Understanding Token #3 (Part 2/2): Maker (MKR)

Looking at possibly one of the greatest Tokenomics Designs

Hi, welcome back for Part 2 of 2 of the Maker overview.

Today, we’re exclusively focusing on the Tokenomics of the MKR token undergirding the protocol.

Please keep in mind this is meant to be accompanied by part 1, so please read that first before moving on to this, unless you’re already an expert in the Maker Protocol.

TL;DR: The MKR Tokenomics are fantastic through the MKR burn mechanism resulting in a current projected 4% annual supply burn. I’d advise potential MKR investors to pay special attention to the risk presented by being backed by such large amounts of USDC as well as large employee costs paid out in MKR which could be dilutive.

I cover token use cases, and the overall Tokenomics, with a presentation of revenues and costs as well as some of my final overall thoughts.

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Understanding the Maker Token (MKR)

At genesis, there was a total of 1M MKR tokens. 8,522 have been burned so far and 84,000 belong to the treasury, so the overall circulating supply is about 91% of the original 1M.

Maker Token Uses

Governance

MKR holders have the right to vote on all governance proposals related to Maker.

For example, they can change these on-chain variables:

• The Dai borrowing fee for any vault

• The debt ceiling (how much total Dai can be issued in a given vault)

• Minimum Collateral Ratios for each vault

• Change the Dai Savings Rate

They can also:

• Vote on compensation plans for protocol employees

• Vote on strategic efforts, such as growth or marketing plans

Since the Maker protocol mints artificial dollars, Maker governance can actually mint Dai to pay their employees. Cool stuff.

Ownership of DAO Treasury

The treasury currently has 84K MKR and governance can vote as they please to utilize this.

The system also has surplus Dai from interest & liquidation fees. This is currently worth ~$40M and also owned collectively by MKR holders.

Lending Backstop

If there is a lending shortfall, new MKR will be issued to cover any shortfall. Thus, all MKR holders are acting as insurance for the protocol.

MKR Burning

Let’s explore how the protocol returns money to token holders. Traditionally, there are 3 ways for companies to return capital to their share holders:

• Dividends

• Share Buybacks

• Acquisition Event

Acquisition events don’t really have a clean parallel in Crypto.

Dividends are received often through Staking. You Stake your crypto-asset, such as SUSHI, and are entitled to a % of fee income, which can be thought of as a dividend.

MKR uses the Share Buyback model. The Maker Protocol has a “surplus buffer”. This is where all revenues go. Any lending shortfalls are first covered by the surplus buffer if the surplus buffer cannot cover a shortfall, the Maker protocol issues MKR to cover the shortfall.

The surplus buffer has a cap.¹ Past this cap, extra Dai is used to buy-back MKR and burn said MKR. Thus, the supply of MKR should go down over the long-term. Indeed, already, 8,500+ MKR tokens have been burned or 0.85% of the supply.

MKR Revenue Sources

Let’s look through the different revenue sources. The Maker team even put together a financial presentation for the month of May.

Source: Maker May 2021 Financial Presentation

Interest/Lending Income

In May, they earned $13M in income or ~$156M annualized run rate. After the liquidations and some consequent interest rate, reductions, the protocol is currently at a ~$120M annualized run rate.

Most banks, and the MakerDAO, refer to this as Net Interest Income, which is Interest Earned from Lending - Interest Paid to Depositors. Maker doesn’t pay any interest to depositors so the $120M belongs entirely to the protocol.

Trading/PSM Income

As users convert USDC to Dai and Dai to USDC via the PSM, the Maker protocol earns fee income. Annualized, this represents about $15M.

A recent governance proposal² eliminated the DAI->USDC fee.

The USDC->Dai fee is 0.1% when many AMMs charge less than this so this fee could also come down over time.

I wouldn’t rely on this income over time.

Liquidation Income

This is extremely fascinating. May was an extremely volatile month for crypto, and Maker nearly made $10M from liquidating loans!

The price of ETH crashed 20% within an hour, 40%+ within hours, and 60% within a few days, and the Maker protocol, mostly collateralized with ETH, actually made a profit from all of this!

Maker carried out hundreds of liquidations and only 2 were unsuccessful, meaning the collateral couldn’t cover the amount lent.

The Maker Protocol may be the first anti-fragile lender. No other lender is making this much when the collateral they hold crashes in value.

Obviously, this income will be very choppy and not predictable, but makerburn, a fantastic resource that tracks Maker protocol statistics, estimates this at $36M+ a year in income and this seems right.

Total Revenue

We can estimate current annualized revenue at $160M+.

Maker Costs

There are a few costs, but the largest, by far, is employee compensation.

Dai Savings Rate

This is currently at 0.01% and costs literally <$10K a year. Not worth thinking about for now.

Liquidation Shortfalls

If there is a shortfall after liquidation, money is first taken from the surplus buffer, and if that is not enough, MKR is issued to cover the shortfall.

This is already covered in the revenue section, as liquidations are a large net profit and even in very choppy markets, Maker has lost little money recently after re-vamping their liquidation process.³ However, in an even more extreme event, this could be an extremely large cost.

Thus for now, I’d rate this as 0 cost, and leave it to readers to price in the tail risk.

Employee Compensation

The financial report pegs the May monthly cost at nearly $600K.

For June, the budget distribution proposal⁴, has nearly $1.5M in disbursements.

