[Discussion] Liquidation Mechanisms For DROP Assets -- Under-Collateralized & Mispriced

I have not found a complete discussion of the liquidation backstop for Centrifuge (DROP token) assets, so I wanted to start a new thread. This is an important issue that I hope we can all discuss in a respectful, informative manner. As forewarning, I will raise a couple questions below. Hopefully there are clear answers to them that I just haven’t discovered or have not absorbed yet.

Also, much discussion has surrounded the DROP agreement for Centrifuge assets. This thread is for discussion of the practical mechanism of liquidation and its implications, specifically. An in-depth discussion of the DROP agreements in general is more appropriate elsewhere.

As I understand it, our model for Centrifuge assets is to open a private vault. The SPV (special purpose vehicle) which issues DROP tokens to investors on Centrifuge’s Tinlake platform is the entity able to access that vault. As collateral, they lock DROP tokens in the Maker vault. Note that DROP tokens are the initial collateral. Maker does not own the tokens, just as the ETH or WBTC or YFI locked as collateral is also not in the possession of Maker.

If everything goes smoothly, the SPV will repay its DAI loan to the vault, removing DROP collateral.

If things do not progress smoothly, at the moment liquidations must be initiated manually. This could be done for any number of reasons, and deserve their own thread. But it must be done through a governance vote at the moment.

Should a liquidation be initiated, Maker sends the DROP tokens to Tinlake for redemption. Tinlake pools are timed in blocks called “epochs” which have a minimum but not maximum duration. Whenever the end of an epoch is triggered, a settling occurs of requested redemptions against available DAI reserves for that pool + any new capital contributed by investors waiting for the next epoch to begin. Epochs have different lengths for different pools. I am not a good source for how long each one is – maybe it is a day, maybe it is weeks – and will defer to anyone who knows or can provide a source.

Should there be insufficient capital to meet all redemption requests, there is a Solver Mechanism that kicks in to determine in what order and proportion redemptions are met. I will not pretend to have studied the Solver Mechanism closely enough to guess at its effectiveness or how it operates in real life. To my knowledge – correct me if I am wrong – the Tinlake platform has not yet had to go through this unfortunate liquidation process in real life to provide any guidance from experience. This mechanism could be quite important if Maker liquidates a DROP vault.

While there may be some creative ways for a non-entity like Maker to pursue the limited recourse provided to DROP holders, to me this is the end of our involvement. The backstop is the liquidation process on Tinlake. DROP is our collateral, and whatever you may think does or does not secure DROP tokens, DROP is what Maker has available to liquidate.

My concern is that we are significantly mispricing our risk by accepting DROP collateral. Let me lay it out point by point. I hope someone has a clear, concise answer to each one:

  • If reserves are less than the value of the DROP Maker liquidates, we suffer a loss. Note that there is no 13% liquidation penalty to provide a buffer. Our involvement in each of these is significant, and I worry that by taking large shares of each DROP pool we onboard, we have exposed ourselves to the possibility of liquidating at steep losses.

  • We call for liquidation manually. I suspect the main reason we would do this is to get ahead of a potential collapse of the cash flows that collateralize DROP tokens. But to do this requires a governance vote, a public discussion of why we should vote to liquidate, and a reliance upon Maker’s limited ability to monitor the performance of the assets the SPV is managing. Our very discussion here to liquidate seems likely to signal to DROP holders on Centrifuge to also head for the exits, and the DROP we take as collateral is in no way senior to the DROP held by other investors.

  • Our ability to monitor these assets is currently quite limited. It will largely depend upon the self-reporting of the SPV that issues the DROP to investors and locks DROP to generate DAI. Given that Tinlake’s own representation of a pool’s metrics to prospective investors is bugged, I hesitate to rely upon the platform’s monitoring to supplement our own in a meaningful way. Our own processes and procedures for monitoring are still being refined and have not yet hit execution in a way that is sufficient to protect Maker from significant losses.

  • These pools are being interpreted by the DAO as being collateralized by the assets under management by the SPV. While these assets are important to consider, as they are the source of cash flows to repay DAI generated in RWA vaults, they are not collateral for Maker or the DROP tokens (See Section 4.G of the DROP agreement for proof of the latter). DROP tokens are what we have available to liquidate, and not what underpins the DROP tokens (which themselves are not secured). The mechanism by which we are able to recover funds is through the Tinlake redemption process. If we believe that DAI can be recovered there in full or large part, then a DROP is sufficient collateral. If we do not believe that DAI can be recovered there in full or large part, then DROP is not valuable collateral.

