MakerDAO: the Sleeping Giant

Long-form research reports published by the HFA Research Team. 100% Free.

Intro

Most people reading this will likely already have an idea of what MakerDAO does… at its core Maker is a CDP protocol allowing users to borrow DAI (their overcollateralised stablecoin) against multiple collateral types (both volatile and stable crypto assets and tokenised Real World Assets/RWAs). The lending side of the platform is denominated purely in DAI and MKR is the governance token. 

While DAI supply has been trending down since Feb 2022, it is still the 3rd largest stablecoin and the largest “decentralised” stablecoin by quite some margin. As for the governance token, historically MKR/ETH has been down only and has become somewhat of a cursed pair. Despite this, over the past month or so MKR has outperformed quite significantly (mostly during EU hours):

h/t @not_trademarc

Some speculate that outperformance can be attributed to a short squeeze or simply shorts closing while others speculate that it could be indicative of institutional buying (there is some evidence to support this but it is always difficult to differentiate between custody shifts vs actual buying).

Steady State Fundamentals

First let’s take a look at the underlying steady state fundamentals and then some more dynamic development-based catalysts which may have led to this move and could contribute to continued outperformance. 

Maker derives revenue from three main sources:

• net interest margin generated from the spread between the interest borrowers pay on loans (stability fee) and the DAI savings rate (more on this later)

• liquidation revenues from fees charged on liquidated CDPs 

• stablecoin trading fees from the Price Stability Module (the PSM allows participants to swap other stablecoins for DAI at a fixed rate with a 0.1% fee to maintain the peg)

MKR as a token is responsible for recapitalization in the case of protocol insolvency: liquidated collateral value < outstanding DAI. In this scenario the protocol mints and auctions MKR, diluting supply to attempt at covering losses and ensuring protocol solvency. This eventuality actually played out during the March 2020 crash and has henceforth been referred to as “Black Thursday” - link. 

Beyond covering development/operational expenditures and contributing towards the Surplus Buffer (a fund to cover potential liquidation losses), MKR tokens also indirectly accrue value as revenues are currently used to buy and burn MKR tokens (~2.2% of supply burned thus far). 

The protocol also earns yield on the Surplus Buffer, protocol treasury and the stablecoin backing of DAI through various asset allocation and lending activities. This introduces some maturity and liquidity risk but equally allows Maker to operate at a profit. A part of this revenue is passed through to Dai Savings Rate depositors (again, we will dig in below). 

From an underlying business perspective, Maker has been chugging along during the bear market. While DefiLlama and TokenTerminal show different data, using the makerburn site (which seems to be trusted by those close to the protocol), we can see that Maker is profitable and experiencing growth:

Over the past 12 months we’ve seen strong growth in the “annual profit estimate” (all revenue sources annualised - current expenses) and a reduction in expenses.

Development-based Catalysts

Beyond the steady state fundamentals, there have been some key developments recently which which have undoubtedly led to the recent growth spurt Maker has enjoyed: 

• The Dai Savings Rate (DSR) is a native yield offered by MakerDAO on DAI. It acts both as an incentive for participants to hold DAI (supportive of the peg) and a monetary policy tool to control DAI supply. In mid-June the DSR was raised 2.49% from 1%>3.49%. This has led to a 100m+ increase in the amount of DAI sitting in the DSR and an increase in the amount of DAI minted with stablecoin collateral backing (link). MonetSupply notes that the recent DSR increase shows that Maker is resilient against margin compression as the costs associated have increased less than vault revenues have increased which is promising (in banking terms this might translate to: net interest margin has tightened but an increase in borrowing has led to a net positive impact on earnings). A good thread on the DSR and potential impacts here; not all of this has played out quite yet but in theory it should in due time. 

• A significant increase in the use of RWAs as DAI collateral (see below), which implicitly reduces the risk of DAI and removes some cyclicality previously present in the protocol (this can work both ways!). 

• ‘Smart Burn Engine’ proposal: rather than buying and burning MKR, this proposal discusses buying MKR with DAI generated by protocol fees to be paired with excess DAI from the Surplus Buffer (activated when Surplus Buffer>$50m, it is currently $70m) to go towards Univ2 MKR/DAI protocol owned liquidity. The idea is that this would reduce protocol risk in another “Black Thursday”-esque scenario by increasing MKR liquidity.

• The launch and growth of Spark, a growth-focused arm of Maker allowing users to interact with the protocol via a friendly user interface akin to Aave/Compound. Spark has a credit line from Maker called a Dai Direct Deposit Module (D3M) which allows users to borrow DAI at the DSR rate. This thread goes into more detail in terms of how Spark works (they have more integrations than just Maker). Spark is being developed by Phoenix Labs but is wholly owned by Maker Governance and is acting as a growth arm on their behalf. While the TVL is still low at sub $50m, it has been growing and the use case for a long term borrower to borrow at a semi-fixed rate (the DSR) while using a multitude of possible collateral types could be an attractive product for some users. 

• Multichain Expansion planned: link

• Plans to develop fixed-yield products for savers (think DSR users) which could help offset some of the maturity risk between the asset and liability sides of the protocol balance sheet.

Summary

Of course there is notable competition, with Frax, Curve and Aave all circling on the same market but with DAI supply being so high (relatively) the protocol can still be successful even while losing relative market share (h/t @MonetSupply). 

Given current profit estimates (per makerburn), Maker is estimated to make roughly $80m (annualised) which on a fully diluted basis (at the value of writing) backs out to a P/E of 10. While the ‘Smart Burn Engine’ derisks the entire protocol in the long term by providing an additional backstop in the case of a black swan it does not directly drive value to MKR. One could also argue that Maker is accruing a yield generating asset (its own POL) in a treasury which ultimately belongs to tokenholders. Perhaps the market can look past this and assume that value will accrue to MKR at some point once the Surplus Buffer and POL are sufficiently large - all they would have to do is direct those same flows of DAI to MKR holders (perhaps reserving some future profits in the treasury for growth/acquisitions too). Clearly there are other incentives for the DAO at present and securing the safety and solvency of the protocol through the long term is not a foolish decision in the slightest. 

MKR seems cheap at a roughly $1bn valuation and likely performs well on a multi-year time horizon. The bigger question for me is whether it outperforms ETH and/or its peers over the same time horizon, this will depend on the continually changing competitive environment and Maker’s internal strategy. While MKR and other DeFi 1.0 protocols are operating profitable and increasingly sustainable businesses, betting on them is really a bet on regulatory clarity. I say this because I view direct distributions of DAI as unlikely without regulatory clarity, given their scale and token holderbase.

More Resources:

Interview with Spark Protocol

Dune Dashboard

DAI Backing Dashboard

MakerBurn - best place to track metrics

Sébastien Derivaux’s Blog - good reading on how to think about “Crypto Banks”