Maker x Aave: Tackling Variable Interest Rates in DeFi
MakerDAO Green Lights seamless AAVE Integration
MakerDAO recently announced the implementation of Dai Direct Deposit Module (D3M) in collaboration with Aave to minimize the uncertainty involved in borrowing DAI over Aave. Users of DAI have held back from borrowing loans because of varying interest rates prevalent within DeFi; Aave users looking to use DAI no longer have to worry about it, thanks to the D3M which solves this problem by enforcing a maximum borrow rate. The maximum borrow rate is the maximum rate at which an issued loan accrues interest over time, only to be paid back by the borrower.
In turn, Maker expects to earn interest because of the demand surges fueled by the confident borrowing of DAI over at the Aave protocol. The D3M module “makes Aave like a commercial bank on top of MakerDAO’s central bank,” in the words of Haseeb Qureshi, managing partner at Dragonfly Capital. The liquidity of DAI on L2 provided by Aave will enable Maker to consolidate its position as a prominent provider of stablecoins across L2 while its users can enjoy the security offered by the collateral stored in L1. For more information on liquidity providers and stable coins, check out this article.
How Market Makers Operate in DeFi
Market makers in DeFi provide a pool of tokens, generally stored in a smart contract, which can be used by users to deposit and borrow the constituent tokens. The depositors contribute to the pool in exchange for special tokens, such as Aave interest-bearing tokens or a-tokens in the case of Aave, which represent their contribution and the interest accrued on it. The number of these special tokens received by the depositor after contributing a certain number of tokens depends upon the exchange rate. As the exchange rate increases over time, the depositor becomes entitled to an increased number of contributed tokens if he wishes to cash out of the pool.
The interest a depositor receives is indicated by the supplier’s Annual Percentage Yield (APY). Similarly, a borrower may wish to issue a loan from the pool and does so by the process of overcollateralization: deposition of assets worth more than the loan being taken. The loan is issued with a certain interest rate, depicted by the borrower’s rate, and it is more than the supplier APY.
Why over-collateralize your asset? Why not simply sell the collateral in the first place? You may not wish to sell off those tokens — though you have used them as collateral — in exchange for fiat money; in fact, holding them as collateral is a testament to how precious they are to you. This overcollateralization ensures that in case the smart contract suspects the borrower from defaulting on their payment, the asset will be safely liquidated and there would be enough assets to pay back the depositor.
The smart contract executes the liquidation of collateral if it is indicated that the value of the borrowed amount has exceeded the value of the collateral multiplied by its collateral factor: a measure of the quality of collateral being provided by the borrower.
For an off-chain example, think of an entrepreneur who wishes to borrow 5 million USD. He promises to repay after a certain time but the banks wish to ensure that in case he fails to pay, they have enough assets to pay their investors. Thus, the banks ask for collateral — say, a farm — worth 10 million USD. There is an interest operating at the 5 million USD loan he had taken, and should he fail to repay along with the principal amount, it will be liquidated and sold at an auction. The money generated would then be used to compensate the investors of the bank. The reason the farm was collateralized was that the market keeps fluctuating: assets kept as collateral may degrade in value. Thus, an asset (the farm) worth more than the loan is accepted as collateral.
The Maker Story
Maker, lovingly dubbed as Ethereum’s “central bank”, has two operating tokens: MKR and DAI. MKR is the governance token used in MakerDAO — the DAO that oversees and regulates the policies of Maker — and DAI is a stablecoin: its value remains pegged to one USD. Both MKR and DAI can be purchased on exchanges and they increase in value by incentivizing their scarcity.
DAI is created when users of Maker lock up a certain amount of ETH or other Ethereum-based assets (such as USDC) in Maker Vaults, smart contracts acting on Maker protocol, as collateral. When you deposit the ETH-based assets as collateral in a Vault, you receive DAI as a loan that maintains a soft-peg to USD. However, because the price of these assets is always fluctuating, Maker mandates users to over-collateralize: deposit more assets than the DAI they get. It is standard practice across DeFi, as discussed previously. DAI loans then accrue interest over time; on the borrower’s end, this rate is known as the stability fee. A problem inherent in the volatility of DeFi is the wide range of stability fees that can accrue over time, adding an uncomfortable uncertainty for the borrower. If the market has more DAI than its current demand, DAI faces a risk of being oversupplied; this equates to the value of DAI depreciating over time and its price dropping. MakerDAO counters this by incentivizing the borrowers to pay back their loan, in part or whole, by increasing the stability fee. The incentivized repayment reduces the presence of DAI in the market.
The principal amount of the loan along with the stability fee must be repaid in DAI. The deposited DAI is then burnt to contract the supply of tokens and drive the price back up. DAI is essentially backed by debt and since the loan is repaid, in part or whole, the corresponding amount of DAI is burnt.
Aave
Aave is also a market maker functioning on a peer-2-contract model, allowing a user to exchange assets with a smart contract and eliminating the need to find a peer who is willing to engage in a transaction.
Aave works by facilitating lending (deposition) and borrowing using smart contracts. The depositor contributes some assets to a smart contract — incentivized by the supplier APY — and the borrower withdraws it while promising to return it — with the interest dictated by borrower APY — after placing his assets (such as ETH) as collateral. Just like Maker, Aave ensures that the model is overcollateralized: a user ends up depositing more collateral than the asset they end up with as a loan.
The borrower rate is higher than the APY. These rates change from time to time as each transaction takes place on the blockchain, highlighting the availability of tokens in the protocol, leading to variable interest rates.
