[DeFi] Masterclass on Collateralized Debt Protocols, Part 2: MakerDAO v2
In this article, I will talk about the current version of MarkerDAO, how it has improved over-time, but also where it should do better.
This article is the part of a series containing the following articles:
- MakerDAO v1
- MakerDAO v2
- Alchemix
Abstract
The current version of MakerDAO includes significant improvements from the original design:
- using yield bearing tokens as collateral
- adjusting the lending fees based on the leverage taken
- staking DAI to get the yield from short-term T-Bills
- using MKR to stabilize the system
But there still some shortcomings with the protocol:
- crazy high fees
- dynamic lending rate adjustment
Let’s talk about MakerDAO in-depth !
Maker DAO v2
This new version of MakerDAO is bringing new collateral types, such as WBTC, which both brings more opportunities for users, but also reduces the systemic risk by diversifying the underlying assets backing the whole system.
The most interesting type of collateral they introduced, are yield bearing token, which are most complex, but where the amount of underlying asset being collateralized should increase over-time.
For example, WSTEH is a Liquid Staking Derivative (LSD) currently yielding 3.5% APY on ETH, by using it as collateral, you would be able to offset the totality or a part of the borrowing fees.
This compounding effect can be extremely powerful and greatly increase capital efficiency of DeFi users. That’s why CDPs should focus on offering the best type of collateral if they want to reduce the competing on driving down the borrowing fees.
Leverage & Risk Management
The next feature improves risk management by offering users different strategies for the same collateral.
The WSTETH-A Vault offers a 150% liquidation ratio and a 5.25% stability fee, while the WSTETH-B Vault offers a 175% liquidation ratio and a 5% stability fee.
The user is offered a trade-off, use less leverage and pay less fees, or choose for a more aggressive strategy and pay more fees. This is a smart way for the protocol to adjust the fees with the risk taken.
Stability Fees
This topic is very important, and let’s be honest, the 5% rate seen before is just outrageous. The rate is too damn high !
Let’s see what the documentation says, and how they justify it:
The Stability Fee parameter is an annual percentage fee charged on the DAI generated on vaults.
Ok, fair ! You use a service, you pay for the service.
Each vault type has its own Stability Fee that can be adjusted by Maker Governance.
Here we have 2 information:
- Each vault type has its own Stability Fee, as seen before, the rate will be adjusted based on the collateral and the leverage offered.
- The Stability Fee can be adjusted by Maker Governance: basically, the rate is set by MKR holders
The primary purpose of the Stability Fee parameter is to compensate the Maker Protocol for the risk it takes being exposed to changes in the price of the collateral used to back the generated DAI.
Exactly, the rate should be proportional to the risk taken by accepting the collateral ! So why are they charging 5% on ETH, with a liquidation ratio of 175% ?
MKR holders are incentivized to extract the maximum value from users, and in practice, the increase of the stability fee did not have a significant impact on MakerDAO’s market share, as we did not see a massive migration of users to any competitors.
In my opinion, charging 5% on money you can print for free is just insane ! Maybe MakerDAO is able to charge this much because the demand for DAI is still very strong thanks to the DSR, but I don’t think it will last, and I am convinced that it will be detrimental for the future of the protocol.
Do we really think that DeFi will revolutionize Finance by charging 5% to print basically free money ? Nope, I don’t think so !
Dynamic Fees Adjustment
Dynamically adjusting the lending rate is terrible in term of user experience.
Long term users usually open a position and keep it running for years possibly, without having to check the position, only checking the price of the collateral and assume the position should still be healthy.
If the DAO decides to unilaterally crank up the lending rate, there no way to make sure all users are aware, there is nothing like sending an email to an address !
The unsuspecting users would assume business as usual, while being ripped off by outrageous fees, while if he knew about it, he would have had the chance to reconsider if the new rate fits with his strategy and potentially close his position.
Of course, in this case, the best move would be to choose an other CDP offering a better rate or at least having a system that treat their users better.
System Stabilizer Module
MakerDAO has introduced a new system to handle Risk Management:
The System Stabilizer Module’s purpose is to correct the system when the value of the collateral backing Dai drops below the liquidation level (determined by governance) when the stability of the system is at risk.
The MakerDAO protocol can be in 2 states: healthy or unhealthy.
The system is considered healthy when all positions are over-collateralized and the system is in surplus via collecting fees.
When the system is healthy, the SSM will use the surplus to buy & burn MKR, therefore increasing the value of all MKR holders.
The system is unhealthy when some positions are under-collateralized, liquidation failed and bad debt was created.
When the system is unhealthy, the SSM will mint & sell MKR in order to repay the bad debt, therefore diluting and decreasing the value of all MKR holders.
Dai Savings Rate
One of the major problem of Collateralized Debt Positions (CDPs) must tackle in order to succeed, is the absence of incentives to hold the stablecoin, especially when compared to the risk-free 5% APR offered by the Fed.
The Dai Savings Rate (DSR) was created to incentivize Dai holders to keep their Dai in the MakerDAO ecosystem, rather than exchanging it for other cryptocurrencies or fiat currencies.
Using the DAI locked in the DSR to acquire short-term treasuries, the DSR facilitates the transfer of yields from real-world assets (RWA) on-chain.
The DSR can be considered as a vampire attack on USDC, as anyone holding USDC without earning any APR may find it advantageous to convert their USDC to DAI and place them in the DSR, capitalizing on the 5% APR.
Tokenomics
Now that we have seen how MakerDAO works, let’s look at the numbers.
The Total Value Locked (TVL) chart clearly shows tremendous growth during DeFi summer in 2021, followed by a sharp decline during the bear market of 2022.
However, it seems the protocol’s TVL is still declining despite the whole ecosystem slowly recovering in 2023.
The fees generated by the protocol seemed to strictly follow the TVL until end of 2022, and have since been growing at a steady rate. This sharp rise in revenue for the protocol coincides with the release of the DSR, which is now the main source of profit for the protocol.
The price chart for MKR is a bit more complex to analyze. We can clearly see the epic rise leading to the ATH being reached during DeFi Summer, as well as the steady decline during the bear market.
What’s puzzling me is the slow and steady price increase, when the fees are at all time high, MKR is still down 3x from the top.
With the conjunction of the DSR and DSM, MakerDAO is literally printing money and burning MKR, exercising huge buying pressure, it should send the MKR price to the moon.
However, this is not what has been happening, so far…
Conclusion
In its current iteration, MakerDAO stands as a vastly improved product from its original design, introducing new collateral like LSD, enhancing DAI’s appeal with the DSR, and delivering substantial profits for MKR holders while fortifying risk management through the DSM.
Undoubtedly, MakerDAO stands out as one of the most trusted and robust collateral debt protocols (CDPs). However, there’s a notable gap between the protocol’s success and the corresponding benefits reaped by MKR holders. Despite its strengths, the protocol still grapples with certain shortcomings.
As previously highlighted, these weaknesses leave room for potential competitors to seize opportunities. Competitors could offer collateral with superior yields, such as leveraging assets like sfrxETH instead of stETH, or they might focus on reducing the fees, with a target around 1–2%.
Next time, we will talk about another very robust protocol: Alchemix !
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