Maker Foundation Interim Risk Team
PLEASE READ IMPORTANT DISCLAIMERS HERE
On November 18th, 2019, the Maker Protocol is scheduled to upgrade to a new version called Multi-Collateral Dai (MCD). The current iteration, Single-Collateral Dai (SCD), will live in parallel for some indeterminate amount of time. During this overlap, the MKR community will be tasked with managing two Dai currencies, two stability fees, and, ultimately, two ecosystems. This presents a variety of risks to the Maker Protocol, and as a result, we, the Interim Risk Team at the Maker Foundation, are proposing a conservative migration strategy designed to mitigate overall risk.
Please note: the current SCD version of Dai will be called ‘Sai,’ and the new MCD version will be referred to as ‘Dai.’
SCD has been in operation for almost two years now and has gained significant traction in the DeFi ecosystem. There are many benefits to the SCD protocol, such as battle-tested code and relative simplicity. However, we believe that that SCD users will eventually choose to migrate over to MCD for a variety of reasons:
These features should result in lower stability fees, improved liquidity, and future growth of the Maker Protocol.
The current SCD protocol has four primary stakeholders: Sai holders, CDP owners, liquidity providers, and MKR token holders. The current Sai supply is roughly 90 million, which imposes the following responsibilities on these stakeholders:
The goal of this Migration Risk Construct is to transport the above stakeholders from SCD to MCD in a safe and secure manner. This will be achieved by:
Sai holders and CDP owners can migrate in a variety of ways. How they choose to do so entails different levels of risk and/or may impact the market negatively. A migration that occurs completely in the open market could represent an uncontrolled and potentially risky path for the ecosystem. For example, an undesirable path to migration is as follows:
These scenarios are undesirable because:
Due to the potential for destabilization of both the Sai and Dai price, there will be a special migration contract included in the Maker Protocol. The functionality of the migration contract is contingent upon governance approving Sai as a collateral type in MCD.
The migration contract works as follows:
Because this process is fully contained in the migration contract, neither Sai holders nor CDP owners need to interact with public exchanges. This mitigates destabilization risks for both the Sai and Dai price. Further operational and technical details for this process can be found here.
When the community has determined that it is no longer possible to effectively manage the Sai ecosystem, or desirable to do so, an emergency shutdown will be triggered in SCD. An emergency shutdown is essentially an unwinding of the protocol, which allows Sai holders to redeem their tokens for $1 USD worth of ether (based on the oracle price at shutdown) and CDP owners to collect their collateral, minus the balance of their drawn Sai.
Other emergency scenarios (some of which are described further below) may also necessitate an emergency shutdown to be triggered.
The launch of MCD represents a collection of significant improvements to the Maker Protocol. There are new governance levers (such as the DSR), a new liquidation process, and the inclusion of multiple collateral types. However, governance must manage numerous additional risk parameters, a significant increase from the current model of just two (stability fee and debt ceiling).
Additionally, the migration effectively represents a deleveraging of 90 million Sai and a potential re-leveraging of 90 million Dai. Two sudden supply shocks in a short period of time put a strain on market liquidity and threaten the stability of both Sai and Dai. Consequently, the risk team proposes what it believes is a conservative governance strategy, which is designed to mitigate potential risks during the migration process. Part of this strategy is the selection of the initial risk parameters, which the risk teams believes will help minimize any potential negative impact on the Sai and Dai price.
One strategy for achieving a safe and orderly migration is to incentivize users to upgrade in a coordinated and predictable manner.
A straightforward way to incentivize Sai holders to migrate is the introduction of the DSR, a tool that makes holding Dai more attractive compared to Sai. Given the absence of any empirical data, it is difficult to select a precise starting DSR value. However, a DSR of 2% is likely to be competitive with the broader DeFi ecosystem, which currently offers a ~6% (and dropping) savings rate on Sai. After adjusting for the added counterparty risk present in other platforms, a 2% DSR should incentivize a moderate amount of Sai holders to begin the migration. This parameter can be adjusted through governance as needed.
