Institutional Vaults - Economics & Terms

As discussed in the Institutional and Long Term Vaults Proposal, the RWF team wanted to analyze the economics of the institutional vault terms and assess the revenue impact in various scenarios so the community understands the proposal’s financial effects.

Summary

  • In a declining rate environment, institutional vaults will move funds out of their vaults to ETH-A or competitors once economically viable to do so (origination fee mitigates this to an extent)
  • In a stable rate environment, a $400M institutional vault must mint >$76M of Dai per year for MKR to breakeven over three years compared to a $400M with no incremental Dai minted at a 2% SF (ETH-A)
  • In a rising rate environment, MKR faces significant opportunity costs, allowing institutional vault users to capture the spread between the fixed vault rate and market rates which grows as the spread widens. We are seeking Community feedback to mitigate this risk.

Scenario Analysis

  • Scenario 1 - interest rates remain stable at 2%; compares a $400M ETH-A vault with no additional mint vs a $400M institutional vault that mints $38M in Dai every six months

  • Scenario 2 - interest rates remain stable at 2%; compares a $400M ETH-A vault with $100M/year additional mint vs a $400M institutional vault that mints $100M Dai/year

  • Scenario 3 - interest rates remain stable at 2%; compares a $400M ETH-A vault with $200M/year additional mint vs a $400M institutional vault that mints $200M Dai/year

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  • Scenario 4 - interest rates start at 2% in month one then increase by 50bps per month until they reach 6% and are flat for the the remainder of the current year as well as the subsequent two years. Institutional Vault owner mints aggressively to capture the spread, and benefit of 10bps of lower interest rates for every 100M Dai minted until DC of 1.5B Dai is reached

  • Scenario 5 - interest rates start at 2% in month one then increase by 50bps per month until they reach 9% and are flat for the the remainder of the current year before declining to 6% at year 3 end. Institutional Vault owner mints aggressively to capture the spread, and benefit of 10bps of lower interest rates for every 100M Dai minted

In the rising interest rate scenarios, if the institutional vault is important and the USDC PSM becomes empty, the rate pressure will be put disproportionately on non-institutional vaults to keep the peg. Institutional vaults will be subsidized by non-institutional vaults.

Another consideration I believe the community should keep in mind is of strategic importance. My view is that market share should be prioritized over profitability in MakerDAO’s and this industry’s rapid growth stage.

That doesn’t mean we have to forgo profitability, but there must be a balance so the entire ecosystem can grow sustainably. To that end and as mentioned in the summary, we would encourage the community to provide feedback on how we can mitigate upward and sustained interest rates as outlined in scenarios 4 and 5. A few options to consider to start the discussion:

  1. Higher fixed rate or origination fees
  2. Increase the maximum amount the SF can change every six months (current max is 1%)
  3. Cap the interest rate spread between the Institutional Vault and ETH-A SF

Shout out to the great work done by Growth, Risk, and PE to get this proposal to where it is today. I strongly believe this product will be a game changer for MakerDAO. Looking forward to the community’s feedback and input!

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I continue to think that we should manage the origination fee and fixed vault rate using the framework of the Deco Protocol. I already mentioned this, Fixed Rate Vaults Proposal With Deco Protocol - #15 by Joshua_Pritikin

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To clarify my understanding, is the following correct?

  • 2 (increase maximum SF change per period) makes sense in a rising rate environment only and leaves more room for renegotiation.
  • 3 (cap SF spread) makes sense in both rising and declining rates environment, and moves towards a dampened variable rate loan (rather than a fixed rate loan).
  • 1a (higher fixed rate) makes sense only insofar as the initial rate should already reflect your best guesses about both the future rate environment and the overall value additional DAI supply brings to Maker.
  • 1b (higher origination fee) seems like a bandaid.

Overall I like the proposal a lot, but the specific combination of public contractual terms, at-will loan refinancing and semi-fixed rates is not easy to think through.

Still thinking, but did want to just get out there early in the conversation that I suspect rates in crypto will converge more and more with real-world rates for dollars. To that extent, I think it’s unlikely that rates in crypto will rise significantly any time soon unless the spread between safe and risky assets blows out.

I do, of course, reserve the right to be wrong, and have no crystal ball for the future. But I just don’t see how the increasing integration of the two economies can cause anything but net lower rates in crypto as capital flows into it from the real world.

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I am attaching here the first few papers of an early edition of my whitepaper:



We have a fully developed Smart Contract and Frontend Product for fixed interest rates on Maker Vaults ready for use. We are ready to open up our codebase to Maker Protocol Engineering.

you can see some of what it looks like here: link

We have undergone an audit by Iosiro.

