[Informal Poll] RWF Collateral Risk Level

Title: RWF Collateral Risk Level Informal Poll

Author(s): @Eumenes, @christiancdpetersen

Reviewers: @williamr, @luca_pro, @SebVentures, @Porter_Smith

Type: Proposal

Purpose: For discussion

Date Proposed: 2021-12-16

Introduction

The RWF Core Unit has formulated an investment standard for potential asset originators, arrangers and any other credit counterparties, that the RWF Core Unit would like to share with the Maker community for feedback. In preparing this benchmark, the RWF Core Unit has sought to synthesize inputs from the Maker Forum, Maker delegates, the vision for RWF developed by @luca_pro in the SES Project Real-World Sandbox report and the Maker community’s commentary thereto, and the RWF Core Unit’s own structured finance experience.

The present post aims to build on the collateral criteria guidelines suggested by the SES RWS report by adding an additional layer of granularity to the discussion.

The RWF CU proposes to use this standard to (1) signal to potential MIP6 applicants the Maker community’s expectation on investment quality and (2) provide a metric to evaluate MIP6 applicants.

The RWF CU requests the Maker community’s input to the proposed standard.

Proposed On-boarding Standard

The RWF Core Unit recommends that the Maker community approve the following standard for potential on-boarding investments in structured finance transactions to the Maker protocol. A structured finance transaction is created by pooling financial assets and issuing securities representing interests in the pool to investors.

The Maker community has displayed a bias towards the on-boarding of a structured finance investment that either:

  1. Has a rating by an internationally recognized credit rating agency demonstrating the investment’s ability to pay timely interest and ultimate principal under the terms of the transaction’s legal documents at a risk level that is Investment Grade or

  2. By combination of the following quantitative and qualitative assessments, the specific tranche of the structured finance transaction demonstrates the ability to pay timely interest and ultimate principal under the terms of the transaction’s legal documents at a risk level that is equivalent to Investment Grade:

    • An Originator/Sponsor operational review evaluating the qualities of the parties that originate the collateral in the transaction;

    • A Servicer/Sponsor operational review evaluating the qualities of the parties that service or may provide backup servicing for the collateral in the transaction;

    • An assessment of the collateral performance history of the Originator/Sponsor and transaction level characteristics, estimating base and stressed collateral performance;

    • An assessment of the overall transaction financial structure and the specific tranche, including credit enhancement, priority of payments, transaction performance thresholds and triggers, asset eligibility criteria, financial covenants and revolving credit transaction terms such as concentration limits;

    • An assessment of the transaction legal structure reviewing primary as well as secondary documents and all relevant legal opinions, including the bankruptcy-remote SPV and the receivables transfer;

    • A cash flow analysis determining whether the transaction cash flow and structure are adequate to make contractual payments to the investment at Investment Grade stress levels; and

    • An assessment of the Sponsor’s reporting and portfolio management capabilities, including the ability to provide timely and accurate transaction information and manage both day to day and material events for the transaction.

Certain investment priorities that, for reasons that have been approved by the Community, may be subject to a different set of requirements (such as assets belonging to the “Clean Money” initiative) and should be assessed on a case-by-case basis. It is important, however, for such exceptions to be ring-fenced within clear size limits vs. base case exposures, and that those limits have been set with a portfolio mindset by the appropriate governance mechanisms

Next steps

We acknowledge that it is a nearly impossible task to standardize eligibility criteria across all RWF collateral types this early in MakerDAO’s investment journey. This consultation aims to provide guidance for the direction of travel for the bulk of the volume of collateral, so that Maker can scale safely and at pace.

Strategic collateral considerations such as those aligned with legitimate sustainable financing principles might be subject to their own separate guidance.

We appreciate and encourage inputs from the Maker Community, delegates and token holders.

RWF Collateral Risk Level Poll:

  • YES
  • NO
  • ABSTAIN

0 voters

13 Likes

Thanks, @Eumenes for launching the discussion.

Here are the comments I’ve made on the proposal:

  • I’m fine with investment grade, but then why not go directly to traded bonds actually rated by credit rating agencies? Why not just ask PIMCO or other top tiers institutions to manage that?
  • Was the barbell method proposed by @Allan_Pedersen explored? Could the RWF CU provide pros and cons to inform the community?
  • What would such criteria leave into the deal pipe and what would most likely be excluded? I have the feeling that dealing with counterparties that are newborn/young startups (all excluding SocGen (?)) and investment-grade are a world apart.
  • What is the current market rate for private credit investment-grade like?

