Summary:
Chaos Labs offers analysis concerning the community’s potential strategy to mitigate risk associated with DAI and DAI-centric assets.
Analysis
Dai Direct Deposit Module (D3M) Exposure
We recognize the community’s concerns regarding MakerDAO’s potential rapid increase of exposure to the novel protocol Ethena. As per our Ethena Perpetual Futures Liquidity Assessment Report, we approximated that the insurance fund (IF) should aim for a bootstrapped size of at least $33M in liquidity for the first 1bn of USDe in circulation, under a 300% linear growth rate assumption and an initial supply of 100M. Currently, the insurance fund sits at just $32M, while the total supply of USDe has grown at an unprecedented rate, reaching 2bn in just three months.
However, from the lens of DAI, it’s important to clarify that the proposed 600M D3M cap does not suggest immediate or swift deployment. Instead, it functions similarly to the GHO facilitator capacity, enabling Maker to deploy conditional debt incrementally, up to 100M at a time, based on the overall health of the protocol and cash flow rates from the D3M. From GHO’s standpoint, with appropriate listing parameterization for sUSDe on Aave and anticipated ongoing increases in the GHO borrow cap, a similar outcome can be achieved, with a portion of GHO debt backed by sUSDe.
Much like GHO cap increases, the D3M sUSDe naturally relies on the assumption that the Maker Risk team will act prudently and rationally under the proposed parameterization, gradually allocating debt while maintaining sound risk management practices. The total welfare and rate-limiting of the Ethena protocol, however, are effectively out of Maker’s control and should be assessed accordingly.
D3M Vault Allocations
As a result of Ethena prioritizing rewards for USDe utilization over sUSDe, there is a notable difference in the absolute increases in USDe total supply compared to the USDe staked in sUSDe. Currently, only 24% of all USDe is staked, leading to an asymmetric insurance fund accrual mechanism as the protocol scales up. As per the Ethena docs, for “the duration of the shard campaign, the reserve fund will be funded by a portion of the yield generated by the Protocol asset backing, which relates to the proportion of USDe that is not staked.” The remaining surplus, currently 76%, is being directed to the underfunded insurance fund to maintain its growth alongside the rapid growth in USDe supply.
Gradual Debt Decreases: On redemptions and hardcoding USDe to $1
The price oracle utilized on Morpho hardcodes USDe to $1, while sUSDe bakes in the sUSDe/USDe exchange rate accordingly.
In the event of a mass redemption event, likely triggered by the draining of the insurance fund due to prolonged periods of negative funding rates, it is expected that sUSDe will trade at a discount to its D3M-enshrined value, considering the 7-day redemption cooldown period involved. However, there currently exists minimal rate-limiting redemption mechanisms for USDe, allowing for 2M redemptions per block and a 25% moat of USDT to ensure a stable liquidity buffer. With 83% of the D3M size allocated towards USDe-specific pools, this implies that the collateral ratio (CR) would have to degrade significantly to not only become net unprofitable for liquidators, based on the liquidator incentive function employed on Morpho, but also for Maker specifically, as demonstrated below.
| LLTV (Break Even) | Morpho Liquidation Incentive | USDe CR Threshold (to deter liquidators) | USDe maximum CR decrease from CR Threshold before DAI insolvency | Time Buffer Under Compounded Max Daily Negative Returns (Days) |
|---|---|---|---|---|
| 0.77 | 7.41% | 0.9259 | 20.24% | 35 |
| 0.86 | 4.38% | 0.9562 | 11.18% | 21 |
| 0.915 | 2.62% | 0.9738 | 6.43% | 13 |
| 0.94 | 1.83% | 0.9817 | 4.43% | 9 |
As mentioned previously, the aggregate USDe collateral ratio break-even point for Maker sits at approximately .875, and .7875 through the deployment of the surplus buffer. While we do not endorse this type of oracle logic for the imminent listing of sUSDe on Aave, we recommend implementing an oracle that utilizes $\min(CR,1)$ to adequately price USDe during tail events. However, hardcoding such a value may have acceptable implications from the perspective of any shortfall realized by Maker. This is because a substantial amount of negative funding would need to accumulate rapidly to pose a highly dangerous situation and drop the collateral ratio below the break-even point, thereby allowing a time buffer for all parties to react accordingly. Assuming the largest historic daily negative funding rate, on the day of the Merge (-0.077%), is continuously compounded without any insurance fund, it would take the following number of days for Maker to react to such an extreme scenario occurring:
While we naturally anticipate that market dynamics will evolve with the introduction of Ethena’s substantial OI size, we can utilize historical rates as a proxy to estimate the gradual rate of accumulation and, thus, the implied time buffer.
