As might be guessed from the speaker series I’m organizing, I would like the DAO community to become more familiar with monetary policy and the theoretical base that underpins all mainstream understanding of monetarism.
For MakerDAO, this is not just a theoretical exercise. The Maker Protocol has some superpowers that heretofore I’ve not seen mentioned. I will let my economics education show and do that mentioning here. Grasping the significance of these will underline exactly what a powerful thing has been built on this protocol. I cannot overemphasize enough the power some of these allow us in terms of both scaling and being able to play the white knight for dollar-demoninated economies and markets.
Maker can profitably loan at negative real interest rates
Normally, it is a money-losing proposition for lending terms that are less than expected inflation, as the repayment is – in purchasing power – less than the amount loaned. For those unfamiliar with the concept, imagine a bank lends for one year at 2%, but inflation ends up being 2.5%. The bank has 102% of the funds lent out at the end of the loan, but ~99.5% of the purchasing power of the principle it loaned out originally.
Maker does not suffer from this problem. Why? The answer lies in two facts.
The first is that Maker generates DAI, which is successfully pegged to the USD. 1 DAI approximates 1 USD with very little slippage.
The second is that the opportunity cost is different for Maker. Because we can mint DAI against collateral, we do not have to source the funds lent out from other sources, or from idle funds that would otherwise be put to work in other uses. In a manner, the protocol rubs its hands together and makes DAI appear while locking up collateral. As long as the peg is maintained, this means that dollar-equivalents are created.
This is not a secret. Memes about about the (de)central bank concept. What this means, however, is that as long as absolute yield is positive, the protocol can profitably lend at below-inflation rates. If the appeal of this to borrowers is not obvious, imagine you are a government or corporation on the other end of the example above. You borrow $1 but pay back $0.995 at the end of the loan in real terms.
This comes with some strong caveats. What is true in theory is often entangled in real-life friction and surprises. The biggest of which is that there is no room for defaults or disorderly liquidations when lending at ultra-low rates. Only the absolute safest assets are appropriate for this kind of lending.
However, we already have proof of concept, though it has gone unrecognized. The PSM effectively makes this type of lending, with a fixed 10 bps in “interest” on loans of indeterminate time against USDC. Note also that many loans financed by the protocol – including if it becomes reality, against farmland in Iowa – are also tracking below expected inflation with the 10-year breakeven expected rate currently in the neighborhood of 2.5%.
Hopefully the fact that this is already being done within the protocol should allay any fears about this – as long as the nominal yield is positive and the assets are themselves ultra safe.
I hope it also does not need additional emphasis to point out that Maker can outcompete traditional lenders unquestionably, as long as there is zero or near-zero risk of the debt becoming bad. The physics of our fund sourcing gives us an ability to, say, finance lending to the US Treasury in ways that cannot be matched by anyone other than another central bank.
Edited to add: @SebVentures correctly pointed out below that I was leaving implicit the assumption that the DSR (or any future method of MarkerDAO borrowing) is at or near 0%. For obvious reasons, we cannot accept margins below the DSR unless we have motivations beyond profitability for a transaction.
Maker’s loans exert deflationary pressure
The loans facilitated by the protocol for our crypto assets exert deflationary pressure. The key reason is that the self-lending enabled by Maker vaults require deposit of collateral that itself can be used as a medium of exchange, thanks to the highly marketable properties of any asset on multiple exchanges.
This means that while DAI supply grows, total money supply of the crypto economy shrinks when a Maker vault is utilized. The reason for this is simply the overcollateralized nature of Maker lending. If a user deposits $200 in ETH and withdraws $100 in DAI, the total money supply has faced a negative growth event. Note that in fractional reserve lending, that deposit would be loaned out into the economy, making it inflationary in terms of growing the money supply. Maker vaults lock the collateral out of circulation, though.
I’ve not fully thought through the implications of this as Maker becomes larger. If there is not a robust integration between the crypto and real-world economies, I can this this having undesirable effects.
When Maker has enough scale, this aspect will be highly desirable, however, on the part of certain real-world borrowers if there is robust integration. Maker is far from the only deflation-exerting force in the crypto economy, so linking the two should help the crypto economy sop up some level of inflation if the crypto economy can in aggregate become large enough to matter.
Note also that Maker’s power to profitably lend at below real rates against real-world assets are likely to also exert deflationary pressures, though it is not clear in what magnitude, as this is a frontier in economic thought that hasn’t been explored.
While there are other implications I am still working through and asking others to think through, there should be one obvious application of these two “superpowers” in combination.
If we want 1 trillion DAI, there already is a collateral market that is deep enough for us to use as a springboard to make DAI ubiquitous enough that our core business becomes a must-have for more customers. Dollar-denominated, AAA-equivalent debt by or guaranteed by the US federal government and the more credit-worthy states offer an easy on-ramp for DAI growth.
This should also be extremely appealing to certain borrowers (Treasury is the most obvious) if Maker is scaled large enough to make a material difference in lending rates. Maker can – at a profit – lend to the US government at a rate that is not only below inflation, but also in a manner that reduces the inflationary pressures of such borrowing on the global economy. This serves to stabilize price levels most world economies and dollar-denominated markets while simultaneously relieving fiscal pressure on the US government – and at scale, Maker brings in large profits that dwarf our current income.
US government debt is both easy to monitor and brings relatively few additional risks, as long as the technical complexity of integrating these instruments with the protocol can be successfully solved. DAI is already heavily exposed to the risk of default by the US government, small though it is, so directly lending to the government or to holders of government debt who themselves collect a spread should not carry as much additional risk as most new collateral types. Practically speaking, it likely holds less regulatory risk than the large amount of USDC on our balance sheet, as there is always the chance that Circle/USDC itself is the target or regulatory backlash rather than Maker/DAI. The underlying promise of USDC redeemability also means Maker is already heavily exposed to risks associated with cash and near-cash held by Circle, but at the moment Circle collects the yield instead of Maker.
I should caution much of this is predicated on the peg remaining intact, though this type of program could also be sped up if we needed to exert (a small amount of) downward pressure on the peg. It would also serve as a way to diversify our portfolio of stable-assets away from stablecoins – in particular USDC.