PS: I actually wonder if we shouldn’t flip the concept. Put “serious ESG”-lending first and curtail the non-ESG to a small box (strategic experiments like SocGen). The community was quite supportive of the Clean Money push.

1 Like

Tagging on a number of key stakeholders to contribute to this.
@collateral-core-unit @SES-Core-Unit @Recognized-Delegates @Growth-Core-Unit @rune @g_dip @Allan_Pedersen @christiancdpetersen @mrabino1

4 Likes

@Eumenes Thanks for the post, I agree with its content and would like to see this philosophy implemented in the arranger model. Would you mind clarifying exactly what the poll is voting yes or no for? Is it the general content of the post?

1 Like

Flip Flop Flap Delegate had a first-hand look at the formulation of the proposed risk standards above and we fully support this proposal. The methodology and metrics to evaluate MIP6 applications for investment quality can provide the necessary parameters and requirements needed to onboard RWA collateral types, and it will help the Maker Community have a better sense of the quality of RWAs that are being proposed.

We believe the proposed Collateral Risk Level standards will help onboard collateral types efficiently and consistently, while arriving at a reliable and appropriate risk assessment courtesy of both a qualified ratings agency and the assessments of the RWF CU. Furthermore, we believe the assessments will provide MakerDAO with quantitative and qualitative analyses, including structural risk, operational risk, credit risk, and legal considerations(if applicable). We also believe the assessments and ratings can provide an open window to view the Asset Originators portfolio performance, credit risk at the asset level, and cash flow analysis of the MIP6 applicant.

Thank you for the hard work and dedication provided by community members @christiancdpetersen @Eumenes @Porter_Smith @williamr @luca_pro @SebVentures for orchestrating this post. We look forward to iterations of the proposed investment standards, including but not limited to continuous monitoring and follow-ups.

5 Likes

As a first-time commenter, long-time MKR investor, and formerly in TradFi credit, perhaps I can offer some insight here. Firstly, I believe the spirit of the arranger model hit the nail on the head. Intuitively it feels much easier to scale RWA by constructing partnerships with outside managers/arrangers, as opposed to underwriting and monitoring each RWA collateral in-house. As long as we 1) set clear and thoughtful criteria (e.g., pools greater than $x need an annual Big 4 valuation review) and 2) ensure proper alignment of interests (e.g., arrangers stake MKR and earn promote), the DAO can outsource a lot of the ongoing heavy lifting.

To expand a little further, imagine how the DAO could rely on Big 4 firms, like Deloitte and Ernst & Young. This post mentions the importance of “operational reviews” – Big 4 firms readily provide this and other valuable services. Imagine Ernst & Young doing a control assessment on a trusted arranger, or performing an annual valuation review for a select RWA portfolio (in blockchain-readable format). Despite their reputation for conservatism, Big 4 are now embracing Blockchain and they are enthusiastic about RWA tokenization and DeFi (EY, my former employer, is building teams to provide blockchain audit, tax, and advisory services).

In summary, I see huge potential for the DAO to lean on external managers and independent attestation firms. And in many instances, professional credit fund managers like Farallon, KKR, and TPG (potential partners for the DAO) already operate at an institutional-quality level, voluntarily doing regular Big 4 financial and operational audits (see “SOC 1” reports). By outsourcing much of the underwriting, ops, admin, tax, audit, portfolio monitoring, etc, I believe there will be a sustainable path to trillions in RWA collateral.

I echo thanking @christiancdpetersen @Eumenes @Porter_Smith @williamr @luca_pro @SebVentures for the hard work and vision.

7 Likes

Good questions. Here are my thoughts:

(1) Top tier asset managers such as PIMCO should always be an option/benchmark. At this point the public bond fund choices in real Green investing is very very limited as there just arent many public bonds in real Green. The same basic issue is also present in the broader ESG public bond market.

PIMCO has solid high quality, liquidi low duration funds such as PTLDX and PTSHX. Both are currently yielding < 1% as are most shorter high quality bond funds.