Based on our discussions with ecosystem participants, there should be demand from Dai treasuries to be counter-party’s to the borrowers.

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It’s exciting to see yet another implementation of fixed rate borrowing. It sounds like Pairwyse is not closely integrated with MakerDAO and, in contrast with Deco Protocol, requires other market participants to take the opposite side of the trade. Is that correct?

Right now Maker is our main integration.

Regarding counterparties thats correct.

I think matching assets and liabilities is the correct way to go about it.

Maturity transformation is very difficult. Thats why we created a matched book.

Okay, so how does your project compare with Yield Protocol?

Isn’t Deco Protocol a counterexample to your assertion?

I cannot comment on other projects.

When I spoke about maturity transformation I didnt mean it in the software sense. I meant from a risk perspective.

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Hi, this is my first ever forum post, so quick Intro about me. I’m co-founder and COO of akiva.capital and very interested in this subject, so wanted to share my own feedback on this proposal:

I believe the rising / stable / falling rate scenarios describe a pivotal tradeoff MakerDAO will need to make due to the impossible trinity, namely an independent monetary policy (e.g. DAI stablecoin issued by a DAO) with a mandate for free flow capital (e.g. non-custodial permissionless access) cannot institute fixed rates long-term without placing volatility pressures on its native currency and flight pressures on capital from the system.

In that sense, I see Institutional Vaults as only a temporary fix for stable rate relief before larger pressures on DAI and TVL force MKR holders to take action against institutional vaults due to many of the risks highlighted in the post.

In short, you can have either a fixed peg or fix rates, but you can’t do both long-term without placing a cap on TVL, which is probably not an option for a DAO with a growth mandate.

So what is the solution?

Well, since the announcement of increased scaling of RWA, a number of fixed-rate protocols built over MakerDAO have been announced, including ours (Pairwyse developed by akiva.capital). To me, these adjunct protocols over MakerDAO would quickly facilitate DAI stable rates for key user segments without forcing MakerDAO to sacrifice the rate, credit and deposit governance it uses to maintain and grow DAI supply and protocol competitiveness/profitability.

You can read more about the impossible trinity problem as it relates to general DeFi protocols in the intro section of our upcoming white paper (screenshots attached). Happy to chat on this subject on- or off-line.



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Alright but I’m concerned about the duplication of functionality and dilution of liquidity. If swap buyers have to choose between three (or more) marketplaces and swap sellers have to manage their books across two (or more) marketplaces then that just seems more confusing than a single fixed-to-floating swap clearinghouse. That’s why I’m asking for comparisons between these extremely similar add-ons or products or protocols (whatever you call them). In my mind, Deco Protocol offers an advantage over Yield and Akiva because Deco does not need swap sellers. With Deco, Maker Protocol itself can handle the sell side.

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I have been working on an alternate Institutional Vault Proposal but have not been able to complete it before this came out.

Lets try to clear a few things off the plate first.

The impossible trinity as far as I can see can’t be gotten out of. The idea that we can create a buffer by trying to focus intermediaries to take the other side of the rate equation only works for the time frame * capital * rate difference against the capital allocated by whoever the counter party is.

While there is concern about collateral outflows and potential capital outflows via TVL Maker while similar in many ways to a government in terms of dealing with financial policy, rates, and capital movements is different in another way. The health of sovereign economies was highly dependent on these capital flows, currency pricing, and rates.

What is interesting here is the additional governance hand tying being attempted here.

For Maker the impossible trinity ends up.

  1. Capital controls (Maker has as one of it’s highest, if not THE highest priority) to not have any capital controls on DAI movement or collateral. Plain and simple this part of the trinity is off limits for any forms of control. Any idea to change this will have significant financial and political implications for Maker and probably DeFI in general.

  2. PEG via PSM is limited to the high side by the aggregate total of stablecoin depositable in the PSM. Once this exhausts there is no upside PEG protection. Lowside PEG protection is by PSM stablecoin backstops if this exhausts we have SF then DSR and are depending on borrowers to have growing incentives to pay down debt and sop up extra DAI. This places a strong limitation on DAI PEG upside management as well as downside with rates via SF being a key component.

  3. Rates. Maker via initial design had to have free rate management. Maker to manage SAI prices had rates as high at 20% from a low of near 0 in less than 6 months. Once I hear about ideas regarding larger vaults via RWA and now Institutional players it was obvious that IF Maker gets sucked into this we could rapidly have significant problems which would appear in the PSM (in fact I begin to wonder whether we are already in that position with a PSM USDC but lets leave that topic for another thread).

