The Maker DAO (MKR) Thesis
Trends & Opportunities In A Higher For Longer Rate Regime: The Real World Asset (RWA) Narrative
Protocol Overview
Maker DAO is an open-source project founded in 2014 and considered one of crypto’s oldest “banks” and a staple of the DeFi space. Maker at its core is an overcollateralized collateralized debt position (CDP) protocol that allows users to borrow DAI against various forms of collateral. Maker governs the supply and distribution of the DAI stablecoin. In addition, accrues all revenues from CDP liquidations, fee revenues, and its other various forms of revenue.
Macroeconomic Considerations
Beginning on March 17, 2022 the FED went on an aggressive rate hiking cycle to combat inflation concerns and reduce its balance sheet. As of today, November 25, 2023, the federal funds rate sits between 5.25 - 5.50% (0.25 - 0.50% at the start of 2022) or up around 525 basis points from 2022. In addition, beginning in July we saw a yield curve inversion which remains true today with the 1 year currently trading at 5.29% (0.5%), the 10 year at 4.49% (1.7%) and the 30 year at 4.62% (2%).
The drastic increase in rates has had a significant impact on borrowing costs and has resulted in a large wave of deleveraging across the market. Capital allocators have since been made to rethink their capital allocations seeing as outside the “magnificent 7” opportunities for market outperformance have been limited. Consequently, they’ve piled onto treasuries earning a comfortable risk free 5%. Overall, volatility is down with the VIX continually trending lower and as such keeping implied volatility low. As previously mentioned, given that capital allocators have been deleveraging, hedging isn’t necessary which is supported by the low VIX trend which is calculated off of option volumes. That said, the consensus is that the FED is done hiking rates. Therefore, switching the narrative from rate hikes to rate cuts. When will rate cuts come and how much will the FED cut? The general consensus expectation being that the first rate cuts begin between Q2 & Q3 of 2024 with the market pricing a 100 basis point cut for 2024. Nonetheless, the FED has been adamant about its “higher for longer” sentiment and it seems that this will remain true for the foreseeable future until we see that first rate cuts come in.
Playing The Higher For Longer Narrative
Historically speaking, in high interest rate regimes long tail assets generally underperform given that cash is preferred in portfolios. In addition, given a greater number of risk averse market participants and overall lower capital inflows there is less percolation into long tail/risk-on assets. However, large companies with large cash reserves and low debt ratios are best positioned to capitalize on market fickleness increasing their market shares. This is true given their ability to loan large amounts of short duration debt capitalizing on higher rates. Furthermore, given their large size, investors seeking exposure look to these companies first when thinking about redeploying capital given their perceived safety.
The Maker DAO Thesis
Maker DAO and more specifically the Maker token (MKR) have long underperformed relative to its counterparts. In addition, the growth of the DAI stablecoin has been extremely slow and underwhelming. The asset has long been hated by the community for its underperformance against the ETH/MKR pair and other stablecoin issuers. However, as they say “when the facts change, I change my mind.”
Over the last year, Maker has continued to increase its holding of US treasuries and other RWA. As of today November 25, Maker holds $3 billion dollars in short term T-Bills earning an average interest of 5% and generating a total of $130 million dollars of its 200 million in yearly revenue for Maker DAO. According to MakerBurn, MKR is generating an annualized profit of $80 million (after all expenses) with a DAI supply of $5.3 billion or a PE ratio of 17.79 against Maker’s market cap ($1.3 Billion). Additional revenues are derived from 3 sources:
Net Interest Margin - Interest paid by borrowers (AKA stability fee) and the sDAI savings rate (DSR)
Liquidation Revenues - Fees on liquidated collateralized debt positions (CDPs)
Stablecoin Trading Fees - Price Stability Module (PSM) Fees. The PSM facilitates swapping stablecoins for DAI at a fixed rate (with a 0.1% fee), helping maintain DAI's peg to the dollar. Additionally, it enables Maker to adapt its collateral structure based on the market's lending demand.
MKR tokens serve to recapitalize the protocol if liquidations fall short of covering outstanding DAI, involving the minting and auctioning of MKR to ensure solvency. Maker protocol income benefits token holders and is used for development costs, a safety buffer to cover potential liquidation losses, and buying/burning MKR tokens to reduce circulation. The safety buffer is capped at 50 million (earns yield on some of this buffer) with any additional surplus capital being used to buyback and burn MKR (2.2% MKR supply burned) . According to MakerBurn and MakerDAO - Dashboard , the buffer currently sits around $55 million dollars and is averaging a buyback of around $7.5 million dollars a month ($90 million annualized) . However, with the new Maker Smart Burn Engine proposal, MKR tokens will now be collected as Univ2 LP tokens instead of being bought and burned. This enhances MKR liquidity, boosts protocol-owned liquidity (POL), generates extra fees, and, to some extent, removes supply from the market.
Maker DAO’s Core Thesis
MKR's success hinges on the ongoing expansion of the DAI stablecoin market cap. In essence, investing in MKR means placing a bet on the sustained growth of the DAI market cap. As the DAI supply expands, so does the potential for increased revenues for the MKR token. The current DAI supply stands at 5.3 billion, reflecting a decrease from its peak of 8 billion. From February 2022 onwards, DAI supply underwent a significant decline, reaching a low point of 4.3 billion. However, a reversal occurred in June, driven by the elevation of the Dai Savings Rate (DSR) yield.
