MakerDAO: The Winding Path to Decentralization
October 13, 2022
Last week MakerDAO, one of DeFi’s oldest lending protocols, voted to invest $500m of their collateral pool into US Treasuries and Corporate Bonds. This is the first time a decentralized organization has voted to undertake a “real-world” allocation of such scale, and all the more remarkable considering it will go to a government-issued asset.
MakerDAO is the Decentralized Autonomous Organization behind the 4th largest stablecoin by market cap, DAI, which is used throughout the DeFi ecosystem. DAI is an overcollateralized stablecoin, meaning MakerDAO is sitting on a large amount of excess capital that has been used to generate DAI. This excess capital hasn’t been an issue up until recently due to a combination of worries over USDC sanctions — which makes up over 50% of the collateral backing DAI — as well as falling yields in DeFi. Q3 was the least profitable quarter for the MakerDAO entity in more than two years, which has pushed the organization to explore other options on what to do with their $9 billion dollar treasury.
This article will delve further into the reasons behind the decision to invest in US Treasuries, which I believe can be summated in an exhaustive list of three:
- Better Yields
- Competitiveness
- Path to Compliance
1. Yields
Let’s start with the clearest-cut reason for MakerDAO’s $500m allocation: rising bond yields. The current macro environment of monetary tightening has seen bond yields rise over 200 bps so far this year. This stands in stark contrast to the sharp downtrend in DeFi yields. A suitable proxy for this trend are lending rates on the lending protocol Aave, which for USDC have fallen from 2.3% to 0.6% in the last 15 months.
Over 50% of DAI is generated using USDC as collateral which has left MakerDAO with a large chunk of USDC on their balance sheet. From a business standpoint, this has MakerDAO holding roughly $4.5bn worth of their competitor’s stablecoin. The issue with this is that while MakerDAO has held low yielding USDC on their balance sheet, the issuer of USDC, Circle, holds over $43.5bn worth of higher yielding US Treasuries, according to their attestation report below. By essentially converting $500m of their USDC collateral to US Treasuries, MakerDAO disintermediates Circle and can start earning a yield on these Treasuries themselves.
MakerDAO’s recent struggle to earn yield is something which institutions are aware of as well, as evidenced by several offers made to the DAO recently. Coinbase offered to pay Maker 1.5% if the DAO deposits $1.6B of USDC from its vault into Prime, Coinbase’s institutional offering. In late September, Gemini, the crypto exchange founded by the Winklevoss twins, proposed to pay Maker 1.25% on deposits of the exchange’s GUSD stablecoin. It seems these offers have been benched in favor of treasuries due to the higher yield on offer.
This additional yield will make DAI a more competitive stablecoin vs USDT, USDC and BUSD who all partake in their own yield earning strategies. This leads me to the second biggest reason behind the decision to invest in treasuries: competition.
2. Competition
One of the most noticeable trends in the stablecoin ecosystem over the last year has been the shrinking popularity of DAI on both centralized and decentralized exchanges. DAI has never truly been competitive on centralized exchanges and is barely visible when charting market share of BTC/ETH volume versus the top 3 stablecoins.
The simple fact is that DAI just can’t compete with the largest stablecoins in its current state, mainly thanks to its scalability issues. DAI is overcollateralized, meaning when a user wants to borrow $100 DAI, they must deposit $150 ETH, for example. Overcollateralization stifles growth as the capital required to keep up with demand will always be greater. The larger stablecoins are all collateralized 1:1 with USD, meaning the capital cost of growth is far less than DAI and has allowed BUSD, USDT and USDC to command widespread adoption on centralized markets. DAI on the other hand, has seen its market share of BTC & ETH volume fall from highs of nearly 1% all the way down to 0.02% at the end of September.
Arguably a bigger warning sign for the fate of DAI in its current state is its usage on DEX’s. When comparing DAI’s volume to its biggest competitor on decentralized exchanges, USDC, DAI’s market share has been massacred in the past two years — representing just 5% of volumes vs USDC now. As a decentralized stablecoin, DAI’s usage on decentralized exchanges is likely more relevant for its target usage and its dwindling market share is a massive red flag for the relevance of DAI.
