MakerDAO is the decentralized minter of the Ethereum ecosystem, pioneers in Decentralized Finance (“DeFi”). The MakerDAO protocol minted the DAI stablecoin asset, which acts as a hedging tool and medium of exchange directly on-chain.
The cornerstone of DeFi is overcollateralization–always having more collateral than assets minted–which means that there is always room for incentivization of a third party to pay back debt on behalf of borrowers, keepers being repaid and retributed by borrowers collateral through an action mechanism.
The MakerDAO protocol proved itself resilient to a 94% drop of the value of ETH in 2018 during the SCD era and the black Thursday event in March 2020.
The MakerDAO protocol is heavily overcollateralized–each makerDAO vault is an independent entity in a mutualist system, with its own collateralization ratio and thus liquidation price. On this basis, the overall DAI collateralization risk should be analyzed according to system global collateralization and critical collateral price levels creating levels of liquidation thresholds.
Data analysis of DAI collateralization
5.5B$ of ETH collateralized for 1.53B$ of DAI minted. ~360% collateralization on ETH-A vaults
DAI has seen significant growth since Ethereum’s “DeFi Summer” of 2020, growing from a 289M DAI supply to a 3.1B$ supply in 7 months ~+800%
The current “global MCD DAI collateralization” is currently historically low due to recent debt ceiling increases at around 230%. Typically 3 USD worth of collateral backs each DAI when considering the protocol as a whole.
Currently, there is simultaneously a stablecoin liquidity shortage in DeFi as well as high demand for stablecoins in DeFi protocols to be used for earning rewards or leveraging/borrowing, which creates high interest rates that potentially could have a negative impact on ecosystem growth as a whole.
DAI “liquidity crush” also creates a significant premium between “cost of money” defined by makerDAO Stability Fee and supply rates on protocols such as Aave.
In theory, the free market should create itself an equilibrium as the premium gap is an earning opportunity for interest rate arbitrage actors.
In reality, market immaturity, more lucrative investment opportunities, “Yield Farming” by leverage loops deposit into DeFi and Debt ceilings limits the natural balancing of premiums between mint cost and supply earnings. Moreover, DeFi is constantly evolving and new products further increase the demand for Dai across the whole network.
The D3M is an exploration of an alternative path to bring more liquidity in secondary DAI venues by minting DAI backed by aDAI and depositing it directly in secondary markets to release liquidity shortage pressures.
The D3M module is a potential new tool for the MakerDAO to stabilize DAI peg, increase DAI attractiveness for borrowers and create new pathways of revenues for the MKR ecosystem.
Additionally, the Aave Community is deploying new liquidity pools across various L2/chains, which means more DAI can bridge into pools to transact affordably and in an inclusive manner, while still ensuring the security of the MakerDAO collateral in L1.
Essentially, Aave could become the distributor for DAI on every L2 and empower new growing communities as the need for stablecoin as a medium of exchange grows across all chains and L2s.
DAI backed by aDAI could be minted leveraging the overall protocol overcollateralization, with limits in size and timeframe set by global protocol collateralization target ratios and secondary market rates target ranges.
The focus of the D3M is to mint & Burn DAI in exchange for aDAI to stay within the Target Max Variable borrow rate of DAI in Aave Liquidity Pools.
Mechanics of D3M
The D3M module mints and directly deposits freshly minted DAI into the Aave V2 protocol, and by doing so, the D3M vault module collects an equivalent amount of aDAI (which grow over time based upon the fact that the Aave DAI pool generates interest).
The D3M has a target rate for limiting the size of the deposit and ensuring DAI to be the most competitive asset to be borrowed on Aave compared to other stablecoins.
The target rate is fixed in such a way that the variable borrow rate does not exceed a threshold value.
This threshold value can be set by the MakerDAO community to ensure that DAI is the most attractive stablecoin for Aave borrowers.
Interest rate curve model allows for precise sizing of mint/burn events for more information on the interest rate curves on Aave, please refers to the dedicated documentation.
The size of the vault could be experimental and later adjusted by the MakerDAO governance as there is more market data. Eventually D3M has the potential to become a global way for the MakerDAO community to inject DAI liquidity across DeFi and even incentivise risk-averse protocols by adjusting liquidity between protocols.
D3M would be the natural step for MakerDAO to expand DAI across DeFi and ensure market positioning as new stablecoins are evolving, including Compound Cash. Working together with the Aave community could position both the MakerDAO and Aave communities uniquely to ensure DAI liquidity across DeFi and decrease the liquidity fractionalization on L2s in mid-term.
What is backing aDAI?
aDAI is an automatically-generated, native token to the Aave protocol, which is issued to a user who supplies DAI into the Aave protocol. aDAI is astandard ERC-20 token, which is natively balance-increasing such that the DAI pool on the Aave protocol generates interest to all suppliers to the DAI pool. he aDAI smart-contract continuously updates the balance of all aDAI token holders (including D3M Vault) to reflect this accrual by increasing their aDAI balance.
As with every deposit into the Aave protocol, there’s no lock-up period and withdrawal can be requested at any time within the limits of available DAI liquidity. There is no slippage associated with aDAI and every aDAI is redeemable for one DAI at a 1:1 ratio. Suppliers of aDAI are covered by the Safety Module (managed by Aave Governance) in case of shortfall event. DAI itself is backed by the systemic overcollateralization of the lending market, where overcollateralization is based on the Aave Risk Framework. Additionally, Gauntlet is performing on-going analysis on the V2 borrowing market’s Market Risk and other related risks.
Additionally, there’s currently ~1.6B$ worth of AAVE and AAVE/ETH in the Safety Module with a 30% slashing parameter activated, meaning that nearly up to 0.5B$ of deposits are protected in case of a shortfall event.
Benefits for MakerDAO
- External source of direct income by collection of aDAI interest
- MakerDAO governance would have direct impact on risk assessment by adjusting the D3M minting across DeFi
- Expanded supply of DAI including L2s
- DAI attractiveness for DeFi borrowers on secondary markets
- If Aave community starts a Liquidity Mining program, MakerDAO will collect AAVE assets and earn governance rights in Aave Governance