Regarding increasing the Surplus Buffer, this post provides some risk and business-related elements elaborated by @Primoz and myself. Feel free to ask more questions.
In short, we are advocating to increase the Surplus Buffer to 2.5% and 5% of Maker’s RWA (risk weighted assets), e.g. something between 70M and 80M xxM. Nevertheless, each community participant should take an informed decision. At the end of the day, it is a business decision on how much risk MKR holders want to take.
Here are some data points you could consider:
One way to objectivize the risk of the protocol is to use the leverage ratio. The leverage ratio is surplus buffer/assets (all loans). This is around 0.5% right now. Nevertheless, this doesn’t take into account the underlying risk of each asset type. Indeed, holding some USDC isn’t risky except on the tail events (regulatory ban of USDC on Maker Protocol). ETH-B is strictly riskier than ETH-A or ETH-C. Additionally, we currently face a lack of Keepers for Uniswap LP vaults making them risky (as we can have 0 bids).
A better way to think about risk is to use a risk-weighted approach when each asset is weighted by a risk factor. This is called Core Equity Tier (CET1) 1 ratio in the real-world.
The bank regulation set the minimum level of the leverage ratio to 3% and the CET1 ratio to 4.5% but those are not necessarily adequate to evaluate the risk of MakerDAO.
Real-world assets (MIP21 and MIP22)
Currently, both MIP21 and MIP22 are quite aggressive regarding loan impairment. Indeed, they all start with a soft liquidation that is transferred to a hard liquidation after a delay (MIP21) or after a governance decision (MIP22).
When the hard liquidation is triggered all the remaining
tab (debt) is declared as
sin which decreases the Surplus Buffer and might lead to MKR minting. This is not necessarily a good representation of the reality and it might well be that most of the loan will be recovered in the future (days, weeks, months, …). Nevertheless, that’s the best solution at this stage.
For this reason, it could be safer to have a Surplus Buffer at least the size of the biggest RWA vault loan.
It might well be that regulations about stablecoin will be enacted in the future.
One is MiCa (European regulation on stablecoin that apply also on USD-pegged stablecoins) which requires a 2% leverage ratio. Should this regulation apply in 2024, it might cut us from EU-based exchanges/centralized products.
If the bank regulation is taken (Basel iii), the minimum leverage ratio should be 3%. This might be the case with the STABLE Act (US-based) that requires stablecoin issuers to apply for a bank license. Again non-compliance might cut us from most US-business.
MakerDAO is currently far from being regulated under those legislations. Moreover, there are plenty of other rules that MakerDAO doesn’t match (meaning having a proper Surplus Buffer doesn’t solve everything). Nevertheless, in case such capital levels are needed, it would take significant time to reach those objectives (assuming we don’t want to dilute MKR holders).
On MKR burn lerp
If the community decides on a surplus buffer size as adequate for the community risk appetite, it doesn’t make objective sense to delay aching the goal by burning MKR. Nevertheless, the need to burn some MKR along the way might be needed for PR.
At this stage, we are generating $100M of revenues annually from lending and we could forecast around $30M of operating expenses annually (Core Units mainly). This lead to a Surplus Buffer increase of around $6M/month.
Impact of the Surplus Buffer on the MKR earnings
The Surplus Buffer is on the liability side. It is therefore not resources we can use for anything per se.
Nevertheless, assuming the demand of DAI to be constant no matter the size of the Surplus Buffer, the only impact would be the size of PSM-USDC-A. This is not an earning asset yet, but some MIPs are proposing to use those USDC in a more lucrative way.
At this stage, and even without earnings, the level of the Surplus Buffer doesn’t impact significantly the MKR return on investment. Indeed, if the Surplus Buffer is 1% of MKR market cap, the impact on earning is 1%.
Without going into much detail, the existence and the level of the Surplus Buffer is a key element of the value proposition of DAI.
USDC, PAX (incl. BUSD and HUSD) don’t have Surplus Buffer equivalents in their design. Nevertheless USDC has a surplus of assets of 0.5% of the issued USDC currently. Moreover, their investments are risk-free assets (T-Bills and FDIC-guaranteed banks deposit mainly).
DAI has a Surplus Buffer but also has more risky assets (crypto-backed loans mainly, RWA soon). This provides a much better return for MKR holders but DAI might want a share of the cake (as they take some of the risks). DAI holders also don’t get $ convertibility. This might lead to a needed increase of the DSR to compete with USDC-like stablecoin if we can’t be better on some other aspects.
Other competitors in the future can be lending platforms (CeFi like BlockFi or DeFi like Compound). They might want to issue a stablecoin to decrease their funding cost and increase profits.
Nevertheless, it should be noted that the DeFi space currently doesn’t care as shown in the USDT case and the existence of algorithmic stablecoins like FRAX.
Risk of having a big Surplus Buffer
As designed currently the surplus buffer belongs to DAI holders at the emergency shutdown of the DAI Protocol (as discussed here). The limit of the Surplus Buffer (before game theory suggests triggering an Emergency Shutdown) is hard to define and depends on the quality and liquidity of the collateral that can be retrieved. Intuitively, you can say that the Surplus Buffer shouldn’t be above a few percents of the DAI outstanding.
Solutions to this problem are either:
- Using the mandated actors multi-sig (which require significant trust in the mandated actors) to store excess funds (above 1% Surplus Buffer)
- Implementing Strategic Reserves (which demands SC work)
- Finding a solution to have residual collaterals (after all DAI holders are given $1 of collateral) given to MKR holders (or mandated multisig or Strategic Reserves) after an Emergency Shutdown. Probably hard to solve.
The first two solutions are not perfect as nothing guarantees MKR holders will refund DAI holders if they get less than $1 at Emergency Shutdown.
Risk premiums and VaR
According to the latest risk premiums table, the weighted risk premium for MakerDAO’s portfolio is about 6%. This means expected losses per year would amount to about 115m on a portfolio of 1.9bn (excluding stablecoins). This metric is however based on the Liquidations 1.2. Further, the 99% VaR value from Andy’s presentation in January measured about 10% of debt exposure (again excluding stablecoins). Applying this to today’s debt levels, 99% VaR would likely amount to around 200m. Again this number doesn’t assume implementation of Liquidations 2.0 and its positive effect on expected and tail event losses.
Assuming huge improvement with Liq 2.0 we could say that the reasonable amount of Surplus Buffer would be between 50m and 100m (also depends on the community’s confidence interval to be hedged against worst case losses, in other words what % of VaR is chosen). This potential range of Surplus value would represent between 2.5% and 5% of Maker’s RWA (risk weighted assets) and would be also somehow in line with Basel recommendations for banks.
Assuming a middleground figure of 75m targeted Surplus Buffer and net income of 6m per month (after DAOs costs), we would need to wait until the end of 2021 to get Surplus Buffer to target levels. This also means no MKR burning in 2021 at this pace of net income.
From MKR holders perspective the issue really lies in current inability to achieve some minimum safe yield on Surplus Buffer assets (currently Surplus Buffer counterparty is non-interest yielding USDC in the PSM). Imagine a 5-10% yield that would be achieved on a 75m of Surplus Buffer.
We therefore think that from a risk perspective a Surplus Buffer of 70m to 80m would be preferred going forward with no burning or a minimum amount of burning (25%) if we are able to make yield on Surplus Buffer assets by implementing strategic reserves or similar type of treasury management concept.