s ecosystem. Tokens are burnt with interests and fees awarded from debt issuance, thus increasing the value of MKR

•DAI – Maker’s stable coin pegged to 1 USD

•Collateralized Debt Position (CDP) – The locked-up collateral needed to issue DAI. The collateral amount is fixed at 150% of the loan amount (i.e. for every $1 borrowed, $1.50 of collateral is required)

•Stability Fee – The fee needed to pay down the debt to close a CDP. It was recently revised from 0.5% to 2.5% in Aug 2018

•Debt Ceiling – The maximum amount of debt that can be created by a single collateral CDP

•Self-stabilising mechanism – Market forces by arbitrageurs will stabilise

DAI prices by maintaining the peg (i.e. DAI holders will sell if the price is above peg or buy when the price is below the peg). Also, a Global Settlement process is implemented as a last resort to shut down the system and unwind outstanding CDPs in the event of an emergency

Currently, the system is running on a single-collateral DAI. However, the team will be pushing out multi-collateral DAI, allowing more assets to be collateralised in the near future.

Thematic Views

Weaknesses in current stabilisation mechanisms – One key factor that to maintain DAI’s peg to the USD is Maker’s notion of stabilisation mechanisms. The nature of Maker’s structure does not allow 1 DAI to be redeemable for $1 unlike Circle’s USDC and True USD, where a user can always redeem one token for $1 from their platforms since the collateral that backs it is in USD instead of ETH. Therefore, Maker has to rely on other stabilising mechanisms derived from general market forces combined with economic theories on supply and demand to maintain the peg. We lay out several mechanisms and its weaknesses that add to MKR’s price volatility in the market.

•Global Settlement - The option to shut down the system in a black-swan event. This is triggered by global settlers who are elected representative of the platform. If an imminent crash happens, which tend to be fast and big, it will be difficult for the system to buy back outstanding DAI quickly to prevent the platform from becoming under-collateralised. Furthermore, it is unknown if settlers could detect irrationality in the markets quickly enough to act on such events. Hence, the intended effect of deterrence in this mechanism is weaker than what it should be.

•Self-stabilising mechanism by arbitrageurs - This mechanism requires market forces to bring the price back to the peg, which is highly dependent on the

rationality of users. For example, if a user thinks that DAI could go to $1.50 in the future, they will have no incentive to open a CDP to issue and sell DAI even if the market price is $1.25. Eventually, this could add to the volatility rather than reducing it. Furthermore, without the redeemable function as mentioned above, this mechanism will have a lesser effect on the overall stability of the ecosystem.

Limited scalability of DAI as a stable coin – There are a couple of parameters within the system that currently limits the scalability of DAI. The first one would be the current debt ceiling of 100m implemented within the system. Even though the debt ceiling is created to minimise downside risk, it sacrifices scalability. In comparison, the overall market cap of major stable coins currently sits at $2.6b, which is far from DAI’s overall market value of $57m. Our analysts do not foresee the debt ceiling to increase to $1b in the near future, as the system is unable to assume the substantial downside risks that necessitate stability. Secondly, for DAI to be issued, a CDP has to be opened by a user with backed collateral. There is little or no incentive for users to open CDP aside from the arbitrage opportunities mentioned earlier. Hence, the CDP market relies heavily on and is skewed to borrowers, which currently does not justify a $1b loan issuance market to support the stable currency. Furthermore, the competitive environment in the lending space with increases Maker’s difficulty in acquiring market share. Therefore, the restrictions to scalability deflate the value attributable to MKR tokens, and in turn its price.

Low trading volume of MKR increases liquidity risk – Maker currently sits comfortably in the top 30 coins ranked by market cap. However, its 24hr trading volume of $0.23m pales greatly from an average of $407m between the 30 coins. MKR’s trading volume is one-third that of their closest competitor, SALT. The lack of trading volume translates into substantial liquidity and systematic risks for MKR holders, as they might incur a substantial loss in transaction value when they liquidate or enter into positions. Hence, investors need to be compensated for holding this additional risk. In some instance, illiquidity could cost investors 20% of the token price, and it is important to note that illiquidity increase during bear markets, which is further exacerbated in a black swan event where MKR is liquidated to cover losses.

Competitor Analysis

Maker’s competitors appear on two fronts, the stable coin market and lending sector. Amongst the stable coins, Maker’s DAI has the widest price range and highest annualised volatility at 22.5%. Having initiated in 2017, DAI has lost traction against its competitors, such as TrueUSD, Circle’s USD Coin, which began in 2018. Even though it has a truly decentralise mechanism, it lacks the direct redeemability feature to 1 USD. A comparison chart with more details is shown below.

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