Two ways have been proposed now regarding how Maker will lay off the risk to offer long term rates:

  1. The protocol assumes this risk directly via DECO protocol.
  2. Now Pairwyse Protocol.

In case (1) above the Maker protocol takes on the interest rate spread risk. In case (2) my quick read suggests this would be done by a 3rd counter party (correct me if I am wrong). In both cases here the issue is going to be pricing of liquidity and ignores some basic concepts of Maker protocol paradigm that does not exist with sovereigns.

  1. DAI is a promise on collateral value not a promise on services or goods.
  2. The protocol only needs to be solvent and manage revenues to guarantee operations. As was seen after Black Thursday the protocol DAI contracted by 1/3 and SF went immediately to zero. Only because of the failed auctions did Maker even need to raise cash. DAI and TVL contractions are par for the financial course and are nomal and SHOULD be EXPECTED.

Now lets get to some meat here…

Given that it is pretty clear Maker must have clear control over rates what we have to be mindful of is the rate spreads between any fixed rate deals we make and our vaults that we will need to manage DAI liquidity and price. This means the limitations on rate changes for IV and anyone seeking longer term rates will have to be adjusted to endeavor to satisfy both market constraints to manage liquidity issues against potential DAI prices. There really isn’t any other option here and I really want to make this clear.

Maker CAN NOT and should not allow itself to be TRAPPED by larger players desiring long term rate deals. Points here.

  1. Since Maker can take on this rate risk - it is probably best suited to be the first line of defense here should we decide it is important to take on the longer term rate risk.
  2. If this rate risk gets to large for Maker to undertake it should seek to lay off these interest rate swaps to another party for a fee in exchange for the backing liquidity.
  3. The length and the amount of the long term rate spread is critical to managing this risk via liquidity.

Analysis

My own analysis suggests that as expenses and SB requirements stand currently that Maker could do reasonably well locking rates for terms no greater than 6 months at a time. The idea that in your analysis @Aes that promised on long term rates based on liquidity demands would just continue to decrease due to terms of agreements simply can’t be tolerated and has to be managed by the following:

  1. Bonuses for IV can and should only extend for limited periods. We might want DAI expansion today but DAI contraction tomorrow. Any agreements around this type of performance should never extend very far into the future.

  2. This .1%/100M is too much. My own analysis suggests giving a .05%/100M up to a DC of 1B is probably best first step. This on a the extra 600M will only take the rate down to 1.2% (giving them a performance modifier of .3%). So these performance modifiers should never modify rates dramatically. I would hazard a general rule of thumb is they should never modify the base rate by more than 25% (.25% on 1%, 2.5% on 10%). But this is an off the top of my head number.

  3. The interest rate LOCK here of this 1%/6 months is somewhat arbitrary and should in principle be a percentage based on the rate changes on all floating vaults. IF for example the combined volume weighted SF changes by 2% (goes from 2-4%) in the next 6 months in the above example I would want rates to change by a minimum of 1/2 this difference + performance rebate. Example +2% in 6 months and a -.3% performance fee on 1B would put Nexo at 2*.5+1.5-.3 = 2.2%. In the next 6 months if interest rates and flat and that -.3% performance fee still exists we go (4-2.2)*.5 +2.2 - .3 = 2.8% etc.

(3) with the 50% of the average SF difference simply gives a tailing rate change of basically 1/2 the nominal SF the system needs and it does this no longer than every 6 months. This will allow the IV rates to eventually converge pretty closely after no more than 2-2.5years.

Because Maker can and should offer something more like (3) IV with a commitment by us to honor this, I think a strong onus on vault owners to basically put up a slashable stake for this commitment. The point here is that IV vaults won’t be allowed to ride lower rates via this model without putting up a slashable stake related to:

  • DAI interest paid to the protocol relative to the interest that would be paid
  • a general commitment to the protocol - that is basically refunded over time as DAI interest accumlates to the protocol.

Examples here. Nexo wants to slide over 400M into a 1.5% 1-1.5B vault which has some kind of terms like the above. Well I want a slashable deposit of that .5% (2M) minimum be put into an escrow fund so if Nexo bails or reduces the collateral deposited (not the TVL the total ETH/BTC whatever) by 50% or more over the period they can lose not just any performance bonuses but also this slashable stake.

What I would give up on to get this slashable stake (and I am still working out terms and details on that which is why I have not released this) is the origination fee.