Ultimately Maker needs to build an investment portfolio that safely meets the needs of its liabilities structure. There is much, much work that is needed here: once we understand our liabilities, we can design and build a sensible investment portfolio. Maker’s investment risk appetite is mostly a function of its liability structure which means protecting the value of DAI (as pegged to the dollar). This requires a liquid, high quality, transparent, investment portfolio. But this is a broader question that is beyond the scope of this more focused discussion.

(2) Where does Maker want its investments to be in terms of risk-return? What is the current investment opportunity frontier along these key dimensions? These are key questions and related to my points in (1). What gains does Maker get from taking high risk investments versus the potential costs, particularly in stressed scenarios? If protecting the value of the DAI is key, this should help guide Maker on sizing its riskier investment bucket.

(3) There are many non-investment grade originators/issuers that issue investment grade asset backed securities. This is the main point of asset backed investing: allowing lower rated companies to issue debt securities in structures backed by solid collateral pools. The overall credit quality of the resulting asset backed securities will be substantially higher than the corporate credit of the originator.

There are definitely opportunities in the pipeline that can meet these standards besides SocGen.

(4) The private credit market is very large and diverse. Whenever Maker considers a potential investment, it needs to understand how that specific risk is being priced versus other opportunities. We dont want to be dumb money.

(5) Clean Money is clearly a key Maker initiative. The Community needs to decide how it fits into the broader investment mandate. The relative private/illiquid nature of most current Green opportunities needs to be considred in designing an investment portfolio. Again the investment portfolio needs to fit Maker’s liabilities.

6 Likes

The general content of the post.

We are working on more specific guidelines on what RWF seeks in structured finance investments.

Thanks for posting.

Maker definitely needs strong controls/oversight on collateral quality. Its essential that the assets being financed are (1) underwritten in accordance with their eilgibility criteria and (2) serviced in according to the servicing criteria.

The Big 4 can definitely be helpful here. There are also good collateral diligence focused firms such as that can help as well. Clayton, for example, focuses on real estate diligence.

https://clayton.com/

2 Likes

Thank you @Eumenes for elucidating so well the RWF philosophy.

Personally, I believe that supporting a sustainable evolution of the DAI footprint is the overarching pillar we should try our best to align around. My view, not sustained by any governance process.

In addition, the community has in several occasions supported that such sustainable evolution should be done via:

  1. Exploring new opportunities (i.e. the MCD, real-world financing push, the D3M, and most recently the ambitions supporting the RWF Sandbox Report from where this Informal Poll emerges)
  2. Growing those opportunities with caution
  3. Continue to innovate internal processes and checks and balances
  4. Protect decentralisation
  5. Incentivise a sustainable economic development, both environmentally and socially

I believe that the parallel processes that the RWF is currently working on, including SocGen, the work with 6S, Centrifuge, Monetalis, and others can go in this direction, as well as the exploration of other avenues to expand the footprint through listed credit as suggested by @SebVentures.

In the long term, it is my opinion that Maker should not become simply a cheap source of liquidity for TradFi to plug itself into, but rather as an engine of change, innovation, and better community-led innovation. This can be achieved only through experimentation as the CU is doing now.

In addition, I do not necessarily believe that “start-up” / new investment ventures are unable to provide investment grade level of credit. On the contrary. Most of them can thrive on the arbitrage that exist for investment grade quality of credit currently underserved by banks because of very specific issues that an innovative group such as Maker can solve. I am sure we can do great things there as well.

I am looking forward to continue to support this effort, by enhancing the quality of the conversations, improving checks and balances, and help the community be exposed to more and more of what’s happening out there.

We are leaving through exciting times, thank you for putting together the proposal.

3 Likes

Is there a target rate of return in mind for providing this financing? Sure, we all want the risk level to be minimised and the above is a good way to ensure risk is low. But if all these investment standards are met, we may end up generating sub 2% returns (this is a guess). That’s fine if the Community agree sub 2% is an acceptable rate of return, but I think some approximate numbers would be helpful when considering how much risk we’re happy to take on. Others may think that’s sub-optimal so would be happy to step up the risk curve off the back of realising what the returns could look like.

1 Like

Thank you @justin1066,

It is difficult to look at a target rate of return in isolation. Even if we would be able to calculate a net yield (net of everything, i.e. net of expected losses, costs of liquidity, transfer pricing of costs, etc.), it would be difficult to “price” the tail risk of a liquidation in a world of non-smart contracts.