The DSR is a native yield provided by MakerDAO for DAI, serving as both an incentive for users to hold DAI and a tool to regulate DAI supply. In mid-June, the Dai Savings Rate (DSR) began elevating its yield from 1% to the current rate of 5%, propelled by the increased T-Bill rates that generated significant returns from MKRs RWA portfolio. As a result, there has been a notable surge in deposits into the DSR, soaring from 100 million to an impressive 1.62 billion. This increased demand for DAI has contributed to an additional 1 billion in its overall supply. Despite the influx of deposits into the DSR, which could theoretically increase expenses due to DSR payouts, an examination of the revenue chart reveals that DSR costs have risen significantly less than vault revenues. This suggests a favorable scenario where the increased costs associated with the DSR are outweighed by the growth in vault revenues.
Additionally, Maker has boosted the demand and supply of DAI by introducing expansions like Spark, an extension of Maker with a focus on growth. This extension allows users to borrow DAI at the DSR rate. Since its launch on May 9th, Spark has accumulated a TVL of over 1.16 billion, as reported by Spark - DefiLlama. The long-term borrowing use case involves borrowing at a semi-fixed rate (the DSR) and utilizing a variety of collateral types, most notably attracting demand from staked ethereum (stEth). With stEth reaching all-time highs and Spark facilitating borrowing against stEth, it has played a significant role in increasing the demand for DAI. Furthermore, Agave Finance on Gnosis Chain is another expansion from Maker DAO. Agave Finance employs a strategy of placing idle DAI in the bridge into the DSR, opening a vault for xDAI depositors to access this yield (netting up to 17% APY for sDAI) , thus facilitating DSR access on Gnosis Chain. Most recently, the launch of Blast, a layer 2 scaling network with native yield for stablecoins and ETH, has attracted large amounts of DAI through its bridge. The contract currently holds 84 million in DAI deposits. These integrations and expansions adding additional use cases is what DAI supply needs in order to grow.
Additional Tailwinds & Catalysts
According to projections by Boston Consulting Group, the tokenization of global illiquid assets is poised to become a $16 trillion industry by the end of the decade, with only $600 billion in tokenized treasuries estimated for 2023. This suggests a Compound Annual Growth Rate (CAGR) of 59.85%. Such a robust annual growth rate lends considerable support to the expectation that Maker will rapidly attract substantial TVL. When compared to other industries, this rate stands out significantly, given that most industries typically experience a CAGR ranging between 8% and 25%.
While the increase of profitability and MKR buybacks is expected to fortify the MKR price in a relative context, I believe the true catalyst for the next substantial outperformance lies Maker's forthcoming Endgame Update. Endgame marks a pivotal shift for MakerDAO, steering it towards the solidification of the core Maker protocol while channeling innovation into subDAOs and resulting in the following changes:
Rebranding of MKR and DAI Tokens
Maker DAO seeks to completely rebrand both the MKR and DAI tokens in a way that allows for easier understanding of MKR’s governance over DAI and a two token system.
1:12,000 split of MKR (eliminating unit bias and establishing a new chart for MKR)
Historically, token splits have been extremely bullish for asset appreciation and the new MKR token price will be easier for retail and other consumers to purchase the new MKR token. Attributed to the cognitive/psychology bias for assets that have smaller ticket prices.
SubDAO Farming
SubDAO Farming introduces multiple spin-offs of various entities and protocols within MakerDAO, with the Spark protocol exemplifying one of the SubDAOs. Participants have the opportunity to stake rebranded MKR and/or DAI, earning a share of these SubDAOs. It's noteworthy that the heightened interest in farming SubDAO tokens with rebranded DAI is poised to drive DAI supply expansion, DSR outflows, and consequently contribute to an increase in MakerDAO profitability and MKR buybacks. I believe Endgame slated to launch Q1/Q2 of 2024 to be the next driving force in MKR outperformance.
Risks
Besides the usual smart contract risk and other forms of third party risk incumbent to the DeFi space, Maker’s largest long term risk is regulatory risk surrounding tokenized assets. As pointed out by this article, MakerDAO's trustee, the Wilmington Savings Fund Society (WSFS), poses a risk due to potential fines that can be deducted from Maker's trust holdings. In addition, the Corporate Transparency Act, effective in 2024, complicates matters by requiring disclosure of substantial ownership, conflicting with Maker's anonymous voting process. These challenges create uncertainty for Maker's RWA program, as WSFS may question compliance. Another significant risk lies in the possibility of the FED deviating from their "higher for longer" narrative sooner than anticipated, resulting in reduced yields from the DAI portfolio. In my opinion, monitoring the strength of the employment market outlook is crucial, as a decline in employment numbers will force the FED to initiate rate cuts.
Closing Thoughts & Target Price
Once again punctuating my MakerDAO thesis. The prolonged "high for longer" narrative, increasing MakerDAO profitability, ongoing DAI supply expansion, buybacks, and imminent catalysts like Endgame form the core of the MKR thesis. Regarding price targets, I find MKR undervalued at a $1.5 billion dollar market cap, especially when compared to Circle's recent $440 million dollar raise from BlackRock at a $9 billion dollar valuation.
MKR not only boasts a superior revenue per token distribution and given its significantly lower expense ratio also exhibits higher profit margins than Circle. Consequently, I believe a more fitting MKR valuation in the range of $3-4 billion or $3,000-4000 per MKR. Although not significantly undervalued, I’m strongly convicted that MKR's sustained growth in the stablecoin market share will expand over time. This is particularly due to users' preference for earning yields on stablecoins, and sDAI outperforms USDC or USDT in delivering on this demand. In terms of portfolio allocation, MKR serves as an excellent hedge in a balanced portfolio, showcasing outperformance and a negative correlation to recent crypto market volatility. This asset is robust enough to comfortably warrant a significant investment, providing portfolio stability even in overall market downturns. It may not be a home run but it sets you up for one.
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