Employee costs are burgeoning quickly, and if we view new crypto protocols as startups, this is totally fine! Rapid growth requires rapid headcount scaling.

However, these costs are not fully accurate from an investor’s perspective.

Let’s look at the Protocol Engineering Team’s Budget Request⁵, which was approved.

They request $6.12M annually for 16 members. Direct and indirect employee compensation (salaries and healthcare) is at $4.47M or ~$280K total per employee, accounting for 73% of the budget. Other operational engineering costs, such as code audits, quality assurance, gas costs, hardware, cost about $1.65M in total, or ~$100K total per employee, some of which scale and some of which don’t.

Good Solidity Developers are expensive and an engineering team’s all-in cost of ~$380K/yr is not unreasonable.

However, they also have a vesting schedule whereby they receive MKR over 4 years, a practice that’s similar to tech companies. Currently, each full-time team member receives 995 MKR (0.1% of overall supply) over 4 years, or at current valuations ($3710 per MKR), $3.7M over 4 years. Thus, the actual all-in cost, is $1.3M per engineer per year or more if the MKR token increases in value.

Handing out stock, or tokens, to employees is a totally standard practice, but such large amounts are not handed out when the company, or protocol, is already large and successful. After all, MKR’s market cap is over $3B, so it can be thought of as a unicorn. The average engineer is not receiving $1.3M in all-in compensation, or $900K in stock per year, at a $3B company.

Source: User Planet_X

A user on the MakerDAO forum has done the math and found out that the total proposed yearly distribution of the most recent plan is 11,640 MKR per year or $43M per year at current valuations. Keep in mind, if Maker is to go up, employees receive even more.

Now, this proposal was withdrawn, but the protocol engineering MKR budget distribution has already been approved. Furthermore, the primary reason given for withdrawal was the disparity among core units, not the overall level of dilution.

Furthermore, there are bad incentive:

• Since the current model is to give MKR to each additional hire, rather than a fixed pot for a set of work, this incentivizes teams to over-hire since compensation is on a per-headcount basis

• There is no performance-based pay for MKR vests. It exists for base salary compensation, but not MKR vests, which make up the vast majority of compensation costs. It’d make sense to tie compensation to specific outcomes or goals but that is not the case.

Keep in mind, dilution through 2025 will equal ~5% of MKR outstanding. Investors should price this in and hopefully, future MKR governance voters rein in token vesting compensation, or at least improve incentive structure.

Total Costs

Scaling the June employee costs to be annualized, we see that there are $18M in annualized employee costs. However, I have to remind investors again, the proposed MKR distribution costs are $43M annualized, with the costs tied to the MKR price. If the price of MKR is to skyrocket, costs will skyrocket as well.

Tokenomics

We can see that the yearly profit of the MKR protocol is at $140M+ currently and on pace to grow rapidly.

A $140M yearly profit can be used to burn nearly ~40K MKR annually or over 4% of the market cap.

This is a fantastic Tokenomics model. MKR holders control their risk, they act as the last backstop for lending shortfalls, and are compensated through a great token burn model.

I would like to see Governance pay more attention to token vesting costs, but this doesn’t impact the thesis that much currently. If Governance in 2025 is still approving outlandish token vesting plans, then that would be a cause for concern.

Let me share some final thoughts before I wrap up.

Risks & Final Thoughts

Blacklisting & Peg Stability Module

The PSM represents a very large risk to the overall Maker protocol.

The CENTRE Consortium behind the USDC, has the right to blacklist addresses.

“When an address is blacklisted, it can no longer receive USDC and all of the USDC controlled by that address is blocked and cannot be transferred on-chain,” according to a policy document shared with CoinDesk.⁶

CENTRE says there are two circumstances under which they would blacklist addresses:

1. “If there is a potential security breach or other threat to the network”

2. “to comply with a law, regulation or legal order from a duly recognized U.S. authorized authority, U.S. court of competent jurisdiction or other governmental authority with jurisdiction over CENTRE”

Essentially, overnight, by a US government order, CENTRE could blacklist all USDC held by Maker in the PSM, rendering it worthless as collateral.

CENTRE blacklisting a USDC holder is not some weird, unimaginable event. It’s happened before.⁷

Of the total 4.8B DAI in circulation, 2.2B+ is tied to USDC. Needless to say, this is a very large risk for the overall protocol.

Other Thoughts

• Can Maker Governance provide effective oversight over a 100+ headcount project?

• How will Maker fare against other lenders like Liquity that charge no interest? Put simply, is the current level of fees sustainable? It seems possible that Maker and other synthetic lending platforms could be sustainable purely on the basis of liquidation fees.

• How bad could a tail risk event be?

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I would love to hear your thoughts and questions.

You can find me on Twitter @AishvarR or reach out to me at raishvar@gmail.com.

Personal Disclosure: I own a small amount of MKR.

1. Even before the cap is hit, 25% of earnings are used to burn MKR but this isn’t really an important distinction.

2. The proposal can be found here.

3. In March 2020, the Maker protocol suffered a $5M+ lending shortfall.

4. The proposal can be found here.

5. This can be found here.

6. https://www.coindesk.com/circle-confirms-freezing-100k-in-usdc-at-law-enforcements-request

7. Transaction Hash 0x15cbde1b9bf285db50e22eeff1a7d04ea267dd94726df8ecabdb4cb6c2b590cb if you’d like to look it up.