From a competitive point of view, DAI seems to be losing every battle. I put this down to its inability in its current state to fill a niche. DAI is marketed as a decentralized stablecoin, but with over 50% of collateral in centralized stablecoins this is far from reality. Its overcollateralized mechanism means it cannot compete with the biggest centralized stablecoins who can all scale far quicker. DAI is essentially trying to compete with McDonalds in the fast food sector with 30 minute wait times. What DAI needs to do is pivot and fully commit to a healthier alternative to McDonalds: decentralization.
3. Path to Compliance
The regime of rising bond rates and falling DeFi rates has, for the first time in recent history, seen crypto markets offering up a smaller premium than traditional finance. This begs the question as to why a crypto native entity would hold stablecoins as opposed to treasuries which are far more liquid and now offer better yields.
The answer to this question would simply be to prioritize decentralization; a project holding stablecoins rather than US government bonds should be more resilient and isolated from government sanctions or regulatory actions. However, the issue with DeFi today is that it is overly reliant on centralized stablecoins. We wrote about crypto’s overreliance on centralized stablecoins in our Data Debrief last month where we found that on Uniswap, crypto’s leading decentralized exchange, over 76% of swaps involve a centralized stablecoin.
The majority of DAI’s $9bn collateral pool is made up of USDC, a centralized stablecoin.
This is the reason why I disagree with people saying this investment in US Treasuries makes them significantly more centralized. The centralization of DAI isn’t anything new and has been an issue as long as they’ve accepted USDC as collateral. The move into treasuries does make MakerDAO more compliant, but does not make them significantly more centralized.
The investment in treasuries makes MakerDAO more compliant with US authorities, as a protocol that is directly invested in US government assets will no doubt be looked upon more favorably than one that has their investment elsewhere. Take Tether for example — US regulators have been honed in on the USDT issuer as of late, requesting to see backup of reserves again last week. A big factor in their tenacity with Tether is down to the location of Tether’s reserves. Tether’s transparency of reserves has long been under scrutiny and the majority of their reserves are non-US government assets, something which acts as a red flag to the bull that is US regulators.
This path to compliance makes sense short-term. It allows Maker to move away from USDC, which has been in the hot seat since the Tornado Cash sanctions, and towards US backed government assets which help ease some fears regarding sanctions of assets. However, this move doesn’t fit with DAI’s longer term ethos of decentralization and it needs to be followed by a move into more decentralized assets such as ETH in the near future. Otherwise DAI is on track to be just as centralized as its competitors.
Holding ETH or any decentralized asset is the only path towards resilience from regulation, rather than compliance, as the reserves should ideally be beyond the reach of any sanctions. This would likely mean that DAI will need to ditch its peg to the USD, as the 1:1 peg will not hold when using a volatile asset such as ETH for the majority of collateral. DAI has had one of the more resilient pegs as of late thanks to its USDC backing, but as we’ve seen the security of the peg has come at the cost of any growth. Ever since talk of a possible free-floating peg gathered steam over the past month, DAI has traded at a persistent discount.
Conclusion
The combination of increased yields, better scalability and appeasing regulators make this a good business move for MakerDAO and DAI. The initial reaction from the public when MakerDAO made the announcement of their investment in US Treasuries and bonds was mixed, and any negative sentiment was focused on the supposed added centralization. What this sentiment fails to account for is the inherently centralized nature of DAI to begin with — an overreliance on USDC has made DAI centralized long before this move. This investment helps MakerDAO appease regulators by investing directly in US government assets. When you factor in the potential sanction risk that comes with USDC lately, moving from USDC to Treasuries makes a lot of sense from a risk management perspective as well.
All in all this is a good short term move for DAI. However, the investment does little to improve their decentralization at this moment in time and needs to be part of a longer term roadmap to abide by the ethos of decentralization. If this is just a purchase to make DAI more competitive versus other stablecoins they are just kicking the can of irrelevance further down the road.
MakerDAO will eventually reach a fork in the road when they need to choose between the path to compliance and the path to decentralization. In order for DAI to be successful long term it needs to fill the niche of a decentralized stablecoin that is so badly needed in crypto at the moment.
