This paper proposes a bidding strategy based on “participation costs." Using this strategy, we calculate the maximum recommended bidding price for a sample of auctions. 75% of winning bids in the sample were unprofitable, as the discount from market price did not cover the participation costs. This behavior may be caused by inexperienced participants, or by altruistic actors who desire to keep the auction system running smoothly. An example calculation may be found here.
What price should keepers bid at in Maker auctions? A new working paper, entitled “Optimal Bidding Strategy for Maker Auctions” attempts to answer this question. We are posting this paper to allow for comments, prior to uploading to ArXiv.
Maker liquidations auctions are primarily common-value auctions: everyone has the same valuation for the auction collateral, which is the market price of the collateral. However, there are two private-value components:
- Alternative usage of collateral
- Costs to participate in the auction
The paper focuses primarily on “participation costs,” which are defined as the following:
- Transaction fees: Gas to dent/deal, join/exit from the Vat, and trade on Uniswap
- Conversion costs: Slippage when converting WETH to DAI
- Cost of capital: Implicit required return (discount rate) on capital held for bidding.
Other costs are incurred as a keeper (hardware, maintenance, etc.), but these are not incurred on chain, and are therefore not included in the analysis.
The paper proposes that participation costs can be optimized to their lowest possible point, by adjusting the minimum/maximum capital balance held for auction bidding. Once participation costs are optimized, bidders can determine the minimum discount from market price that they need to still make a profit. Alternatively stated, bidders can determine the maximum price they should bid at for each auction.
A total of 155 auctions, from March 23 through July 28, 2020, were analyzed. The analysis first optimized the participation costs to the lowest possible total, based on the auction parameters (tab) and the network conditions (gas price, and current ETH/DAI price). The analysis then compared the optimal bidding price to the actual bidding price that won each auction.
The analysis found that 75% of auctions were won at prices that did not cover participation costs. That is, the actual price was above the optimal price, which meant that the discount from the current market price was too small for the winning bidders to gain a profit, according our model of participation costs.
The gap in optimal vs. actual price is most prevalent in bids of $1,000 or less (83% of these auctions were won at a loss). The two charts below show the optimal discount vs. the actual discount / markup, relative to the market price at the time of the auction.
Several theories may be proposed to explain the differences observed.
- Indifference to cost of capital: This cost is implicit, and some participants may not be thinking about their required rate of return (estimated at 40%).
- Inexperienced actors: Some participants may not be accounting for the entirety of gas / slippage costs.
- Altruistic actors: Some participants may bid at a loss in the auctions, but they still benefit from having the Maker Protocol run smoothly (e.g. no repeat of Black Thursday). Even though they are losing money on paper, their total utility from the system is positive.
The paper (see here) covers the theory and findings in greater detail.
What does this mean for Liquidations 2.0?
The strategy proposed in this paper will still apply for Liquidations 2.0, but the definition of participation costs will certainly change under the new system. For example, one proposal under the new system is to lower participation costs by adding the ability to “flash-mint.” The full effects of the new system will need to be modeled after the system design has been finalized.
A Google spreadsheet has been created to show the model used to calculate participation costs. The sheet is included for any keepers that want to test their own strategy, or try to improve on the calculations.
- I am the first listed author in this paper.
- The research team does not hold any MKR or DAI. The team has also never participated in a mainnet auction (only on the Kovan network).