Economics behind Real World Assets ("RWA") - Part 1

Background:

With the primary objective of MKR Governance should always be to keep the DAI price as close as possible to its reference currency, the US Dollar, MKR governance over the course of 2020 has for the most part lowered risk premiums to almost zero in an effort to spur DAI issuance to re-balance the price.

Such actions were and are justified. That said, there is a corresponding trade-off that we cannot ignore. Risk of “default” took a back-seat to the peg with regard to priority. This is a balanced approach given the situation at the time.

One amazing aspect about DeFi in addition to the rate of innovation is the ability to add another tool to the toolbox. The DSR being just one example. RWA as collateral represent the natural evolution of get another tool.

Where we are:

Aggregated risk premiums are at almost record lows, thus the Price-to-Earnings is at a record high.

As outlined above, if MKR governance increases its blended risk premium across all assets just 200 bps, MKR looks undervalued in the market. While not the primary object of MKR governance, we should not be blind to the economics of what makes MKR governance sustainable either.

At present, if MKR governance increases its rates, the logic would dictate that a portion of Vault holders would unwind their positions due to an elevated cost of capital. To do so, they would need to acquire DAI thus causing the price of DAI to elevate given this new conceptual demand.

Given that DAI is still above the target reference price, this initiative seems one that should be taken cautiously. There are some yield farming aspects that may also cause new DAI minting however, it is unclear how long yield farming will continue (or if we are just at the very beginning).

Insert Real World Assets

By having an uncorrelated assets as a capital sink, we are now inserting an essential counterbalance.

For every time the blended on-chain collateral risk premium is slightly increased (thus causing the DAI demand referenced above and thereby the price to increase) an emerging counterforce emerges that further motivates the RWA participants to mint new DAI to deploy external to the ecosystem.

What does this mean?

A new equilibrium will be found for pricing risk for collateral that is further dislocated from monetary policy. It won’t happen overnight, but it is the start of that journey. The objective being to balance the structure with market forces such that the risks are priced efficiently while demand can be throttled with the DSR and debt ceilings can constrain borrowing for any given asset class.

Economics on the Real World Assets

Real World Assets as collateral (at least for the initial roll-out) are best suited to be used a capital sink / overflow valve for the existing DAI market. Thus the risk profile suitable for such a capital sink should be one of a principal protection thesis with high credit quality as excess DAI might need to sit there and be recycled in the real world for years (it all depends on the price of DAI and market forces for the RWA lender).

Since the DAI that is deployed is minted into existence specific for RWA, the MKR cost of capital is zero. However, for the RWA Lender, the cost of capital it pays to access that credit facility should be based on a blend of LendCo’s underlying collateral, its credit quality, the legal enforceability of the entire structure to foreclose if needed, and correlation of assets (to just name a few). The name of the game is a diversified portfolio. All of that being said, the cost of capital for an off-chain lender with a “known” and community accepted structure and collateral is just more DAI that goes to buy and burn MKR.

Once setup and continually acting as a capital sink, one can easily imagine that in a few years, the majority of the MKR burn will be coming from the risk premiums associated to RWA.

DAI stability

To truly have DAI be a synthetic USD, the DAI < — > USD volume needs to 100x (or more). Right now DAI is at 1.013… From my perspective, 1.00013 is too much of a deviation off the peg.

Historic DAI volatility needs counterweights and market participants that reply on market forces to drive their decision making.

When RWA is added to the mix, the counterbalance structure of V-8 engine can be imagined. https://youtu.be/aATDsYVVcRM Further, MKR governance has the unique position of being able to make that V-8 into a V-10 (or more) and tune the parameters on the go. Even further, off-chain lenders, like the suggested LendCo, can have its scope expanded by MKR Governance ratification. This is specifically important as it means LendCo can on-board new collateral with no technical changes with all of the control levels still held at and by MKR Governance.

Summary: Real World Assets solve critical governance challenges by acting as both an overflow valve and an economic counterweight while simultaneously economically benefiting the MKR community to do so !!

Full Disclosure:

I am presently advancing a real world assets structure for consideration by the MKR community. Regardless, the points above hold true for any real world assets onboarded correctly and safely.

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