Updating the short-term bond strategy?

[SebVentures]

Summary

• MakerDAO is currently in loss making situation of 35M DAI/year
  • We need the short-term bond yield even more than when proposed.
• MakerDAO should have most of its balance sheet earning at least the risk-free yield.
  • Currently it’s almost 0%.
• The proposal suggests shortening duration to allow easier/safer/faster scaling
• We need more generic investment platform like MIP65 (at least 3 diversified)
• If we can get 4B DAI to yield at least SOFR, this would translate into 120M annual revenues.

MakerDAO profitability situation

As a context of our investment strategy, I will start by restating our profitability situation. MakerBurn provides a profitability estimate that is widely used. Nevertheless, the default parameter for Liquidation income is to use the last 12 months. It is unlikely that it is a good assumption as we can’t get liquidation income from vault that we already liquidated and we don’t have many vaults left anymore (exposure ~1B).

Therefore, we should note that MakerDAO operates from a significant loss-making position.

Shortening duration risk

As highlighted in the MakerDAO ALM forecast, getting back to profitability should be a key priority before it is too late. We still have little of a Surplus Buffer to take risk.

The key learning is that we need to get back to profitability with the current Surplus Buffer to increase it, invest more and grow faster. If we can’t get back to profitability with the current Surplus Buffer we will get stuck

Luckily for us, short-term rates have kept rising, so we can generate more income without taking much risk.

The original Declaration of Intent - Invest in short-term bonds was done in a different context where our ability to generate income revenues after structural cost of the investment structure was more challenging.

Since then, SOFR rate has been rising dramatically, while the credit risk yield (using A-rated spread) didn’t moved as much. Adding 100bps when yields are close to 0bps is a great operational leverage, less so when risk-free is already above 300bps.

On the duration risk, there is quite some uncertainty going forward and we don’t need the term premium for now.

Therefore, we might consider targeting a shorter duration (< 1 year), avoid credit risk and scale more aggressively.

Note that this discussion is based on a DSR close to 0bps. I recognize we will have to increase DSR to increase DAI circulating (or just to respond to competition). This will change the conclusion. But we need a fully allocated balance sheet first anyway.

Balance sheet allocation

We have a strong pipeline of proposals and prospects to deal with. Public proposals are in the chart below.

On the ALM Target, it is coming from Modeling DAI Maturity.

https://dune.com/embeds/907852/1593357/b97e5319-27ee-458b-94c9-05a4ca8b10a7

Liquidity Layer 1 - PSMs

Should contain at all time 1.2B DAI (assuming 6B DAI outstanding) and should be intrablock liquidity (i.e. PSMs).

This would take care of our 1-block and 1-day liquidity needs which are currently estimated at 1.2B DAI. With time we should be able to get SOFR on this part of the balance sheet but it will take time. The Gemini partnership is a step in this direction.

Liquidity Layer 2 - Algorithmic liquidity

We also have a big bucket of liquidity needed between 1-week and 1-month (~800M DAI). For this one, we are exploring algorithmic ways to invest, i.e. those investments would be unwinded automatically without MakerDAO governance involvement. For instance, MIP81, if the USDC could be wrapped in another smart contract, would be a great option. An independent ALM smart contract would allocate from MIP81 to the USDC PSM when liquidity would be thin and the opposite when liquidity is overflowing.

The same could probably be made for our current crypto-backed loans exposure (ETH-A, …).

We don’t have such solutions yet, which means the layer 2 liquidity needs would currently be added to layer 1 and the investment option to the investment layer (next section). Challenges are on the smart contract, legal and financial level. We are exploring some options. I think plenty will appear to get close to the SOFR rate for this bucket within a year.

Investment Layer - Investment bucket

This bucket is the most geared towards yield generation and less towards meeting our short-term liquidity needs. As discussed previously, we have plenty of capital (most) that is not getting SOFR rate even while we don’t have strong liquidity needs. Therefore the focus should be on moving those lazy DAIs to SOFR-generating DAIs.

We should develop a diversified base of platforms to get at least the SOFR rate. A platform would be an independent set of legal structures (e.g. the BVI trust for MIP65, the Cayman RWA Foundation for HVBank) and operators (custodian, crypto-broker, arranger/reporting agent). I would target 3 of such platforms but happy to have the view of the community of that. Diversification would not be here to solve complete failure (as exposure would be too big anyway) but would provide time to find a solution if any issue should arise without locking too much liquidity.

Currently we have MIP65 which is still in the pilot phase. It was a long process but will unlock access to yield. A priority should be given to deploy generic platforms.

For exploratory reasons, some investments would be outside this scope (SOFR like). Those are private credit/RWA styles or to deploy corporate bonds capabilities. Experience we are getting there will be valuable going forward. We also might have an ETH exposure for strategic reasons.

Community feedback

Community discussion, especially @Recognized-Delegates , is more than welcome. I tried to start the discussion in the last delegates office hours but I hope having this summary post as basis will help structure a discussion. I’m sure we can find other ways to move forward.

The aim is to provide better feedbacks on “what community wants” to potential proposals.

