MakerDAO Valuation

The following report was written by Messari Hub Analyst(s) and commissioned by MakerDAO, a member of Messari Hub. For additional information, please see the disclaimers following the article

Introduction

As a consequence of DeFi’s recent boom, the demand for stablecoins has soared, driving the total stablecoin supply to surpass the $100 billion mark. While the necessity of stablecoins in DeFi for liquidity and volatility purposes has become evident, the long-term sustainability of centralized stablecoins is now a growing concern. Mounting regulatory uncertainty and opaque reserves have pushed many users seeking more transparent alternatives.

Within this context, MakerDAO, and its stablecoin DAI, has risen as the most successful decentralized stablecoin protocol to date, growing its total supply by 46x in the last twelve months and generating over $63M in net earnings since the start of 2021.

In this piece, we look at the Maker protocol, a core building block of the DeFi infrastructure stack, and the metrics behind its governance token MKR.

About the project

MakerDAO: History

Founded in 2015, MakerDAO is an overcollateralized stablecoin project running on Ethereum blockchain. MakerDAO was born out of the recognition that early cryptocurrencies were highly volatile and thus not very useful as a medium of exchange. The development of the project was originally led by the Maker Foundation but is now controlled by a DAO.

The protocol was officially launched in 2017 as the Single-Collateral DAI system (also known as SAI) which allowed users to mint DAI using ETH as collateral. In the same year, Maker raised $12 million through a sale of MKR tokens to Andreessen Horowitz, Polychain Capital and other crypto-focussed venture capital firms.

Following the successful launch of Single Collateral DAI, Maker launched the Multi-Collateral DAI (MCD) system in 2019, accepting an increased variety of collateral types beyond ETH.

The total supply of DAI reached $100 million in May 2020, 7 months after the launch of MCD. A little over a year later, in June 2021, the total supply of DAI has now surpassed $5 billion

Project Description

The Maker Protocol allows users to issue DAI, a stablecoin pegged to the value of the US dollar, by locking collateral assets of a greater value in the system’s vaults. Maker currently supports a variety of collateral types including volatile cryptoassets, stablecoins, liquidity tokens and Real World Assets (RWA).

DAI combines the advantages of a low volatility currency with the key attributes of cryptocurrencies (permissionless, borderless, transparent, peer-to-peer, etc.). DAI is generated, backed, and kept stable through collateral assets that are deposited into Maker Vaults on the Maker Protocol (e.g. $1,000 worth of ETH is deposited into a vault as collateral to issue 500 DAI). This, paired with the adjustability of interest rates, ensures that DAI’s value is always equivalent to one US dollar.

When DAI is issued, the Vault owner takes a loan against their deposited asset, similar to any other form of collateralized lending. If the collateral value of the vault decreases below a specific threshold, the position could be liquidated by the Maker protocol to repay the outstanding DAI debt. The user will be charged a penalty for being liquidated. Under normal circumstances, a vault owner repays their original DAI loan back with interest to regain control of their collateral.

The protocol’s revenues are derived from three main sources:

1. Interest revenues from overcollateralized loans
2. Liquidation revenues from fees charged on liquidated vaults
3. Stablecoin trading fees from the Price Stability Module (PSM)

Note, the PSM allows users to swap other stablecoins for DAI at a fixed rate (including a 0.1% fee). Its primary purpose is to aid with keeping DAI’s peg to the dollar. Moreover, it allows Maker to adjust its collateral structure depending on the market’s appetite for lending services.

Maker Tokeneconomics

MKR is the governance token of the Maker protocol. It allows those who hold it to vote on protocol changes such as collateral onboarding, governance parameter changes, budget approvals, etc.

MKR tokens are also responsible for the recapitalization of the protocol in the event that liquidations would not fully cover outstanding DAI. In this scenario, the protocol would mint and auction MKR tokens, therefore diluting the supply, to cover the protocol losses and ensure the solvency of the system.