That is why, during the Sandbox exercise, we decided to talk about risk hurdle rates rather than return hurdle rates. It is difficult to condense risk appetite in a single number. Obviously, being IG, I would be highly surprised (and not necessarily in a good way) if such level of risk would yield the 2% you are talking about.

Nevertheless, I believe that a “cost of equity” type of conversation should be precious for Maker. Such conversation, however, would pertain more to a capital management function rather than a credit risk function. Calculating a cost of equity is a way more ample effort that cannot be completed before understanding every aspect of the business, starting from liquidity risk, the twin of credit risk when it comes to financing.

That is why I believe that, within a very clear mandate, the new Finance CU that @Aes is proposing would be precious in doing this. As a passionate financial professional and Maker community member, I am so much looking forward to have this kind of conversations with @Aes, @SebVentures, and the rest of the team in case the community will support the incorporation of the CU.

2 Likes

Looks like a very good starting point - and I think it is a great idea to get a more practical ‘what we want’ asset acquisition list out into the world. I think it is a good list.

I have a few suggestions on edits/additions/considerations:

a) It seens to emphasizes an extreme reliance on external rating agencies in making credit quality determinations. I would recommend against that. A rating is purely a starting point for an appropriate credit review. Usually a very good starting point I will add, but ultimately only a starting point. All of the pieces sketched out for non-rated credit should be considered as well in the review I’d think. I don’t believe the community is saying we should just take any credit rating agency word as gospel. It still needs a serious credit review. I would be disappointed if the signal we send to the world on Maker asset acquisition is ‘just get a Moody/Fithch/S&P/whatnot’s A and you can get Maker to take on just about anything’. Can I suggest we think about qualifying that part about rating agency requirements to make it more clear that Maker is not beholden to any rating agency’s rating and the credit quality needs to stand on its own merit after Maker’s own review.

b) So the list seems to refer mainly to “financial safety” - i.e. ensuring Maker get’s its money back essentially - and not very much about our societal, morale or policy standards/code, which in todays world is actually an integrated part of investment quality evaluation. If this signal is to go broader into the world, I think Maker would be doing itself a disservice if not such items were signalled also in this list. As we start interfacing with the real world we do need to show that we are willing to operate as a global responsible citizen. For instance, at the very least, I think we should sign up to a global standard “blacklist” (i.e. or, to be precise, we would require the credit participants to sign up to for getting access to Maker credit): Surely we don’t lend to organizations and businesses that are associated with human trafficking, child labor, prostitution, organized crime, human rights violations, etc etc (there are multiple global standards one could consider to adopt). Overall there should be this minimum set of global voluntary standards that Maker would require participants getting capital from Maker should sign up to. I suspect determining such a reasonable set of standards would take a bit of time (but time well spent!) - so in practice I recommend adding to the list, before it is released, that Maker does indeed intend to act as a global responsible citizen and that any credit application must show they do so too, by virtue of their policies, guidelines, standards etc - and the Maker review must, unfortunately, also include a review of this ‘global responsible citizen’ measure. And then more precise guidelines will be added over time from Maker. Within the crypto-world, most financial elementals can stay “value neutral”, but I fear trying to be “value neutral” when projecting out into the real world might get Maker into trouble - so a “miminmum world view” stand would need to be taken fairly ASAP as we scale the real world asset piece up. Ultimately I do not believe any regulator (or society at large for that matter) will accept the entry, expansion and survival of a new large capital participatnts into their markets that displays no explicit concience and moral compass.

c) Just one note on ‘Clean Money’. The vast majority of the ‘green economy’/ESG investment world is doing profit with purpose - i.e. the fact that you have certain non-financial requirements around what purposes you are willing to borrow to should not cause you to trade-off in credit quality or yield. I believe the majority of credit opportunity within the Clean Money initiative would fit within this category. It would be unreasonable to particularly ringfence and/or limit these profit-with-purpose credit opporunities. If the credit quality is there AND it is ‘clean money’ focused, I see very little reason for the opportunity to be singled out and punished. That stance would push these opportunities away from Maker rather than towards Maker, which I certainly don’t think is where the Maker community wants to go. On the other hand, if a particular credit opportunity in the clean money intiative is indeed seeking the Maker community to make such a trade-off, well, then obviously ringfencing and limits should be considered. But please don’t single out ‘clean money’ initiatives as inherently dangerous, unprofitable and of low credit quality. Can I suggest you edit that part of the list to include the trade-off? i.e. ringfencing/limit when a credit quality vs clean money impact trade-off is proposed.