  • Maker accepts a lower rate of return than DROP holders on at least some of these pools. The New Silver pool is a good example. We accept a 3.5% stability fee, while DROP holders have a targeted return of 4%. This is actually less of a spread than when the pool was launched, when DROP was targeted at 5% vs our 3.5%. Note that we have less upside than a typical DROP investor, yet share the same exposure to the downside. Most importantly, should Maker and other DROP holders attempt to redeem simultaneously and there are insufficient reserves, Maker enjoys no special preference in repayment, despite accepting a lower yield. (*Edited to add*: Apparently all other investors and the asset originators are subsidized with liquidity rewards as well)

My takeaway is that these loans are under-collateralized, and have been mispriced. The collateralization ratio that is important is that of the value of DROP to DAI debt, not the underlying SPV’s assets under management. Not only are the assets under management not collateral for DROP (Annex B, Page 1 even has a section titled “DROP Tokens are unsecured”; Annex B, Page 2 also has "DROP tokens are non-recourse to the Issuer), Maker has only uncertain methods of pursuing any rights (through arbitration) attached to any DROP tokens it is left holding in the event of an unsuccessful liquidation on Tinlake.

Our approval of DROP vaults should be dependent upon our belief in a robust liquidation process, which will not only depend upon our confidence in Tinlake but also in each pool’s reserves (currently 0 DAI in the case of New Silver). The assets under management should not be our primary concern because while they do influence the ability of the SPV to pay DROP holders, those assets under management are not ultimately how Maker would recover liquidated debt.

We also do not have the benefit of oracles to forewarn us of impending issues, and any liquidation by Maker would provide ample time for other DROP holders to exit before or simultaneous to Maker, depending on the length of an epoch for that pool.

If anyone sees some factual errors in what I have laid out above, or feels I have mischaracterized or misinterpreted anything, please (charitably) explain in the comments. My main request is that you show your work.

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I guess they do it manually, because of the issue that there are no oracles to be able to see the real time price of a DROP asset, but it is based on trust with Centrifugue and the Maker intermediary

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Thanks @PaperImperium for such a detailed set of questions. I’m sure that good answers to this are essential and we do need a respectful and informative discussion on this.

I have two questions

  1. Why do we not have the same 13% buffer as we do with crypto vaults? Even with the Tin and Drop system detailed here, why not have the buffer anyway as additional risk mitigation?

  2. You say that when liquidation is initiated, Maker sends DROP tokens to Tinlake for redemption. So am I correct in understanding that this is different from the keeper system where anyone can bid on the collateral and is instead all done via governance actions? If yes, why is this preferable?

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The answer to both of them is that Tinlake handles liquidations. A really important reason for this is that Tinlake performs KYC on their customers, so DROP can only be sold peer-to-peer if both parties are already whitelisted.

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I hope I can answer your questions and concerns in my response below. I appreciate you taking the time to ask them.

This is incorrect. The reserve is not the only place from which Maker and other DROP holders get repaid. This is described in MIP22 and the technical documentation goes into the details of how the contracts prioritize cashflows in the pool. Nevertheless I will summarize this again here:

DROP investors redeeming from a pool always have first priority. This means any DAI in the reserve will go to them. If that is not enough, then new investors wanting to join the pool can provide liquidity to pay out investors wanting to leave the pool. And most importantly, if that is not enough, then any loan repayments by borrowers are redirected to investors leaving the pool. There is no loss for Maker just because the reserve is 0. It means a liquidation for Maker is not instant but that does not equate a loss. These assets don’t see daily volatility in the double digit percent range like ETH and other collateral does and thus a liquidation does not need to be as fast as with these highly volatile assets. This was discussed at length in the Maker community when we initially published MIP22 and I encourage you to go back to the governance and risk calls as well as the collateral onboarding calls that occurred at that time.

The bug was not a smart contract issue but purely a display issue. It has been fixed and should be reflected in the subgraph update within the next 24hrs. It’s important to know that no onchain data was ever incorrect and that is what ultimately matters. The RWF Core Unit’s reporting is posted on the Maker forum on a regular basis and provides an up to date view into what happens both on chain and off-chain. This is the most recent report. We are looking forward to the Maker Oracle team bringing in new data sources that allow the Maker community to add third party verified information.

A simple way to monitor it on-chain is the price of DROP and the size of the TIN buffer. The DROP price-performance makes sure that Maker is receiving its stability fees. A sufficient TIN buffer shows that the pool is healthy and overcollateralized. This is also reported by @SebVentures in his reports.