The Tradeoff: Impact of setting DAI LTV to 0
To clarify the discussions in this thread, it’s important to note that modifying DAI’s Loan-to-Value ratio or Liquidation Threshold does not directly impact its supplying or borrowing capabilities but rather solely affects its usability as collateral within the protocol. Considering this perspective, we present the aggregate DAI-collateralized debt LTV below to assess the potential impact of making such changes within the protocol. It’s observed that the current value follows a downward trend, currently standing at a modest 7.02% of the total DAI supplied, with approximately 60% of this value being used to collateralize stablecoins. This indicates a relatively low demand for DAI as collateral, suggesting that most DAI suppliers are primarily interested in earning interest rather than utilizing it as collateral for borrowing purposes.
In dollar terms, the cumulative debt has remained relatively stable despite the growth in DAI supply on Aave V3, currently amounting to a meager $13.8 million. Taking the average total debt value of $10.2M since inception, and assuming an average weighted interest rate of 7% APY and an aggregate 15% reserve factor, this would translate to an annualized revenue of just ~$107K.
Therefore, in the broader context, the proposed adjustments related to DAI LTV would have minimal implications on protocol revenues and overall utilization.
On altering sDAI LTV to maintain consistency
From a risk perspective, there is virtually no difference between adjusting collateral-related risk parameters in DAI markets and sDAI markets. However, unlike DAI, sDAI maintains an aggregate LTV ranging between 30% and 60% due to its inherent yield-bearing features, although its utilization and total value supplied within Aave have fluctuated.
Conclusion:
The introduction of a pioneering product like Ethena introduces unprecedented quantitative considerations in the DeFi space, particularly regarding the impact of accumulating negative funding on the insurance fund and the overall collateralization of the system. Currently, the protocol utilizes a speculative and artificial reward system, which, while contributing to the insurance fund’s convexity with respect to supply growth, makes it challenging to accurately predict the protocol and the insurance fund’s absolute growth in the long term. The Maker Risk team has adopted a facilitator-capacity-esque framework to model potential future increases, and while the theoretical implied D3M risks are relatively modest at its current scale, such a system inherently relies on implicit trust assumptions from Aave’s perspective. Coupled with the minimal revenue DAI collateral brings to Aave, the community could decide to reduce exposure to DAI as collateral. In this case, we suggest the following two options below.
Conservative
Decrease DAI and sDAI LTV by 12 Percentage Points, LT 1 Percentage Point Per 100M Deployed:
Based on the details outlined in this post, there is a planned gradual reduction in the LTV ratios for DAI and sDAI on Aave V3, transitioning from 77% to 75%, accompanied by a decrease in the LT from 80% to 78% across most chains. Considering these anticipated adjustments and the maximum implied percentage of total DAI backing by (s)USDe at 12%, we conservatively recommend a linear reduction of an additional 12 percentage points in LTV. Regarding the LT, we suggest a conditional decrease of 1 percentage point for every 100M in D3M exposure, with a maximum reduction of 6 percentage points, assuming the full 600M is deployed. LT reductions naturally come with potentially induced liquidations, thus if the amount liquidated due to LT changes is deemed too large, we will modify accordingly. This process will begin with a 1% reduction from the current value to account for the initial 100M, once the initial expected decrease has been completed.