The income generated by the Maker protocol indirectly accrues to tokenholders. Currently, cash flows are used for three main purposes being:

1. Covering the protocol’s development and operational costs
2. Building a safety buffer to cover potential liquidation losses (surplus buffer)
3. Buying and burning MKR tokens out of circulation

Conceptually owning MKR could therefore be compared to owning equity of a bank that is performing continuous stock buybacks.

Out of the initial supply of 1,000,000 MKR tokens, around 907,000 are still in circulation. The difference is accounted for by the ~9,000 MKR tokens bought back and burned by the protocol and the 84,000 tokens that have been given over to the DAO by the Maker Foundation in May 2021 as part of of its dissolution process.

Recent Upgrades & Initiatives

Below are noteworthy recent updates to the protocol:

• Dissolution of the Maker Foundation: The Maker Foundation, the organization responsible for most of the development of the Maker protocol to date, has announced in May 2021 that it was accelerating its dissolution by gradually shifting responsibilities for development and governance to a DAO. As of the end of July, the dissolution and transition has been essentially completed.
• Real World Assets: In April 2021, Maker began issuing loans backed by real world assets through the onboarding of New Silver, a lending service provider for real estate investors. This bridge between the worlds of traditional and decentralized finance represents a major milestone for Maker and DeFi as a whole. Backed by strong community support, RWA backed lending represents a trillion dollar growth opportunity for Maker, which would also contribute in spreading collateral risk to assets uncorrelated to crypto.
• Liquidation 2.0: Since the events of the March 2020 Black Thursday, which resulted in 5.67 million un-collateralized DAI, Maker has made several improvements to its liquidation system. In addition to its liquidation portal, Maker has released in the first half of 2021 its new liquidation 2.0module. This system has proven itself extremely efficient at minimizing losses. On May 19, 2021, amid a c. 45% drop in the value of ETH, the system settled $41M of debt through 177 auctions – generating $5.1 million in liquidation fees while only incurring two liquidation losses totalling $12 thousand.

Traction

DAI Supply & Demand

Following the rise of the DeFi ecosystem, stablecoins such as DAI have experienced tremendous growth as a key enabler of decentralizing lending and exchange activity. Over the last twelve months, the overall stablecoin market has grown from $11 billion to now over $100 billion.

This 10x YoY surge in total supply was driven by sustained capital inflows into the crypto economy as well as growing volumes in DeFi. The popularity of stablecoins can also be attributed to their inherent qualities – offering investors a low volatility safe haven while retaining all the key attributes of cryptocurrencies.

Maker has been able to capitalize on this surge, increasing its outstanding DAI supply from $127 million to over $5 billion in the last twelve months. DAI currently has an 8.2% share of the stablecoin market on Ethereum and about 5% overall. It is the fourth largest stablecoin by market cap.

Given mounting regulatory risks around stablecoins issuance and reserves, notably from the European Union, United States and China, DAI possesses a strong competitive advantage versus larger centralized stablecoins. MakerDAO’s reserves can be audited on chain whereas projects such as USDC and USDT have to rely on external auditors. In the case of USDT, the project recently experienced increasing scrutiny as the provenance and credit quality of its reserves are challenged.

There is a trade-off between centralization risks of collateral like fiat-backed stablecoins and volatility risk of trust-minimized crypto assets such as ETH. So far, Maker has proven through its liquidation module that it is considerably resilient to volatility and as such, has gained the confidence of users.

Maker Performance to Date

The demand for lending and DAI has pushed Maker’s monthly net income soaring, with the first six months of 2021 resulting in over $63 million in profits. When compared to the last six months of 2020, this represents more than a 7x increase. This performance can be broken down as follows:

Lending revenues, derived from interest earned on loans, averaged approximately $7.7 million monthly during the first half of 2021, up 13x from the second half of 2020. This growth is directly attributable to the uptake in loan volume as well as higher interest rates, which have risen progressively from 2% in late 2020 to 5% in April / May 2021 and now sit at 2% (for the ETH-A vault) due to decreased market demand for leverage. Lending revenues represent Maker’s most recurrent and stable source of income.

