Maker (MKR) Investment Thesis

Fundamental Analysis and Valuation

*Updated February 2019*

Background/Overview

Founded in 2014 by Rune Christensen, MakerDAO is one of the oldest stablecoin projects in the space. After raising $12 million in venture funding led by Andreesen Horowitz and Polychain Capital in December 2017, it was launched shortly thereafter. MakerDAO employs a two-token model: the stablecoin Dai, that has maintained a close peg to the US dollar with relatively low fluctuation, and Maker (MKR) which is used for governance and interest payments. This MKR token acts as pseudo-equity in the project and is designed to appreciate in value as the Dai ecosystem grows or depreciate if risk is mismanaged. MakerDAO looks to create a system for taking out loans and peer to peer transacting that maintains many of the same characteristics as bitcoin such as trust minimization and censorship resistance, while keeping the relative stability of fiat currencies such as the US dollar. This avoids much of the reliance on the legacy financial system and its inherent problems.

How it Works

Dai are created through a dynamic system utilizing Collateralized Debt Positions (CDPs), where a user can send ether to a smart contract, which then returns an amount of Dai based on the collateralization ratio. The user is then free to spend that Dai however they please. In order to get their collateral back, the full debt denominated in Dai needs to be returned plus interest which is to be paid in MKR and is subsequently burned. In the event that the collateral value falls below a certain threshold (liquidation ratio), then it is sold to repay the debt plus a liquidation penalty of 13%. If the price of Eth drops precipitously and cannot repay the debt, then MKR will be diluted and sold to close out the CDP. If there is any remaining collateral it is returned to the user.

MakerDAO plans on transitioning to multi-collateral Dai (MCD) in the future where assets other than Eth can serve as collateral. While there is no official date to release MCD, the code was released in September for review. When MCD is released, it will include a feature called the Dai Savings Rate (DSR), which

“creates a whole new dimension of incentives for balancing the supply and demand for Dai. This model allows for capital to be more efficiently deployed while still fulfilling its core role of providing users with strong, decentralized stability.”

The DSR allows a user to lock in a set amount of Dai in order to earn interest on that deposit. It is funded by stability fees and creates another lever for MKR holders to influence monetary policy. When the Dai price is below $1 the DSR can increase, so more users will deposit Dai which decreases the supply bringing the market price closer towards the $1 target price. Another change in MCD is that the liquidation fee will act like a stability fee being paid in MKR and then burned, providing value to existing MKR holders.

Note: If anyone has access to historical stablecoin data, please reach out as I’m interested in a more rigorous statistical analysis of prices. (CMC only rounds to two decimal places when >$1.0)

Since Dai are freely traded based on market dynamics, the price is susceptible to fluctuation. However, over its history has been able to maintain a peg close to $1, becoming more stable over time. This is due to an efficient mechanism where users with CDP’s outstanding are incentivized to buy Dai when the price is lower than when they opened their CDP, helping to bring the price back up. Conversely, when the price is above the peg, users will want to create more CDPs to receive Dai at this higher price.

If an event occurs that threatens the entire system such as a hack or extreme devaluation of the collateral, a process is in place called Global settlement that acts as a fail-safe to guarantee all Dai holders and CDP users receive the net value of assets owed to them. This process is initiated by global settlers that are designated by holders of MKR. Once activated, CDP creation is halted and the price feed is locked in at the current value to process all claims. Users can then call a claim function on the Maker platform to receive their collateral equal to their Dai or CDP outstanding.

These mechanisms are designed to instill faith that Dai will maintain a stable peg. Those who believe in the MakerDAO system can then purchase Dai when it breaks the peg with the assumption it will eventually return to par to then make a small profit. These arbitrageurs further help keep the peg until the margin is so small it is no longer profitable in which case Dai has succeeded as a stablecoin.

Governance

“The notion of trust has not vanished in this trustless system. It has merely diversified. Diversified to the extent that has never been realized before, creating a portfolio of actors to which we can assign smaller portions of our scarce resource of trust and thus establishing a new sense of character. If one or a group of actors fail, we can still rely on the majority of actors to keep our notion of character and trust in place “— MakerDAO Governance Framework

Trust is diversified in this system through the MKR token, which plays a vital role in the evolution of the platform. Token holders have the right to vote on changes such as:

Type of CDP: This can include CDP’s with collateral other than Eth, or a new set of Risk Parameters.

Risk Parameters: Debt ceiling, liquidation ratio, stability fee, liquidation penalty, DSR rate

Set of oracles: These are the set of nodes that the platform uses in deriving its pricing of collateral. MKR holders decide who these nodes are and how many of them exist.

Price feed sensitivity: The largest change that the price feeds can affect on the internal price values in the system.