2 Likes

Thanks Allan for the thoughtful reply.

Here are my thoughts:

(a) Good point on credit ratings - we do not mean to just ‘pass through’ the credit rating. We need to review the credit and leverage the work already done by the credit rating agency. We are also working on a more detailed list covering what we seek in typical investments.

(b) I certainly agree that ethical standards are important investing - its just beyond the scope of this initiative.

(c) As long as the credit quality is there, we are not suggesting ringfencing any types of collateral. Except for overall portfolio concentrations, liquidity needs… that apply to all investments.

I think generally the OP above taking into account commentary below is a decent starting point.

My biggest issues with RWF MIP6 applications was not just wanting a concise sets of standards that could be applied, but PEOPLE who actually were tasked with implementing these before a MIP6 is posted to governance for polling.

Every time I see a RWF MIP6 I ask - what does RWF and RISK say about these? In effect I would like to see these two CUs dedicate some effort to do a basic MIP6 pre-screening and if the application passes for the relevant RWF and RISK CUs to add themselves as co-sponsors to the proposal mostly so the proposers and governance players know who did the pre-screening and everyone knows who to talk to if there are questions or issues.

governance does not have the manpower or mechanisms to pre-screen these RW MIP6 applications and so are a poor filter. Worse people taking the time to write a proposal only to be rejected will not have a good Maker experience and maybe later (when they could be accepted) may not come back.

From my perspective how Maker handles these needs to be more along the lines of how businesses manage their prospects and should be handled with significantly more care than allowing anyone to toss whatever they want at governance and see what does or doesn’t stick.

6 Likes

@Eumenes made a great point about how IG credit can be structured out of non-IG credit. For instance, if you have an MCA flow purchase pool, the losses might be sky high, but the collateral returns 1.2x over 9-12 months on a static pool basis, then you can structure a senior loan at a 60~70% advance rate and still get a 4-5x loss multiple coverage.

Which leads me to my next point: the essence of the ratings that the major ratings agencies is essentially that loss multiple - given the historical performance of the loans originated from the platform, and the historical performance of benchmarked loan data, at what multiple would the investment be impaired? Note that across the ratings agencies, “impaired” is defined slightly differently as well (i.e. first dollar of principal loss vs first dollar of interest lost).

I think the items in #2 are standard in the tradfi structured credit / direct lending / ABL space, but I think this bullet point in #2 is the key:

" * A cash flow analysis determining whether the transaction cash flow and structure are adequate to make contractual payments to the investment at Investment Grade stress levels"

You can take a non-rated private senior warehouse loan, project out the collateral cash flows, and given the deal waterfall, show at what loss multiple on the collateral pool you start incurring impairment (however you might define it). Alternatively, you can benchmark this deal to rated term securitization issuances given collateral type, CE levels, etc, but in my opinion, this comps-based approach is not as good as structuring the deal based on loss multiple coverage.

1 Like

I personally couldn’t support this more @MakerMan,

Starting from the RW Sandbox exercise, and the deep and extensive process and governance review that RWF and the SES (and incubated) teams are doing. It is the ambition of those involved:

  • To provide Governance and the Community with a Comprehensive Assessment for a MIP6 that would provide a full risk, technological, legal, and process/ compliance report

  • To remain transparent with Community and Governance, given that no delegation of power has occurred to RWF or any other unit, in providing views and commentaries on the official applications

In the background, rest assured, all those involved are doing immense work to educate and screen counterparties and streamline process while improving quality and scale.

2 Likes

Atm, the MIP6s do not contain the necessary information for an informed decision on whether to move something forward or not. The community is going to have no way of knowing if the deal is worth doing if we don’t. :wink:

What we’ve discovered in our conversations is that we need to push a lot more work into MIP6 than what we have today. In some respects, the MIP6 is also a pre-assessment. That way, the key CUs can also provide their opinion on whether we recommend the collateral to move forward or not…and avoid a Greenlight poll all together.

It’s important that we stop work leaking into the system since it’s robbing us of valuable time that can be spent elsewhere.

7 Likes