I recently solved one issue I had with the accounting for MakerDAO. I will try to discuss that in this post.
This might have a lot of important implications (in my view):
- Unify crypto vaults and RWA vaults
- Unify demand driven investments (people creating vaults) and direct investments (Maker making the investment, for instance using Strategic Reserves)
- Unify Maker with a real world bank
I’m not 100% sure it’s fully correct, but I hope it does make sense.
What is a balance sheet
I will use a balance sheet representation a lot in this post so let’s discuss that a bit. In accounting, a balance sheet represents what assets you own (the assets side on the left) and how you finance them (the liability side on the right). You can finance an asset using a loan for instance. Whatever is left is your equity. Equity is your net worth. There is one rule, at all time, sum(assets) = sum(liabilities).
Below, you will find how we can describe a wallet containing 10 ETH (the ETH Bull Wallet). Let’s assume that a wallet can’t make a loan. So if I have 10 ETH and 1 ETH = $600, the equity of the wallet is $6,000.
Adding a vault
ETH Bull is bullish on ETH so he will leverage his position with Maker. In this representation, I assume a vault is a separated entity (you can transfer the vault ownership so it make sense to present that as a separated entity). Therefore, ETH Bull create vault #1 and transfert the 10 ETH in this vault. Those 10 ETH are no longer in the wallet but in the vault. Nevertheless, the wallet has ownership of the vault. The equity value of the vault is 10 ETH so almost nothing has changed. ETH Bull still has 10 ETH but through the vault (there is one indirection).
Taking a loan
Thanks to the loan smart contract, it is possible for ETH Bull to take a loan from Maker for Vault #1. ETH Bull get some DAI but the equity value of the vault is now decreased by the loan amount. Therefore, the net worth (equity) of the ETH Bull Wallet remains constant as it should be.
On the MakerDAO side (or more precisely, the DAI Credit System), we can see that the balance sheet was expanded by two items. On the asset side, we now have a loan from vault #1. It’s a promise to repay DAI at some point in the future with some stability fees. On the liability side, we have issued some DAI which are quite similar to a bank note. All DAI are fungible bearer assets and are a promise to repay a value of $1 at emergency shutdown.
Here is something interesting. It is not Maker that created a loan on the Vault #1. It was ETH Bull decision. Maker bought the loan (or lent the money, which is the same). How did Maker buy the loan? By minting DAI. If we zoom on the process, we start with 1. no asset and no liabilities on Maker balance sheet. Then in 2. we mint some DAI (creating the liability and having the same on the asset side). Finally, in 3., we use the DAI asset to buy the loan issued by Vault #1.
What we have done is what is called issuing unbacked DAI in many forum posts (but it is never unbacked as it’s not possible in accounting). This is called expanding the balance sheet of the bank in the real world.
PS: By definition it doesn’t make much sense to have DAI on both side of the balance sheet. Only Maker can have DAI on it’s liability side, and the net position will always be a liability for Maker.
But let’s go back to our story of the ETH Bull wallet.
Leveraging the position
So far, ETH Bull hasn’t achieved much. If we merge the vault and the wallet (as the vault is owned by the wallet), we can see that its balance sheet is bigger but the the DAI asset is fully equal to the DAI/ETH loan (except the loan will accrue interest). None are exposed to ETH variation. The exposure to the ETH price is still 100% of its net worth, there is no leverage.
We will need to introduce a new player in our little world: ETH Short Wallet. ETH Short has some ETH but think the price will fall and want to sell them for a stablecoin. Maybe he can make a deal with ETH Bull. They can swap DAI and ETH to end up in the following situation:
The transaction hasn’t changed the balance sheet of both Maker and the Vault.
What happen if ETH price increase?
If ETH increase its value by 50%, all ETH rectangles see their height increased by 50%. Using the rule of sum(assets) = sum(liabilities) and the fact that equity is what remains, we can see that the value of the Vault #1 increases by 100% (Vault #1 equity was 50% of ETH Bull net worth therefore a +50% increase on ETH Bull net worth). ETH Bull wallet has also 50% of ETH that has increased by 50% (meaning a 25% increase of ETH Bull net worth). ETH Bull Wallet net worth is now increased by +75% (1.5x leverage).
The DAI/ETH loan hasn’t changed as we assume no time has passed. ETH Bull is happy.
What happens after 1 year if ETH is stable?
Let’s see the impact of stability fees. They are increasing the DAI/ETH Loan value. Again with the same basics rules, the equity portion of Vault #1 decreases, impacting ETH Bull Wallet equity.
On the Maker side, the loan is on the assets. That increases the equity. This is currently our surplus buffer. It represents the accounting value of the MKR tokens.
Why does it matter?
The Surplus Buffer != DAI
As you can see the Surplus Buffer is collateralized by a loan (if someone repays a loan it decreases the DAI liabilities we have). A loan is a promise to pay DAI. It’s not DAI. They may pay … or not. That’s why @primoz want to increase the Surplus Buffer when we have higher risk of bad debt (USDC-A).
Using DAI to buyback and burn MKR is only a financial strategy.
Crypto Vault and RWA SPV are the same
For RWA we use Special Purpose Vehicles (SPV). The only difference is that the RWA “SPV/Vault” contains many assets that are expected to be uncorrelated but are also less liquid than crypto assets. There is almost no differences from an accounting perspective between the crypto world and the real world.
Buying any asset would work
Nothing prevents us to increase our balance sheet and buy something with DAI because we are doing it every time a vault issue a loan. Let’s say the Yield Protocol issue a DAI bond of 1 year maturity and there is demand (I took the Yield Protocol because it’s based on DAI and after maturity it become a ETH-A vault). Isn’t it better for us to invest in a 5% yielding bond than a ETH-A vault yielding 2% (assuming risk is similar)? Especially if there is a lot of DAI demand but not much ETH-A loan supply?
If the price is above $1, we have to expand our DAI supply.
We can sell the loans
On the other side, if the price of DAI is too low, we can sell the loans (that would mean changing a lot of stuff on the Smart Contract side I guess, I’m not saying we should work on that). That would reduce the DAI supply and most likely some people will want to buy that (the yield will be better than in Compound/Aave as there is no spread between the lending rate and the borrow rate). It will be at a discount if DAI is below $1.
This can also be a risk management. If there is a lot of demand for YFI vault, we can sell some DAI/YFI loans to reduce the risk (but probably take an origination fee).
Optimizing the equity section
As said, the amount of equity we want to have is a financial decision. Currently, we are limiting ourselves by the amount of loan people want to take from us. And we have only limited diversification benefit. But there is more and more opportunity to invest in DeFi. Would you agree to increase the Surplus Buffer to 10M if that would mean having twice the revenues (meaning burning twice the MKR amount after the first 6M used for increasing the Surplus Buffer) and the same risk?
This might be a lot to digest, especially if you don’t live in the accounting world. I think it offers a new perspective on what Maker is.