What sets Aave apart is the fact that borrowers can choose to issue a loan on a stable or fixed interest rate. Despite what the name suggests, the stable interest rate is maintained only for a short duration of time — until the protocol is in dire need of liquidity or the liquidity providers are not satisfied with the APY they are receiving — and can be rebalanced. The variable interest rate remains a lucrative option in certain market conditions, so users have the option to switch between the two models for any asset that they have collateralized.
The liquidity providers of Aave receive a-tokens, the value of which remains pegged to the sum of the values of the underlying token — say, DAI — and the interest accrued on the token as per the APY. These a-tokens are ERC-20 tokens and are transferable; the owner will have rights to the original contributed amount and the interest accrued upon the same. The number of a-tokens a depositor receives for providing liquidity is fixed in a 1:1 fashion in the case of Aave; as the blockchain transactions continue to accumulate over time, the increasing exchange rate is indicated by a corresponding increment in the number of a-tokens the provider has.
Varying Problems, Stable Solutions!
Maker is one of the largest Ethereum applications that provides lending and borrowing services to its users. The fluctuating rate of interest on loans has been a deterrent for many users who wish to borrow DAI on Aave. These interest rates, raised by MakerDAO to maintain the soft-peg of DAI with USD and provide stability, remain elevated till the price of DAI stabilizes. The stablecoin has been constrained in matters of supply for over a year at this point leading to unattractive DAI borrow rates in secondary markets, such as Aave.
On the other hand, Aave has relied upon private individuals in the past for supplying stablecoin. The practice was no longer in line with the growing rate of expansion the protocol was experiencing in recent times; it needed access to an efficient, sustainable, and reliable outlet of stablecoins which it could provide across L2 and consolidate its position.
Where D3M Comes into the Picture
The D3M brings an innovative strategy to mint DAI on the Aave protocol which can be best explained by this tweet of Sam MacPherson, the smart contract protocol engineer at MakerDAO.
“Today MakerDAO is launching the DAI Direct Deposit Module (D3M) which gives @AaveAave privileged access to mint DAI once the test debt ceiling is raised. This marks a transition point from Maker as a commercial lender to Maker as the financial backbone of DeFi.” — Sam MacPherson
Basically, the target borrow interest rate for DAI on Aave can be revised by the MakerDAO community in a way that ensures maximum competitiveness for the token across the protocol. The D3M functionally allows Aave users to borrow DAI at a fixed maximum interest rate — 4% for now — because the collaterals stored over Aave are used to offset the extra interest amount.
The requirement for D3M stems from the fluctuation of the stability fee caused due to market operations. The D3M mints DAI on the Aave protocol; on the other hand, its vault for Maker stores a corresponding amount of aDAI. The automatically generated token, aDAI, is native to Aave and provided to any user who deposits DAI to the pool. aDAI tokens, including the ones stored in Maker’s vault, generate profit for the providers by accruing APY over time just like other liquidity pools functioning on Aave. Maker holds aDAI as collateral while minting DAI; aDAI, in turn, is backed by the collateral of borrowers stored on the Aave protocol.
The D3M vault would adjust for varying interest rates by changing the amount of DAI present on Aave. As the interest rates drop below the desired level, the D3M will remove a calculated amount of liquidity to stabilize the interest rate. Similarly, if the interest rates go above the desired level, the D3M will mint more DAI to be deposited in Aave’s lending pool.
Significance
Maker benefits from the increased liquidity of their stablecoin as users of Aave will now be encouraged to borrow it after the mitigation of extreme variations in stability fees. Maker’s reliance on USDC for the expansion of DAI supply also reduces as a result of D3M. The interest accrued on aDAI, generated as a result of depositing DAI in the Aave protocol, will act as an external source of revenue for Maker. Furthermore, MakerDAO enjoys the benefit of asserting influence over Aave governance by collecting its assets, now that Aave has started its liquidity mining program.
Aave is currently branching its liquidity pools across L2 and can be a potential gateway for the spread of DAI across the same. It has relied on private individuals to issue stablecoins as loans in the past which were not robust enough for the path Aave envisioned. Now, Aave users can get them straight from Maker. The users of the protocol enjoy security against double-digit interest rates prevalent in DeFi which stop people from borrowing loans and the subsequent risk of losing their collateral in case of sudden market fluctuations.
MakerDAO basically aims to expand its stablecoin across DeFi and ensure its market position amidst the rise of new stablecoins.
~Anthony Beattie, Maxbit
As a whole, this partnership opens up new and exciting avenues across DeFi, such as the ability to deploy stablecoins through other secondary lenders across L2. The D3M’s basic idea — holding the collateral of another protocol as your own in exchange for lowered interest rates — can be extrapolated to Web3 applications and crypto at large. Partnerships built upon the trust of protocols benefit the users of both and incentivize competition to reassess the market to keep their competitive edge. While the D3M is a powerful experiment to tackle one of the main obstacles of the DeFi industry — extreme fluctuations in interest rates — its basic idea can be used by other kinds of DAOs.
The module has managed to remove the limitation of high-interest rates for the borrowers and added the functionality of incentivizing exclusive cross-DAO collaboration. Social DAOs, for example, can create media markets and exclusive content for their partners. Likewise, DAOs that focus on creators can create exclusive spaces with their partners for young talent to showcase their skills and gain recognition faster in an otherwise overpopulated sphere. There are largely two ways an industry can progress: removing limitations or adding functionality. Maker x Aave D3M has managed to do both.
Author Bio
Psych Guy is a grad student of psychology who is interested in behavioral dynamics across Web3. He enjoys the philosophy of decentralization. (twitter: @psychguy_eth)
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