Put simply the origination fees over time are not going to make up for interest lost, Maker can’t afford to give up points for origination fees. There is no way in hell a 1 time fee can make up for lost interest over time.

The points for a interest rate change on IV vaults model (3) should be clear from the above and at least in my own analysis inescapable. No matter the party, rates have to converge to market norms at some point. Can the Maker economy deal with limited TVL growth - yes. Can Maker deal with somewhat less revenue due to this model probably always undershooting rates - only for a short time and I can’t stress enough we will need to manage the SB to have an even higher amount and/or get some DAI stashed out of this system to deal with managing liquidity issues. We will also have to keep a careful eye on the PSMs because doing the above will likely put the DAI price in jeopardy to the downside which we are most concerned about.

I am still trying to digest issues here and come up with a reasonable counter proposal but pay attention here Maker.

Interest rate control via SF IS the last free variable here. Mess with this with significant peril to the system overall.

Also final points. Apologies for length and that I can’t just unveil a IV counter proposal. This whole if we commit to you with IV vault - and how to make a IV player commit to maker (slash-able stake or some other model is the most difficult part here). While writing this and looking back at my own analysis I realized having reasonable freedom with SF is basically all Maker has left as this point in the impossible Trinity and we can’t give this up or even flex on it without careful consideration of the significant systemic risks doing so would pose.

In conclusion @Aes you are right - the IV offer/terms needs to change for this to work in any way, much less a sustainable way. How we do this exactly to take on modulating risk for less (and not more fees) is really the tricky part. Doing it sustainably while retaining competitiveness is really the challenge.

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“DAI and TVL contractions are par for the financial course and are nomal and SHOULD be EXPECTED.”

This is a really key point.

What we envision is a ladder of matched book transactions diverisified across duration and maturity so as to avoid concentration risks. It will be the job of an Asset Liability Management Committee (ALCO) to set the maturity dates. Of course, MakerDAO would be in charge of that.

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The community has shown very strong support for the institutional vault proposal and I think the discussion regarding a fixed rate technical implementation from Deco, Pairwyse, Sense, Element Finance, etc. needs to be discussed separately until the community is further along in deciding which fixed rate implementation is best suited for MKR. That implementation would be well-suited for the Long Term Vaults and we could potentially discuss transitioning any institutional vaults to one of those fixed rate products down the road.

Max SF change can also be beneficial when rates decrease as institutional capital would be more likely to be remain in a vault in the event of a rapid rate decrease.
@Primoz can correct me if I’m wrong, but I believe the rates are more a function of risk as it relates to the collateral which is why you see higher rates for less liquid/risky/volatile collaterals.
Higher origination fee is disincentivizes moving capital from the institutional to ETH-A or outside vaults.

Welcome to the forums and appreciate the insightful post. How long would an implementation of Pairwyse take if the community decided to go this route? In the near term, the community has shown a desire to beta test the institutional vault proposal so any thoughts on how the terms can be adjusted to account for the risks discuss would be greatly appreciated. My impression from your post is that max change in SF per period and the period length itself should be shortened.

Appreciate the thoughtful response! I think you raise many important points as we consider our options here. As it relates to the slashable stake component, how do you envision the below working?

Sounds like on one hand we are getting into profit sharing and on the other hand (below) we are offering a rebate of sorts.

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Sure, but the reason I think the discussion is relevant now is because it would be nice if the bespoke terms of institutional vaults could easily be harmonized with whatever fixed rate implementation we eventually select. As it stands, the instutitional vault is proposed to have some terms that could not be easily reconciled with fixed rate protocols:

  • Origination fee is a one-time thing, not recurring per time period
  • The fixed rate cannot increase by more than 1% per time period
  • Stability fee can be set depending on how much debt is incurred so large vaults pay less stability fee.

Whereas I am still generally in favor of institutional vaults, I’m concerned about how much negotiation between Maker and Nexo is going into the terms of the deal. I’d like to see the terms be more generic and, ideally, applicable across all vaults. If we have to involve core units and governance to negotiate custom deals every time we have a big customer, it might end up eating more time and effort than its worth.

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I would love to see a fixed rate implementation today but competitors are moving ahead with institutional vault offerings and I believe we need to come to the table with one ourselves until there is a technical fixed rate implementation.

That is the entire purpose of this thread - to provide visibility to the revenue impact of the current institutional vault terms and engage the community with how we could adjust the terms so risks and opportunity costs are mitigated.

This is the first ‘beta’ product offering and I believe it’s important the community is engaged for the aforementioned reasons. Once the community thinks through the points made in this thread I believe we will have a framework of sorts for subsequent customers.