For CDP owners, a spread between the SCD and MCD stability fees should be sustained as well, ensuring it will be cheaper to mint Dai in MCD. The Eth stability fee spread could likely be 1-2% throughout the migration cycle. We propose a 1% stability fee spread to start. CDP users can often be insensitive to stability fee changes, so we do not expect an immediate and strong shift in CDP owner behavior. While a 1% spread may be too conservative, we recommend erring on the side of caution until more data becomes available.
Another incentive we would like to target is the sequence of migration for Sai holders and CDP owners. Given that CDP owners utilize Sai liquidity from the migration contract, it is important that enough Sai holders switch over to support the other migration participants. Otherwise, CDP owners will be forced to source Sai on the public markets, impacting prices.
There are multiple ways this sequencing can be achieved. First, from a practical standpoint, the Maker Foundation has been working with exchanges that hold large Sai balances to migrate as soon as possible on behalf of their users or to provide them with the tools to do so manually.
Beyond the coordinated migration of our partners, however, governance can continue to use monetary policy if they so desire. An increase in the DSR or stability fee spread should impact stakeholders accordingly.
There are several considerations to be made regarding the debt ceiling, which would be monitored and governed separately for SCD and MCD.
Debt ceiling cap space is a critical tool for market makers to effectively carry out their role in helping keep Sai stable. Therefore, governance should ensure that there is always sufficient room in the debt ceiling so that market makers have sufficient access to Sai liquidity should they need it. We recommend a continuous 10-20 million Sai buffer.
For the MCD Eth debt ceiling, we propose 50 million, to be raised when needed. As the Sai supply migrates, the SCD outstanding supply is reduced. The debt ceiling should then be lowered to allow for simultaneous increases in the MCD debt ceiling. However, a minimum supply of Sai as a liquidity buffer for market makers should be kept intact, even as the maximum Sai debt ceiling goes down.
While our initial recommendation of risk parameters represents a logical starting point for the new protocol, standard operating procedure for governance still applies. Typical pressures such as changing demand for leverage, volatile ether prices, or sentiment shifts may still cause instability in the price of Sai or Dai. The governance community will continue to use the same general mechanisms to manage both the old and the new peg.
But, we also must now consider the possibility of additional migration-specific issues that could arise and require rapid adjustments to debt ceilings, stability fees, or the DSR. Governance must remain agile and vigilant with these monetary policy tools so that they can quickly respond to various market pressures.
While we cannot predict the full gamut of possible situations, we highlight a few that might be relevant to the governance community in the coming weeks after launch.
As a general rule for policy tools, we suggest using the stability fee to target incentives instead of the DSR. Due to the relative immaturity of the DSR, it is likely to be ineffective (or unpredictable) as a monetary policy tool. Additionally, any stability fee changes should aim to keep the spread across SCD and MCD in line.
Certain conditions may necessitate an early emergency shutdown. The most likely reason for this would be a shortage of Sai liquidity, leading to highly volatile prices and wide bid/ask spreads. Even with sufficient debt ceiling room, market makers may be unwilling to mint and sell Sai if there is an expectation that the price will continue to increase. For market makers to be willing to sell, they must be confident that emergency shutdown is a credible threat.
Because Sai would be redeemed at its target price of $1 USD in an emergency shutdown, perception would then help drive downward pressure on Sai towards the target price.
Governance Polls and Executive Votes
Due to the unpredictable nature of the migration, the community should be prepared to take unscheduled action with regard to monetary policy. In some cases, emergency action on short notice may be required. Consequently, the community should expect an increased number of governance calls, governance polls, and executive votes. Of note, the community should be on the lookout for emergency shutdown discussions and votes. The Maker Foundation will use all available communication platforms to notify the community when any such actions may be necessary.
Additional Collateral Types
In addition to ether (ETH), the risk team is proposing to launch with one additional collateral type, the Basic Attention Token (BAT), which scored the highest in the asset priority poll held in July. The primary reason for this addition at launch is so that engineers in the development community can fully test all of the features and functionality of the Maker Protocol. In the weeks following launch, a more formal analysis and risk evaluation of BAT will be released. For now, we propose a conservative debt ceiling of 3 million and, for simplicity’s sake, an identical stability fee to Eth.