Liquidation revenues, derived from penalties charged on liquidated vaults (13%), also contributed considerably to Maker’s strong performance. Benefiting from significant market volatility, monthly liquidation revenues spiked to $9.4 million in May 2021. Although more irregular in nature, MKR tokens benefit from decreases in collateral values through the collection of liquidation fees (assuming orderly liquidations). Over time, this means that MKR tokens could have a lower downside correlation with the overall market. Note that we expect liquidation volumes to decrease over time as third-party loan management solutions improve and collateral volatility decreases.

Trading revenues refer to fees collected from Maker’s Price Stability Module (PSM). This module saw a significant uptick in May and June 2021 as demand for DAI rose while crypto collateralized loans decreased. As a result, the protocol has now converted more than $3 billion of USDC to satisfy the demand for DAI.

Dai is therefore a dynamic system that adjusts its collateral backing accordingly to market conditions and needs. As the crypto market expanded during the first half of 2021, the system capitalized on the need for leverage and backed its reserves primarily on ETH loans. Following the decline from the most recent top, the system adjusted its reserves through an inflow of stablecoins to maintain and continue to grow DAI’s supply. This flexibility and resilience are core strengths of the protocol and represent distinctive characteristics of DAI over other stablecoins

Valuation Methodology

As the Maker protocol generates positive cash flows, which accrue to MKR holders through the surplus buffer and the buy and burn mechanism, it is possible to value the token using both a discounted cash flow analysis and a comparable analysis.

Discounted Cash Flow Analysis

The DCF analysis is based on the 10-year projected growth of the protocol. In our valuation, we select a bull, base and bear cases to get a range of possible values.

The discount rate used for 2021 to 2030 cash flows is set at 25%, based on our perception of the risks and progress of the protocol to date. To be conservative, our model assumes a terminal value multiple of 10x 2031 forecasted free cash flow, which is slightly lower than traditional banks.

Our DCF analysis is built on the following assumptions:

DAI Supply Growth Rate

The growth of the total DAI supply has a significant impact on the valuation since it directly drives the total interest revenues (>80% of projected income) and indirectly affects liquidation revenues. Note that in the last twelve months, DAI supply has grown by over 4,500%. All scenarios assume a 4 billion 2021 average DAI supply.

• Bear case: Supply grows at an annual rate declining from 50% to 5% to reach $42 billion at the end of 2031. This would represent assets on the scale of a small-sized U.S. bank. This scenario portrays a notable slowdown in the growth of the crypto ecosystem and/or Maker loses market share versus its competitors.
• Base case: Supply grows at an annual rate declining from 125% to 10%. This would result in a total supply of DAI of $183 billion by 2031, similar to the assets of a mid-sized U.S. Bank. This scenario implies a continuing growth of DeFi along with Maker continuing to gain market share over its rivals.
• Bull case: Supply grows by an annual rate declining from 175% to 10%, putting the total 2031 DAI supply at $359 billion. This would represent assets on the scale of a large-sized U.S. bank. For this scenario to be achievable, Maker would need to capitalize on a significant expansion of the crypto economy as well as on the onboarding of large real world asset pools and/or central bank digital currencies.

To provide additional perspective, Circle, the issuer of USDC, forecasted in his latest July 2021 investor presentation that the total supply of USDC will reach $84 billion and $194 billion by the end of 2022 and 2023 respectively (CAGR of 136% over the next two years).

Below is a visual representation of the projected growth of DAI under the different scenarios:

Interest Revenues

To account for the proportion of DAI that is not backed by loans (generated from the PSM), we have assumed that 55% of the total DAI supply represents the lending base.

On this base, we have applied an APR constant at 3% across all scenarios; this is lower than the average rate on the protocol during the last months of operations of around 4%.