Global Settlers: These are the actors that decide when to initiate Global Settlement

Maker holders implement these changes through Active Proposals that allow root access to change the governance variables. One type of active proposals is single action, meaning they are executed once and then the contract deletes itself. There are also delegated proposal contracts that continuously use root access for more advanced logic. Any MKR holder can vote on these proposals and the smart contract with the highest number of approval votes is implemented.

It is to be noted that while the above features are designed to be governed by the MakerDAO community, there is still a legal entity, the Dai Foundation, with significant decision making power. This was made evident when it was announced that a16z Crypto invested $15 million to purchase 6% of outstanding MKR. The announcement states that: “MakerDAO will receive operating capital through the next growth stage, 3 years of support for the MakerDAO community, and most importantly, full operational support from the 80+ person Andreesen Horowitz a16z team.”

While receiving this type of investment and support from a top tier venture capital firm is undoubtedly positive for MakerDAO, it did raise some governance questions from the community. The main critique of the deal was that the project is meant to be governed by MKR holders, yet they were not involved in the decision-making process. To some, this closed-door deal violated the transparency they have come to expect with an open source community like MakerDAO. However, it is also pragmatically difficult to conduct a deal like this in a decentralized manner. Negotiating the specific terms of the deal such as the exact discount on the tokens would have been difficult if a16z had to get consensus from the majority of MKR holders. In addition, the MKR held by the Dai Foundation is to be used for development purposes at their discretion and this deal appears to provide tailwinds for the project going forward.

Risks

One difficulty in assessing the MakerDAO protocol is a lack of canonical documentation. This is in part due to the fact that there are aspects not yet decided upon. The team has provided a white paper with a general overview as well as a more technical purple paper, but since writing the team has changed various facets. For example, the white paper outlines a stability tool called the Target Rate Feedback Mechanism which they have since replaced with the Savings Rate Adjustment Mechanism. This makes analysis more challenging as it is difficult to assess the current state of the protocol and to have conviction it won’t change dramatically in the future.

Since the growth of Dai depends on demand for CDP creation, there is a risk that not enough people will want to take out collateralized debt using MakerDAO. The decentralized nature of the platform necessitates a high collateralization ratio to keep the system stable, so those wanting to take out secured loans could get more liquidity with less collateral by using centralized providers like BlockFi. While using a centralized provider conflicts with the crypto ethos, the reality is those who believe in those core tenets comprise a small minority. Jon Choi argues:

Ethos-agnostic customers (aka “most people”) will be driven largely by a new feature’s benefit over its next best alternative”

In this case, “most people” will only care about the best rates offered rather than the trust minimized nature of the system

Another risk that could hinder growth is the lack of available collateral to be used on a loan. Currently, ether is the only cryptoasset available, and in order for MakerDAO to scale the potential collateral to be used needs to be orders of magnitude larger. MCD is a major factor in increasing the demand of collateralized debt by first allowing more cryptoassets to used and in the future potentially allowing loans to be collateralized by equities, bonds and real estate in digital form. There is a lot of progress being made on the tokenization of real world assets (See $18 million St. Regis Resort offering), however it remains a risk if they are able to scale to a level necessary to increase CDP issuance.

Competition

Fiat-backed

Examples: Tether, TrueUSD, USD Coin, Paxos, Gemini Dollar

Pros:

Ability to be redeemed for U.S. dollars is likely to lead to a closer peg (Tether is not redeemable for USD and its collateralization has been in question)

Prominent names such as Circle and Gemini behind them provides legitimacy

Less vulnerable to hacks as collateral is not held on the blockchain

Cons:

Backing companies have the ability to censor any transactions

Little privacy

Tether is the oldest and most widely used (95% of global volume) despite any true differentiation. Since it lacks the opacity of regulated stablecoins and the trust minimization of Dai, there is no reason to use it other than its existing liquidity. Since more fiat-backed stablecoins have been launched and are gradually gaining traction, tether can be expected to continue losing market share (Down ~37% in volume and market share from its high). This means a large opportunity exists for stablecoins to gain significant usage. It is likely to be taken by redeemable fiatcoins at first since they should maintain the closest peg. However, as the shortcomings of these fiatcoins become more apparent through censorship, ethos-agnostic users will turn to less centrally controlled stablecoins as they will now provide tangible benefits over alternatives.