I know it is not easy to understand how the legal structure works. We have hosted several calls, some of them with our legal counsel present, and one just a few days ago with the RWA committee where people were able to ask questions. Legal terms are quite nuanced. I am not a lawyer and this is not legal advice but I will do my best to clarify:
(1) The assets the SPV holds on its book are secured and collateralized. In New Silver’s case the >30 loans that different borrowers took out using real estate as collateral.
(2) The SPV setup, the legal framework, and the securitization with a junior tranche which needs to take first losses, and a protected and secured senior tranch with fixed and first income is industry standard. (3) The DROP tokens do not represent a security interest in the SPV but they are a valid claim against all income generated by the assets the SPV holds on its books. It ensures that DROP investors get their money before TIN investors do. It ensures that the SPV doesn’t pledge the assets to anyone and that all income generated by the assets is going to DROP investors first and then TIN investors. DROP and TIN investors have a claim on every dime any liquidation of assets in case of underperformance or default of a borrower is generating.
(4) New Silver has already an independent backup servicer, which can manage the pool or liquidate assets if New Silver disappears. New Silver is also adding contracting with Citadel SPV to add an independent manager as a next step.

The Maker vault requires an overcollateralization of 105% and thus it accepts a lower rate of return. Maker’s inherent model is to ask for the most senior/safest collateral and offer the lowest rate and that’s what the Risk & RWA domain teams have negotiated with the AOs. For each DAI of debt in the vault, Maker has $1.05 worth of DROP that it can use to liquidate. This was discussed in several calls with the Maker community here (this one in particular discussed liquidations) and here where we discuss LTV, overcollateralization and how Maker could have the most senior interest in the pool.

As reflected in my answers above. This is not correct. They are over-collateralized and (indirectly) secured by the assets in the pool. This is described in the operating agreement and the subscription document all of which we have published.

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Edited to add: the answer appears to be found in MIP22, which will enforce repayment from liquidation with code, probably removing any need for legal obligation.

Correct. What legal obligation is Centrifuge under to remit payment to Maker in the event of a liquidation? Normally Maker relies upon enforcement through code, but in this case does not actually have the collateral (DROP tokens) in a vault.

Given that Maker controls neither the collateral (DROP tokens) nor the liquidation process, is there some legal obligation that Centrifuge send the proceeds to Maker? I do not personally think Centrifuge or any of the borrowers would run off with the money, but I wanted to take advantage of your presence on this thread to make sure this isn’t a plan for Maker to do tens of millions in deals on a handshake.

I suspect there’s something somewhere that gives a legal obligation, and I’d be appreciative if you’d be able to point to what that would be.

Thanks!

As far as I am able to understand, I believe Centrifuge has no legal obligation to the DAO. In fact, the thinking with Centrifuge is that the SPV’s documentation mandate repayment to the DAO but in case a member of the SPV does not act in accord with the applicable agreement, then other SPV members would have to initiate a securities-related lawsuit (I think it’s called a shareholder or LLC member derivative action) against the “bad” member.

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Sounds like optmistic rollup for assets.

It looks like the answer is in MIP22: It reads to my not-an-engineer eyes like it will be enforced by code, which removes any need for legal obligation.

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After reading so many comments on this forum about RWAs, I got a rush of Anxiety and had to take a break. I was actually excited to see Rune on a CD interview talking-up how MakerDAO is bringing RWAs to the blockchain this morning and inviting the Media folks to check-out this forum for more details about how Maker has solved the Blockchain/RWA puzzle. But after reading thru this forum and the Rocket Chat–it might not be the best idea to invite them over. Not yet.

All I can say is that as much as I hate to admit it, DAI is not the only game in town. There are plenty of folks ready to step-in and integrate RWAs into this amazing technology. So while we sit here writing these posts that might turn-off some RWA providers from joining this DAO, I can tell you that other protocols within and outside of Ethereum, will make things happen in the RWA realm with, or without MakerDAO. Just keeping it real–although it pains me to say it. I hope we can turn the page–and make it wholesome again.

BTW where’s @LongForWisdom ? Is he back–I miss that dude.

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Right. We need to move now on onboarding RWA, not pause. The smaller 5-10MM get us in with modest risk and then we can perfect structure further on scaling up, and get RWA borrowers using DAI. Issues with New Silver can be hashed out on its request to increase the debt ceiling. Several other RWA proposals before us using Centrifuge do not pose the risk of New Silver’s 12-24 month loans on fix and flip real estate.

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Thanks @spin

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Our additional buffer beyond the TIN tranche is the fact we lend 95 DAI on the dollar but are treated 100 DAI on the $ in a liquidation of DROP

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