MakerDAO Governance/Stability Fee: A Case For VFR (Variable Fee Rate)

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A Case for VFR (Variable Fee Rate)

The first thing I want to examine is how banks make money off of loans. Banks earn money from: “Account fees (maintenance)” , Penalty Charges, Commissions, Application Fees, and interest.

Fundamentally, MakerDAO avoids ALOT of this. This is the beauty of a decentralized application: its loyalty is almost entirely centered around the user’s experience. So the question then becomes, why the change to 2.5% stability/governance fee rate? The team voiced the change was coming because of a potential disequilibrium caused by .5% stability/governance fee(the current rate).How does this disequilibrium occur? Supply and demand.

The price of Dai falls due to supply (quantity CDP generation) exceeding demand (quantity market participants seeking stability), there is then a downward spiral that can occurs resulting in an inaccurate peg. The team claims increasing the stability fee will reduce amount of Dai drawn due to the increase in cost of drawing a loan.

Here is my argument: Increasing the stability fee from 0.5% to 2.5% is a temporary solution and will not truly fix the real core issue. The team will claim CDP generation is the problem, when more accurately it is also demand that needs to be solved. The competitive problem currently is that there are more things you can do with Tether compared to Dai. Therefore, many CDP owners are selling Dai in exchange for tether. This is simply a game of complementary goods where one side has a demand side advantage currently. Multi collateral Dai in conjunction with every pairing possible using Dai is the true permanent solution to the demand side issue.

This is my issue with a 2.5% stability/governance fee as a supply side solution. It is not a true permanent resolver of imbalance. Sure, it might slow down the increase in the supply of dai from CDPs, but it hurts one of the fundamental attractive functions a CDP has; it is the best loan rate you can find practically anywhere. Increasing the fee simply reduces the appeal of using the product in the first place. You do not want to lose users before they even come to the table because of a broadly used disincentive. In my opinion, this change will scare off far more people than they may anticipate.

So now lets think about this on a deeper level. In a real world bank-to-user loan situation, if you do not pay your loan back, the bank has to spend money to start the process of liquidating your assets. Its expensive. There are unknown costs and overhead to the process. With MakerDAO, the loan will always be payed off as a result of liquidation. And if not, the collateral is permanently committed to supporting the system until the loan + fee is payed.

As a result, a user is 95% of the time a beneficial actor for the MakerDAO system (The other 5% are large entities perhaps playing with bite/smart contracts in an unpredictable fashion, not necessarily bad). A bank cannot assume a person is beneficial. People can be expensive and costly if they don’t follow through. This is ultimately somewhat remedied by a flawed credit score system — it is the bank’s attempt to establish trusted users who are financially benevolent and consistent in their payment of loans.

To bring this full circle, what do users who have good credit scores receive? Lower interest rates as a reward. Credit score is a positive incentive. Lets bring this back to MakerDAO. Here is my thesis: The amount you collateralize in relation to the system’s collateralization rate is equivalent to a credit score. A small dai loan drawn with a large amount of collateral is benevolent in that it helps the system because supply is reduced compared to if the user had taken a larger loan, and it collateralizes the system in a beneficial ratio.

Currently, user’s Dai-Draw amount incentives are almost entirely dictated by liquidation price. I am advocating for making the stability fee rate be a positive incentive in parallel to a higher collateral ratio, and a negative incentive in parallel to a lower collateral ratio(compared to one direction proposed) in order to reduce supply. With my proposed system, the higher your collateral ratio, the lower your stability fee rate, a.k.a VFR(Variable Fee Rate).

Naturally, the end game of VFR would be that people who have a lower collateral ratios would have to pay higher interest rates. This falls in line with the idea of a credit score. Safe, benevolent, consistent contributors benefit from the system, and risk takers are somewhat punished. Taking a smaller (less supply generated) “safe” loan should be incentivized by interest rates, not just by liquidation price. Taking a “risky” (larger) loan should also have more negative incentives than just the liquidation price.

Finally, would the stability fee rate be established upon creation of the loan, and then remain permanent? Or would the stability fee be variable based off of the price? Great questions my brain doesn't want to fully wrap its head around right now.

Anyways, I don’t have the numbers perfectly figured out. I am sure my line of thought is flawed in there somewhere, this is coming from a 19 year old college student who was thinking about bank loans vs MakerDAO on a 6 mile run. Would love feedback! Slam me on my lack of economics, I would love to learn more! ❤

Can find me on twitter here: https://twitter.com/l_woetzel?lang=en

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Author of “Building Confidence in Blockchain — Investing In Cryptocurrency and a Decentralized Future”

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