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Agreed, moving forward fast with acceptable risk should be the priority. There are inefficiencies inherent in the hashing out of everything that comes with a DAO but in the meantime competitors are not sleeping. There is not infinite leeway here. To stay alive Maker should prioritize early rough consensus on imperfect solutions with acceptable risk and improve later.

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It appears that Deco can handle at least this feature with elegant simplicity,

Pairwyse is already implemented and deployed on mainnet. There is also a front-end interface available in addition to a back-end liquidation risk monitoring service. We can customize very quickly, including extending Pairwyse to permissioned vaults.

We built Pairwyse over the existing MakerDAO protocol, so we don’t need Maker to build new features into its protocol… just biz + org alignments and we can tweak any technicals on our end, including independent audits as needed.

With the existing Pairwyse implementation, Nexo can receive a fixed-rate, fixed-term, fixed-loan principal offering if Maker simply matches an equal notional amount of DAI from one or more DAI investors and/or reserves it has access to.

As I understand it, there are DAI-holding treasuries seeking low-risk principal-protected yield opportunities, which Pairwyse was designed to provide. In turn, a maturity ladder of fixed rates can be defined for Nexo across a series of short successive FRA term agreements on Pairwyse.

Fixed rates for successive terms can optionally be adjusted relative to expectation of the DSR over a given period and with some consideration given to competitor offerings as well as increased collateralization from the borrower’s end.

Nexo only needs to maintain adequate collateralization for any vault it enters into Pairwyse that is matched by a DAI investment counterparty. In the event a liquidation is triggered by Maker protocol, the investor’s DAI principal remains intact, although their interest income ends early (i.e. call risk).

In general, I don’t see any issues with Institutional Vaults, especially given there are competitors to Maker in this arena. Thus, it would be wise for Maker to address a solution to this quickly. As I mentioned, we can swiftly integrate permissioned vaults if needed or leverage the current Pairwyse implementation over existing Maker vaults. In doing so, Pairwyse can provide synergistic benefits to Nexo, Maker and DAI-holding treasuries to create a win-win-win.

The only issue I see in extending institutional vaults to terms > 6 mo comes back to the impossible trinity where Maker is locked into programmatic fixed rate adjustments, which takes away the free-market aspect of the protocol… such as in traditional money markets, where borrower and investor can typically negotiate fixed-rates across short successive terms.

Overall, we see the relationship between Pairwyse and MakerDAO as similar to a US Bank built over the Federal Reserve, where a bank will facilitate matching of depositors and credit-seekers based on credit & deposit facilities provided to it by its central bank. The only difference is that matching is peer-to-peer directed in Pairwyse.

To me, this is where I see long-term scalability of DAI can be achieved - through protocols that build over Maker’s foundational building blocks, providing value adds without putting Maker in a position of hitting an impossible trinity dead-end, short- or long-term.

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Aas the first potential institutional user of the institutional vaults, I would like to reiterate some of the ideas communicated above on behalf of Nexo, as well as previous commitments made in other discussions or directly to the Maker teams involved in this project:

  1. The fixed interest rates allow for a quasi fixed-interest rate over the long-term, with a limited float.
  2. Predictable rates allow for an aggressive expansion of Nexo current vault (from 400M DAI to 600M DAI) over a 30-day period after the vault launch under these terms.
  3. Progressive reduction of SF in line with size allows for an ongoing incentive to increase those vaults
  4. Having a quasi-fixed, long-term vault over the long-term allows for an open dialogue with Nexo to meet monetary objectives - regardless whether this is contraction or expansion of the monetary policy
  5. Such large scale predictable line of credit allows Maker to keep it’s competitive positions in the face of both emerging protocols aggressively handing out rewards, as well as centralised stable coins aggressively expanding their loan books.
  6. Having long-term commitments from it’s customers means that some of the most important metrics for Maker - TVL & DAI supply would fluctuate less over time and would have a direct lever for counteraction through the institutional vault.

We have clearly communicated with all maker teams that we are aware this is only a first iteration of the product, with possible changes down the line. We are ready to work together with all teams to design the best possible institutional product without sacrificing protocol safety.

We have also proposed multiple ways for both off-chain and on-chain monitoring of risk, that could potentially allow Maker to provide more capital-efficient lending that would over time become more important to attract and retain institutions in the space.

Finally, I want to reiterate that automation of collateral management is our biggest priority at the moment. This provides Nexo with better capital efficiency and all of the above benefits without them coming at the expense of larger systematic risk to the protocol.

Happy to address specific questions and facilitate the discussion further.

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