[TRUEMAKER]

To me this iteration makes sense. Its good practice to shorten the duration given money market rates (<1year) are forecasted to rise, flattening the yield curve or even inverting it. At 4-5% risk free rate by end of year we should be confident staying shorter in the yield curve. As you point out, the main objective is to convert non-yield generating assets into yield-generating assets and return to profitability, so the maturity is a priority but second to deployment.

[flipflopflapdelegate]

I’ve been hearing rumors some of the T-notes/bills purchases are being bought with excessive leverage. Does updating the short-term bond strategy require any MIP65 participants to avoid ETFs that might use leverage? Trying to get an idea if any of the bond strategies are using “infinite leverage”

Otherwise–totally support updating the strategy.

[SebVentures]

In order to immustrate the difference between the 1-3yr bond ETF (IB01) and the 0-1yr bonds ETF (IBTA).

@flipflopflapdelegate The ETFs are not using leverage. But MakerDAO itself is playing with close to infinite leverage. Our current leverage is 75x (assets / surplus buffer) which is very high (LTCM was 21x). Now our problem is more than leverage grow over time as long a we are loss making.

[flipflopflapdelegate]

@SebVentures

Our current leverage is 75x (assets / surplus buffer) which is very high (LTCM was 21x)

Very concerning. TY for the reminder.

[JustinCase]

Maker is facing several potential existential crises at the moment. While there has been a lot of focus on the potential ones via legislation or failure via the PSM, we have slowly been draining our surplus buffer. This is metaphorically like worrying about getting shot while you are slowly starving to death. Something I also expressed concern about during recent polls and one of the reasons I’ve been advocating reducing expenses for some time.

As we currently aim to avoid raising any stability fees given market conditions and the current sentiment in DeFi we are unlikely to make meaningful gains in revenue from crypto collateral in the short or even medium term.

Luckily we have the possibility to put our balance sheet to work to provide meaningful revenue and to avoid becoming extinct. As such I think this proposal takes us in the right direction by aiming for meaningful revenue while keeping risk properly managed. Embracing our unofficial slogan of “Recklessly boring”

However I must comment on the quote bellow because as much as I think this is a prudent and necessary step it can appear a little misleading.

@SebVentures

But MakerDAO itself is playing with close to infinite leverage. Our current leverage is 75x (assets / surplus buffer) which is very high (LTCM was 21x). Now our problem is more than leverage grow over time as long a we are loss making.

While it is true that the ratio of assets to surplus buffer is x75 calling it leverage should be qualified. Given that the vast majority of those assets are in stablecoins and the rest is overcollateralized we are far safer than the expression of being 75x leveraged would seem to imply. We are not sensitive to asset prices assuming there is not a fundamental failure, apart from our vaults and since implementing liq 2.0 we have been through several sharp market declines without accruing any bad debt. Quite contrary, we have increased our balance in those scenarios.

[iammeeoh]

@SebVentures

The ETFs are not using leverage. But MakerDAO itself is playing with close to infinite leverage. Our current leverage is 75x (assets / surplus buffer) which is very high (LTCM was 21x).

What kind of assets did LTCM have? I ask because most of our ‘assets’ are stablecoins .

I mean, we have 77m in the SB currently, and ~1.6B of non-stablecoin collateral. This give:

1600/77 ~= 20x

If you want to include in the calculation of ‘assets’ also the USDC in the PSM, well, I think the additional leverage does not constitute:

@SebVentures

But MakerDAO itself is playing with close to infinite leverage.

In the sense that it’s unlikely that these assets will lose value (ok, I am admittedly ignoring the risk of Circle blacklisting us).

@JustinCase

Maker is facing several potential existential crises at the moment. [… ] we have slowly been draining our surplus buffer.

I am the first wanting to see more profits. At the same time, the SB for some reason or another (aka liquidations) has not gone down very much.

So I think we have been lucky:

1. the SB is still significant (77m now)
2. Rates have gone up in the last 12 months in a way nobody expected, which seems to be a good thing for us now.
3. A lot of work has been done, both by @rune and the CUs themselves, in the direction of optimising CUs costs and efficiency.

There are indeed causes of concern but if we can really start to make money from our balance sheet, I am inclined to be optimistic.

[SebVentures]

I am not at all saying that our leverage ratio is a problem, otherwise I would have highlighted it earlier. It might become one down the line but that’s a problem for later (like after 2 years). We should use the Capital at Risk that is risk-weighted. Yet, as TradFi learnt, purely objective metric is sometime better. The risk-weighted one was abused so they reintroduced a simple leverage.

[Allan_Pedersen]

On LTCM from wikipedia:

…"At the beginning of 1998, the firm had equity of $4.7 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt-to-equity ratio of over 25 to 1.[17] It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

John Quiggin’s book Zombie Economics (2010) states, “These derivatives, such as interest rate swaps, were developed with the supposed goal of allowing firms to manage risk on exchange rates and interest rate movements. Instead, they allowed speculation on an unparalleled scale.”…

Also remember that the current crisis in LDI with pension funds in UK is - again - derivative-driven. The derivative programs were designed to work within reasonable market movement constraints - but completely blows things up in situations where the rise is interest rates are dramatic and large scale - as just experienced in the UK.

It’s when derivatives starts to play a large role on a balance sheet and in return expectations, that one should generally start getting concerned.