Uncollateralized

Examples: Basis, Carbon, Nubits

Pros:

Censorship resistance

No collateral required

Cons:

Vulnerable to a “death spiral” event

Requires continual growth

These uncollateralized stablecoins act as an algorithmic central bank expanding and contracting the supply to maintain the peg. Known as the seigniorage shares approach, they typically work by selling bonds to increase the supply during times of higher demand, and buying them back when demand decreases. Myles Snider pointed out a problem they refer to as the “death spiral”:

One issue this creates is that a rapid decrease in demand can lead to a death spiral in the price of bonds. As the system begins printing new bonds in order to take stablecoins out of the supply, the bond queue becomes increasingly large. This increases the time to payout and decreases the likelihood that each bond is paid. As such, the newly printed bonds must be sold for a cheaper price in order to account for the additional risk. As bond prices fall, the number of stablecoins taken out of circulation for each bond sold also falls. This causes the system to have to print more bonds in order to shrink the supply sufficiently. This creates a recursive feedback loop that could make large-scale supply contraction near impossible

These seigniorage stablecoins suffer from potential black swan events, something collateralization is meant to prevent given a tangible backing to them.

Valuation

The MKR tokens burned after being paid as the stability and liquidation fee can be thought of like share buybacks, akin to cash flows to token holders. This makes a valuation straight forward using a discounted cash flow analysis. In order to estimate the amount of MKR burned, there has to be an estimate of the number of Dai created. However, unlike fiat-backed stablecoins with direct redemptions, Dai supply does not scale linearly with demand. As crypto researcher Hasu explains:

If the price of Dai goes over $1, that will generally incentivize people to take slightly more debt, especially those who already have CDPs open. But it will not incentivize anyone to make a CDP to arbitrage the difference, not unless he was already indifferent towards taking a debt. Since all money locked in CDPs have to come from a natural demand for debt, there is also a natural ceiling to the amount of debt that people are going to take.

Therefore, one should estimate the demand for collateralized, low interest rate loans to determine the future supply of Dai. This demand typically stems from the desire to lever existing positions, manage project treasuries, or to gain liquidity while avoiding capital gains tax.

Intuitively, as the price of the collateral rises, more U.S. dollar denominated debt will be taken out. For example, if your ether is worth $150 you can take out up to $100 worth of Dai. However, if the prices increases and your ether is worth $300, you can take out up to $200 of Dai which you would be inclined to take advantage of. To capture this relationship, the supply of Dai is measured as a fixed percentage of Dai to collateral market cap multiplied by total market cap of the collateral.

The main assumptions used to estimate the supply ceiling of Dai is that bitcoin and ether will be used as collateral, they will both reach prices around their all-time high ($1000 and $20,000, respectively for total market cap ~$450 billion), and the debt as a percent of market cap will be 1.25% (Currently 0.68% according to Makerscan). Since there will likely be more assets used as collateral, you can think of the bitcoin market cap as a catch all for any non-ether collateral. These are particularly subjective assumptions, and altering them can greatly change the supply of Dai. Therefore, it is helpful to look at a sensitivity analysis to show how various inputs affect the outcome.

It is evident that the potential exists for the supply of Dai to greatly increase based on the value and percent of collateral used to take out debt positions. For this analysis, under relatively conservative assumptions, we arrive at $5.63 billion for the Dai ceiling which was modeled out using an S-curve formula, where the supply of Dai is exponential at first before leveling off to its long-term ceiling.

Once the Dai Supply is mapped out, the amount of MKR burned are projected assuming constant liquidation fee and an increasing stability fee from 0.5% to 2.00% to keep CDP demand in check. Using a long-term growth rate of 5% and a discount value of 20%, the implied value for MKR comes out to $333. This number is not meant to be an accurate price prediction as again many of these assumptions are highly subjective. A 20% discount rate was determined considering most risky equities have their weighted average cost of capital (WACC) between 10%-15%, and a cryptonetwork carries additional risk. Once again, a sensitivity analysis was included to see how these subjective assumptions can impact the valuation.

Investment Thesis

This model with its current assumptions does not present a compelling investment opportunity. While a couple tweaks show the potential for relative undervaluation, the inverse is true as well. Therefore, an investment in MKR is a bet on one of two things occurring: either the cryptoasset landscape far exceeds prior all-time highs reaching orders of magnitude more than current levels, or real world assets are successfully tokenized and used as collateral in the MakerDAO (Which if you are reading this you probably believe in one of the two). These are difficult to accurately predict but their impact can be clearly determined by increasing the available collateral to the trillions or higher.

In the first case, cryptoassets would likely have to become a widely-used store of value such that it captures share from the ~$7 trillion gold market, and potentially fiat currencies and real estate as well. In the second case, there would need to be substantial infrastructure built out, issuer willingness to tokenize their assets, and investor demand for the tokens. How one assigns probability and weights to the aforementioned events ultimately determines the price ceiling of the MKR token. Regardless, MakerDAO solves a pressing need in the crypto industry, while it’s governance token MKR gives investors exposure to the overall success of the crypto market with a clearly defined value capture mechanism.