MakerDAO: What Doesn’t Kill It, Makes It Stronger

An analysis on the recent performance of the MakerDAO system

TL;DR: There is a link between the volatility of cryptocurrency prices, and the rate at which MKR gets burned.

MakerDAO Primer

MakerDAO is a system that locks up Ether as collateral, and issues a loan for less than the USD value of the locked Ether. So, for example, you lock up 1 Ether @ $200, and receive anywhere between $1 and $133 worth of DAI. $133 is riskier, as you are betting that the price of Ether will not drop too much, while $1 doesn’t risk anything, but also doesn’t get you much utility.

In order to get your Ether back, you must repay an equal amount of DAI to the MakerDAO system, plus a 2.5% yearly interest fee. This 2.5% fee goes to purchasing the MKR token off the secondary market, and BURNING it in order to remove it from circulation. The constant buying pressure from the MakerDAO system provides a strong price floor for the MKR token, as there is always a buyer for the MKR token: the autonomous smart contract.

There is always a catch in an crypto-economic system, however. Designing a mechanism that only has upwards price pressure is impossible. If a system creates a mechanism for constant buying pressure, there MUST be an opposite force for downwards price pressure.

This is the constant threat of ‘global settlement’. Global Settlement is where the price of Ether moves too rapidly for the secondary market to absorb. If the price of Ether drops too low, and the value of the Ether in the MakerDAO system does not exceed the value all outstanding issued DAI, the MakerDAO system becomes under-collateralized. Consequently, MKR is minted in order to sell assets to become sufficiently collateralized again. Minted MKR adds to the token supply, therefore diluting supply and lowing value. This has not yet happened. We’ll get into how the threat of extremely volatility is closely linked to MakerDAOs close friend: not-so-extreme volatility.

The Data

I was recently bored at work and decided to see what the daily average burn rate of the MKR token is. I decided to go to the burner wallet for the MKR token (Where MKR goes to die), which is available on my google.doc here, and total how much MKR has been burned in the last 30 days.

3.54 MKR (~$2,000) burned from Oct 1 — Oct 31

3.54 MKR has been burned between the period of Oct 1 and Oct 31. Just $2,000?? Only $2,000 a month gets injected into the ‘Buy’ side of the MKR order book?? And that’s supposed to support a market capitalization of $.5 Billion?

I decided I needed more data before I threw the current price of MKR ($650) to the irrational speculators.

38.04 MKR (~$44,500) burned from Sept 1 — Sept 30

30.19 MKR (~$25,000) burned from Aug 1 — Aug 31

This looked a little more reasonable. Over $70,000 in upwards price pressure for the MKR token over the last 90 days. Still, not a whole lot, but throw in a little speculation and some optimism to the price of MKR, it’s seems reasonable. As well as the very healthy growth of DAI… for basically all of its existence adds a strong foundation to the value of MKR, as all the outstanding DAI represents future burned MKR.

But, why so little MKR burned in the last 30 days?

Why is the burn rate of MKR so slow in the last 30 days? What has changed in the crowd’s appetite, that they don’t want to close down CDPs (Collateralized Debt Positions), and burn a little MKR in doing so?

Well part of it is explained by the MKR appreciation. From Oct 1 to Oct 31 MKR went from ~$500 to $650, meaning that about 25% less MKR will be burned from the fee (because the DAI collected from the closing of a loan will be able to buy less MKR, because of MKR appreciation). But that 25% doesn’t account for anything close to the 12x as much MKR burned in September, or the 10x as much burned in August.

MKR: Both Fueled and Threatened by Volatility

What’s changed in the last 30 days in crypto?

Prices have been extremely stable! Bitcoin has been between $6,200 and $6,400 for the past 35 days! Ether has been between 198 and 206 for the same period! Nothing has happened!

People go to the MakerDAO system in order to do one of two things

  1. Leverage themselves
  2. De-leverage themselves

This is because MakerDAO does one thing: allows you to take on increased levels of capital that you didn’t have before. You are able to lock up your $10,000, and receive $5,000 that you didn’t own before. Since 90% of crypto is speculation, it is reasonable to assume that the majority of outstanding DAI was used to purchase more crypto assets.

When prices change, people who have leveraged themselves with MakerDAO have either won or lost a bet. If prices went up, borrowers won the trade. If prices go down, they’ve lost. Both types of parties can, of course, stay at the table and continue playing, BUT, when prices change, at least a few of them will call it a day, win or loss, and close their CDP.

When prices stay flat, the speculation game for crypto prices is still going. Without changes in price, people are still at the same position they were when they decided to open a CDP. Only when prices change is the a difference incentive balance to open or close a CDP.

Therefore, changes in crypto price cause MKR to be burned. Whenever a CDP is opened, it is a promise of future MKR to be burned, and when a CDP is closed, that promise becomes fulfilled.

Volatility causes the burning of MKR

As mentioned above, extreme volatility might one day cause the mass-printing of MKR in order to achieve DAI solvency.

However, all other kinds of volatility benefits the MKR system.

Any kind of volatility that doesn’t trigger the printing of MKR, leads to MKR burning. When more MKR gets burned, MKR should appreciate.

If MKR appreciates, then less MKR would need to be minted in the future, if global settlement does indeed have to happen.

This is a really important point. The more and more MKR gets burned from the closing of CDPs, the value of MKR should increase. This is simply because less MKR is available on the secondary market. Less supply with unchanged demand = higher prices. Therefore, in a Black Swan event, where Ether’s price drops drastically, and the MakerDAO system becomes under-collateralized, less MKR needs to be minted to restore the collateral to the system.

MakerDAO: Leveraging Anti-Fragility and the Lindy Effect

“Anti-Fragile” is the characteristic for when a system strengthens when faced with stressors. Volatility is the one looming threat for the MakerDAO system, but every instance of volatile crypto-prices that doesn’t kill MakerDAO, makes the next instance easier for the system to manage. This is Anti-Fragility.

The Lindy Effect is a concept that the future life expectancy of a system is proportional to it’s current age, so that every additional period of survival implies a longer remaining life expectancy. MakerDAO has this. The constantly reducing supply of MKR, and therefore appreciating price of MKR, represents a hardening of the shell that protects the MKR system.

This represents a positive-feedback loop of security for the MakerDAO system. Positive feedback loops are extremely important in cryptocurrency, mainly for when the security of the system is at stake.

For more information on positive feedback loops, check out my article on the subject here!

Incentive Loops: How Crypto Actually Fixes Stuff

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