In this section, we examine a cross section of migration risks along with potential mitigations. This list is not exhaustive due to the unpredictable nature of the launch. The following risks are listed in no particular order of likelihood or severity.
A slow pace of migration could cause a number of undesirable side-effects relating to the stability of Sai or Dai. First, there will be a considerable increase in operational and social overhead required to manage two pegs and two sets of system parameters. These parallel ecosystems could also result in fractured liquidity, brand confusion, a lack of consumer confidence, and/or a disruption in business for our ecosystem partners.
It is difficult to quantify ‘too slow’ or pin down what the target timeline is for migration. However, the community should remain vigilant in the governance process in order to respond to market forces. For example, depending on the market’s reaction to the initial risk parameters, governance may choose to increase the DSR or stability fee spread if necessary.
Protocol upgrades can often have unpredictable consequences, and a rapidly migrating user base could exacerbate any potential issues. Due to the length of time currently required to complete each governance cycle, the community may not be able to react to emerging threats to the system.
Similar to the above risk, governance must monitor the pace of migration and adjust risk parameters accordingly. Additional governance calls should also be held to speed up the governance process.
Secondary lending platforms such as Compound and dYdX are some of the largest ecosystem users of the Maker Protocol. In total, roughly 50 million Sai has been deposited into these platforms. From that number, roughly 30 million Sai has been lent out to borrowers.
The borrowers on these secondary lending platforms resemble Maker CDP owners, in that they have Sai obligations against their collateral. However, Sai borrowers on secondary lending platforms may not have direct access to Sai liquidity from the migration contract to close their positions.
This has a few consequences:
The standard response to an increase in Sai price is to decrease the stability fee such that market makers are incentivized to mint more Sai and push the price back downwards. This requires sufficient debt ceiling for market makers.
There is a risk that Sai liquidity will dry up, making it difficult for CDP owners and secondary Sai borrowers to migrate and potentially driving the Sai price upwards. This could happen for a variety of reasons:
Ideally, risk parameters are set in such a way that Sai holders are incentivized to migrate early, ensuring sufficient liquidity. However, if any of these scenarios occur, the Sai price may spike upwards. In some cases, market makers may not have the balance sheet capacity to temper the price. If this scenario persists, triggering emergency shutdown is the only available option. As a result, the community must be willing to undergo this emergency measure should the situation arise.
To facilitate CDP owners and secondary lending borrowers migrating over, an appropriate Dai debt ceiling must be set. However, the doubling of the global debt ceiling across SCD and MCD unintentionally increases exposure risk for the Maker Protocol. While this additional debt ceiling is intended specifically to facilitate CDP owners to migrate, there is nothing to stop new users (or an attacker) from utilizing this new debt ceiling space. This could trigger a supply shock and negatively impact Dai liquidity.
Ideally, the MCD Eth debt ceiling should be low enough to protect against too much Dai being minted at once, but high enough to facilitate migration without exhausting the supply. While we don’t anticipate a sudden surge of new demand for Dai leverage, we believe the Maker Protocol should be able to handle an unexpected increase of 50 million in the Dai supply.
The bootstrapping of a second ecosystem within the Maker Protocol will involve managing a series of unknowns with our familiar governance tools, plus a few new ones. Due to the lack of empirical data available to us to accurately model a Multi-Collateral Dai which exists in concert with a Single-Collateral Sai, the Interim Risk Team recommends that the governance community approve this proposal to initialize the launch of MCD with a series of logical and conservative defaults. The Interim Risk Team believes the proposed parameters, as listed in the appendix below, will give the governance community a stable foundation with which it can begin to manage the new monetary policy requirements of a post-MCD world.
If this proposal is accepted by the community, it will signal its support for the following risk parameters to be initialized at the launch of MCD.
Proposed Risk Parameters