Liquidation Revenues

In terms of liquidations, we have assumed that a percentage of the average total DAI supply will be liquidated and thus subject to the 13% penalty fee. This percentage is set at 4% and projected to decrease linearly to 2% over the forecasted period.

Note that in the last twelve months, the total amount of liquidated DAI represented around 6.7% of the average monthly supply.

Trading Revenues

To account for the PSM, we have assumed that that PSM volume grows at the same rate as the average total DAI supply. The base for 2021 is 3.3 billion in volume. The fees earned are set at 0.1% of forecasted volume. This assumption results in this revenue stream representing 5% of lending revenues. Historically, this number has been around 7%.

Expenses

We have assumed that liquidation expenses will represent 7.5% of liquidation revenues. Note that recently, despite spikes in volatility causing significant liquidation events, liquidation expenses have remained close to none.

For workforce expenses, we have assumed that they will account for 20% of revenues in 2021 and decrease linearly to 15% in 2031 as the protocol scales and matures.

Summary of Assumptions

Below is a table summarizing the key assumptions used in the DCF analysis:

Comparable Analysis

Circle, the issuing entity behind the USDC stablecoin, announced in early July 2020 its intentions of going public through a SPAC. Using the investor prospectus, we were able to obtain the financial forecasts supporting the $4.5 billion valuation that was attributed to the company.

As such, we have performed a comparative analysis of the forecasted 2021 to 2023 period for both Circle and Maker (using our base scenario).

From the table above, we see that although Circle is forecasting higher revenues, it is significantly less profitable than MakerDAO. Indeed, as Maker is decentralized, it is able to minimize overhead costs and expenses compared to Circle. Moreover, while Circle relies on “cash” reserves to back its stablecoin, Maker operates a lending service to support DAI, which results in distinctively higher returns on a lower supply base.

In terms of valuation, Maker trades below Circle’s implied 2021E to 2022E EV to revenue multiples and below Circle’s implied 2023E EV to EBITDA multiple, which suggests that Maker may be undervalued compared to its peer.

Note that in terms of stablecoin supply, our base scenario implies a 4.5x increase in DAI over the 2021 to 2023 period. Circle predicts that the total supply of USDC will increase by 5.5x in that same period, which supports our assumption.

MKR Token Valuation

Discounted Cash Flow Result

Below are the results from our DCF analysis for each of our three scenarios:

We value MKR based on the probability-weighted outcomes of the various scenarios. We have assigned weights of 30%, 40% and 20% in the bear, bull and bear scenarios respectively. The remaining 10% has been assigned to a blow-up scenario, one in which MKR becomes worthless due to critical smart contract failure or irrecoverable liquidation losses. In our opinion, this weighting is conservative.

According our DCF model, the fair value of MKR is $6,808 per token.

Comparable Results

Applying Circle’s EV to revenue multiples to our Maker base scenario, we obtain a MKR price ranging from $2,217 to $3,886 per token. When assessing valuation using the 2023E EBITDA multiple, we obtain a price of $20,524 per token.

Roadmap

The following are some of the key upcoming initiatives and updates to be implemented to the protocol:

• Flash Mint Module Implementation: Following a vote passed on July 1st 2021, the Maker Protocol has activated the Flash Mint Module. This module will allow users to mint up to 500 million DAI with the only condition being that the loan is repaid back in the same transaction with a fee (currently 0.05%). This will allow anyone to exploit arbitrage opportunities in the DeFi space without having to commit upfront capital and constitutes a new revenue stream for the protocol.
• Multichain Strategy: The community is working on developing Maker’s mutlichain strategyin an effort to ensure that the protocol remains relevant across multiple chains. Moreover, developers are working on an Optimism DAI bridge that will allow for fast withdrawals from Optimism L2 rollup. This is expected to be fully deployed by Q3/Q4 2021.
• Aave D3M: Maker is introducing the Maker Direct Deposit Dai Module (D3M) in cooperation with the Aave team. This module will allow DAI to be minted on Aave to enforce a maximum borrow rate for DAI on that lending platform. Ultimately, this will help MakerDAO gain capital efficiency, grow its supply and make DAI the primary choice for stablecoin borrowers on Aave.

