Putting it in old school banking analyst terms, along its life the Maker protocol made extraordinary (beyond what required by its own governance to run the business) profits, and distributed those to existing MKR token holders in the form of token burning. Even considering the impact of March 2020, Maker’s risk policy held pretty well through standard turbulence.

The token blowup/ total devastation case

Maker’s history, however, is short-lived and, as usual, it is all good until it’s not.

At the time of writing, Maker aimed to keep a surplus of c. 46m — expenses are paid out of the surplus, and additional collected fees are used to burn MKR tokens as explained above. Maker’s top collateral exposure, USDC, was 2.8b (with 4.0b already authorised). Second exposure in size was ETH with 1.3b, BTC exposure was 230m.

Indirect exposure to single counterparts’s risks (operating, protocol, regulatory risk) is therefore huge, and structurally under-provisioned. Maker’s surplus fund would be wiped out 30 times over in case one of those tokens is put out of business. Effectively, the fund wouldn’t cover any of the top 5 collateral exposures. I will not list here the number of crypto-tokens historically gone out of business, but we are in the thousands. Auctions, however, are executed within the hour in normal market condition; with few and standardised exposure vs. on-chain collaterals, as well as programmatic credit recovery, the notion of credit risk blends with those of market volatility and liquidity.

The question therefore becomes: what would happen to the MKR token if one of its biggest collateral exposures would entirely go out of business? MKR token market cap is currently USD 2.4b, close to the protocol’s exposure to Coinbase USDC stablecoin. USDC blowup would require, assuming unrealistically that there’s no further turbulence in the market, a full recapitalisation of the protocol and dilution of token holders. It is true that credit risk underlying stablecoins like USDC is very low, but concentration and counterparty risk must be taken into account. From Maker’s website (emphasis is mine):

The event of a Collateral asset losing all value is considered a Black Swan, which is defined as unprecedented, unexpected, and catastrophic. This makes it very difficult to predict the likelihood and severity of existential threats to the system. There is no guarantee that MKR Dilution will always be sufficient.

MKR Dilution can recapitalize the system to a certain limit. The severity of the situation is important to consider. If the severity of the situation is high enough, then it may be viable for MKR holders to execute an Emergency Shutdown which would result in Dai being a pro-rata claim on the Maker Protocols Collateral portfolio.

That’s a proper blowup. Things will be different when Maker’s exposure will be less concentrated along a list of token exposures, but the protocol needs to get there first. As things stand today, it would be fair to say that Maker does not have a credit risk policy at all, and that the surplus fund is merely functional to keep Dai stability and smooth operations. Its success, like that of the whole DeFi industry and that of many other innovations, will be path dependent.

Maker has no shock absorption capacity. By design. Maker protocol’s book value of equity is currently 40.3m. This amount represents the surplus fund (38.6m) plus some kind of operating capital. Maker doesn’t have, very differently from a traditional bank, any concept of regulatory equity capital to sustain unexpected extraordinary losses — the Common Equity Tier 1 capital for banks analysts out there. In this, decentralised banking is very different from traditional banking: its proposition is to rely on MKR token holders as lenders of last resort in the same way banks do with their shareholders and, ultimately, with the central bank. At current prices, MKR token valuation sits at a 60x price-to-book ratio, an irrelevant number.

But Maker is valued for profitability and growth, and it’s delivering both. Maker’s earnings, on the other side, are projected at c. 100m for 2021 — although that number swings by a lot, and at current prices that’s a 23x price-to-earnings ratio, which doesn’t seem outrageous when we are dealing with its YoY growth and profitability — 2021 perspective profits are 30x (not %!) of 2021’s beginning equity book value, and 4.5% earning ratio vs. the current market prices. This is not a post dedicated to valuation, but this order of magnitude must be highlighted.

This post is about risk, not valuation, and we should stick to it. But here’s my take on the link between risk and valuation. Thanks to the massive operating leverage guaranteed by the protocol (costs are negligible at 800k a year — try to compare it to the cost-to-income ratio of a bank) and to an ultra-thin equity base to cover unexpected losses, Maker shows spectacular profitability even in a phase of explosive growth. But it is all good, until it’s not. Maker’s current credit risk and provisioning policy is in no way ready to sustain existential threats to any of its underlying collateral exposures. A bet on MKR, in other words, is a levered bet on one of its top 10 token exposures. Investors in the MKR token should take this in consideration.

DeFi is not for everyone. Most people want to sleep well with the often excessive trust on a system that is protecting them and their belongings. This is not what DeFi and Maker are promising.

• MKR token holders bear ultimate governance responsibility. As we describe above, Maker doesn’t have a credit risk policy; as a MKR token holder you should be the one doing the math. And rightly so, MKR token holders are the central pillar of protocol governance, they should be incentivised to stay involved and guarantee protocol sustainability and efficiency — that’s why they should get compensated
• Dai holders have ultimate trust in MKR token holders. So far there is no external regulator guaranteeing stability of the Dai, trusting the Dai peg means trusting that Maker, and ultimately MKR holders, will do a good job. That’s why lending Dai yields 2.45% on protocols like Compound, while lending USD yields zero — the FED is still a more trustable counterparty
• Vault owners are short volatility. Vault owners can use their tokens as collateral in exchange for a stability fee but offer at the same time a backstop to volatility. A sudden drop in the value of the collateral would trigger immediate liquidation and force the vault owner to crystallise a loss. Over-collateralisation mitigates also this phenomenon, but in a market as volatile as crypto it might not a good position to be in

Incentives among those actors are aligned:

• MKR token holders want (1) the Maker protocol to remain in existence, (2) to maximise token value through deflation — i.e. token burning using protocol profits,(3) while reducing risk of dilution — i.e. risk of having to mint fresh MKR tokens in order to cover extraordinary losses
• Dai holders are passive users of the protocol, they just want the Dai (and therefore Maker) to remain in existence — their incentives are aligned with those of MKR token holders
• Vault owners want to access as much Dai as possible at good rates — in line with the profit maximisation incentive of MKR token holders, but at the same time don’t want to crystallise drops in collateral value — in line with MKR token holders’ intention to reduce risk of dilution

All agents know they are running a risk that is proportionally higher than what they would run in the traditional financial system, but the promise of extraordinary efficiency and returns, together with an innate attraction for innovation, seem to more than compensate this additional risk.

We will keep watching.

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Source: https://medium.com/geekculture/makerdao-deep-dive-is-anybody-in-defi-thinking-about-credit-risk-d27a68c405c7?source=rss——-8—————–cryptocurrency