Given current inconsistencies in DAI LTs across the different chains, we will aim to align the LTs and LTVs in the first stage of this proposal. This means that in instances where the LT is currently set higher, the initial reduction would be more than the 1% suggested above. This standardization will be carefully planned to minimize the impact of LT reductions on the likelihood of liquidations.
Specification
| Chain | Asset | Current Expected LTV | Recommended LTV | Current Expected LT | Recommended LT (1st stage) | Recommended LT (Last Stage) |
|---|---|---|---|---|---|---|
| V3 Ethereum | DAI | 75% | 63% | 78% | 77% | 72% |
| V3 Arbitrum | DAI | 75% | 63% | 78% | 77% | 72% |
| V3 Optimism | DAI | 75% | 63% | 80% | 77% | 72% |
| V3 Polygon | DAI | 75% | 63% | 78% | 77% | 72% |
| V3 Gnosis | WXDAI | 75% | 63% | 78% | 77% | 72% |
| V3 Avalanche | DAI.e | 75% | 63% | 80% | 77% | 72% |
| V3 Metis | m.DAI | 75% | 63% | 80% | 77% | 72% |
| V3 Ethereum | sDAI | 75% | 63% | 78% | 77% | 72% |
| V3 Gnosis | sDAI | 75% | 63% | 78% | 77% | 72% |
| V2 Ethereum | DAI | 75% | 63% | 87% | 77% | 72% |
| V2 Polygon | DAI | 75% | 63% | 80% | 77% | 72% |
| V2 Avalanche | DAI | 75% | 63% | 80% | 77% | 72% |
Aggressive
Decrease DAI and sDAI LTV to 0%, LT 1 Percentage Point Per 50M Deployed:
Given Maker’s allocation of a significant portion of potential DAI backing to a new, riskier asset, should the community wish to take more aggressive action, we propose a temporary reduction in the LTV to 0%. Regarding the LT, our recommendation is to conditionally decrease by 1 percentage point for every 50M in D3M exposure, with a maximum reduction of 12 percentage points, assuming the full 600M is deployed. LT reductions naturally come with potentially induced liquidations, thus if the amount liquidated due to LT changes is deemed too large, we will modify accordingly. This proposal prioritizes a risk-averse strategy to hedge against potential future actions by MakerDAO, considering the minimal revenues generated from collateral usage. This process will begin with a 2% reduction from the current value to account for the initial 100M.
Given current inconsistencies in DAI LTs across the different chains, we will aim to align the LTs and LTVs in the first stage of this proposal. This means that in instances where the LT is currently set higher, the initial reduction would be more than the 2% suggested above. This standardization will be carefully planned to minimize the impact of LT reductions on the likelihood of liquidations.
Specification
| Chain | Asset | Current Expected LTV | Recommended LTV | Current Expected LT | Recommended LT (1st stage) | Recommended LT (Last Stage) |
|---|---|---|---|---|---|---|
| V3 Ethereum | DAI | 75% | 0% | 78% | 76% | 66% |
| V3 Arbitrum | DAI | 75% | 0% | 78% | 76% | 66% |
| V3 Optimism | DAI | 75% | 0% | 80% | 76% | 66% |
| V3 Polygon | DAI | 75% | 0% | 78% | 76% | 66% |
| V3 Gnosis | WXDAI | 75% | 0% | 78% | 76% | 66% |
| V3 Avalanche | DAI.e | 75% | 0% | 80% | 76% | 66% |
| V3 Metis | m.DAI | 75% | 0% | 80% | 76% | 66% |
| V3 Ethereum | sDAI | 75% | 0% | 78% | 76% | 66% |
| V3 Gnosis | sDAI | 75% | 0% | 78% | 76% | 66% |
| V2 Ethereum | DAI | 75% | 0% | 87% | 76% | 66% |
| V2 Polygon | DAI | 75% | 0% | 80% | 76% | 66% |
| V2 Avalanche | DAI | 75% | 0% | 80% | 76% | 66% |