Competition

Maker competes in both the stablecoin and collateralized lending markets.

As highlighted previously, DAI has been able to make considerable gains in terms of market share over the last twelve months on its centralized rivals. We believe that this trend will continue in the future. DAI possesses a strong competitive moat due to its decentralized nature, transparent reserves and increasing prominence in the DeFi ecosystem. Regulatory and transparency risks of fiat backed stablecoins and the low reliability of algorithmic stablecoins could further DAI’s competitive hedge over time.

DAI also has the ability to create a low volatility currency backed by real assets (crypto-assets, RWA etc.) Over the long term, DAI could unpeg from the USD and be pegged against a specific basket of goods.

In terms of borrowing, Maker enables more certainty in the charged interest rate than variable rates competitors like Aave or Compound. Furthermore, Maker benefits from variable rate lending protocols as long as their variable rates are higher than Maker’s stability fee. Market participants can borrow from Maker and lend at a higher interest rate with the ability to close out their loan at any time if their collateral value decreases.

Risks

As MKR token holders are responsible for the recapitalization of the protocol in the event that liquidations would not fully recover DAI, MKR holders are supporting a certain level of credit risk. At the time of writing, Maker’s surplus buffer ($48 million) is acting as a mitigation measure while the top collaterals, USDC, ETH and BTC, were of $3.3 billion, $1.6 billion and $230 million respectively.

MKR token holders are also subject to counterparty risks by enabling USDC and RWA as collateral, although exposure to RWA remains minimal for the moment.

The increasing reliance of DAI on USDC creates a non-negligible regulatory and blacklisting risk for Maker as Circle could blacklist part of Maker’s USDC vaults. This also highlights a particular predicament that Maker has found itself in being that demand for DAI currently outstrips demand for lending. We believe that the reliance on USDC is a necessary temporary setback for Maker as wider DAI adoption remains paramount to the overall success of the protocol. We note that the community is currently working on alternatives to solve this issue such as exploring new Uniswap V3 liquidity tokens.

Maker is also subject to protocol development and technological risks, which we have factored in our DCF valuation. We believe those risks to be low considering the external smart contract audits that have been performed and the reputed core development team.

Given that protocol changes rely on a DAO, MKR holders are subject to governance related risks. Despite some built-in safety mechanisms to mitigate against potential governance attack vectors, it is our opinion that the governance process could be improved and streamlined to minimize governance risks. In particular, the DAO frequently grapples with low tokenholder participation rates on votes. This may limit Maker’s ability to quickly react to market shifts and presents a security risk, where attackers could potentially borrow MKR to force unfavorable votes. The DAO is currently working on an improved vote delegation system that should help counteract this issue.

Conclusion

Maker has set itself as a top contender in both the stablecoin and lending markets, two fundamental segments of the buoyant DeFi ecosystem. This has enabled Maker to scale and generate over $72 million in net income for tokenholders over the past twelve months. Backed by a strong development team, community and a growing user base, we see Maker as poised to continue its growth over the coming years. Achieving the proposed valuation will nonetheless require overcoming challenges such as bridging the gap between demands for DAI and lending through innovative solutions such as RWA. We look forward to seeing DAI’s market supply continue to grow and MKR tokens being burned.

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This report was commissioned by MakerDAO. All content was produced independently by the author(s) and does not necessarily reflect the opinions of Messari, Inc. or the organization that requested the report. The commissioning organization does not influence editorial decision or content. Author(s) may hold cryptocurrencies named in this report. This report is meant for informational purposes only. It is not meant to serve as investment advice. You should conduct your own research, and consult an independent financial, tax, or legal advisor before making any investment decisions. Past performance of any asset is not indicative of future results. Please see our Terms of Service for more information.

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