MakerDAO Financial Report: an opened gate to financial regulation
By: Pablo Artiñano
Tags: Financial Services, Makerdao, Cryptocurrency, Defi, Stable Coin

The regulatory side: Solvency requirements for cryptoassets?

In addition, the report provides high-level analysis in terms of capital ratio, as CET1 is named, and leverage ratio. These two metrics come from the banking world and have been used as an industry standard to define the level of solvency of a credit institution, either risk-adjusted (solvency ratio) or risk non-aligned (leverage ratio). To do so, the institution’s assets are compared with its level of capital, distinguishing between risk-weighted assets (RWA) or assets at Book Value depending on whether the assets are considered valued on a pure accounting basis, or whether they require an additional adjustment to measure the unexpected loss associated with those assets. Regarding this, the CET1 or CET1 ratio measures the volume of own funds (equity, mainly according to CRR banking regulations[3]) that the institution holds in relation to its assets on the balance sheet, assets which, as mentioned above, are adjusted to define the probability of default.

Without entering an in-depth debate on the taxonomy of risks assessed and managed by credit institutions, it should be noted that the international supervisor has set minimum levels for both ratios based on the risk to financial stability that the potential inability to assume the losses generated by the institution poses for the other participants in the financial system. This risk derives mainly from the fractional reserve model under which a bank operates, in which it is required to maintain the reserve ratio of deposits collected at the institution itself, and from its intermediation of maturities through the granting of loans.

The banking solvency ratio is set at 8%, while the leverage ratio is 3.5%. By extension, although the supervisor has not yet established a specific solvency requirement for MiCA obligors[4], the calculation of solvency ratios by MakerDAO suggests that the collapse of the protocol may pose a risk to financial stability.

Thus, to understand the solvency fundamentals of MakerDAO, we want to emphasize slide 11, which analyzes the composition of equity as numerator of the solvency ratio, calibrates the risk weights for the volume of MakerDAO’s assets, and finally, shows the aforementioned leverage and solvency ratios.

We will now go through these concepts:

Equity: defined as Surplus Buffer + Operating Wallets. As opposed to the traditional conceptualization of equity as net worth, i.e., contributions from shareholders with no obligation to repay, the numerator of the solvency ratio is leveraged on the Surplus Buffer and Operating Wallets, which should respond to the notion of resources or contributions from the protocol via MKR holders to finance the assets of the same. In our opinion, MakerDAO’s equity is constituted by the volume of DAI accumulated to proceed to the acquisition of MKR via auction, which in turn are disposed of to obtain resources, as well as by all those MKR tokens already accumulated in the wallets. Although this idea of equity is structured on the basis of the concepts of contribution of shareholders or governors of the protocol, it will be the regulation that will finally determine which are the requirements and characteristics demanded to any financial instrument to be counted as own resources in the solvency calculation framework. However, for illustrative purposes, they are defined below:

The Surplus Buffer is the volume of DAI accumulated in the protocol from the Stability Fee income before the MKR auctions are activated. It is a variable volume, as the maximum accumulation of the Surplus Buffer determines the acquisition of MKR by the protocol for its subsequent amortization (generating an income from such sale for the protocol), stabilizing the money supply of the governance token, and reducing the Surplus Buffer for its new accumulation.

Operating Wallets include all those active wallets that hold MKR tokens, as they are resources directly contributed to the protocol, and that assume the potential absorption of losses derived from the fall in the value of the token.

Risk Weights: MakerDAO’s assets, as derived from the collateralization systems, are the collateralized loans granted based on the collateralized lending business line of the CDPs. Such loans are weighted at 100% of the book value, considering that such book value already captures the unexpected loss, and only Ethereum — B and Ethereum — C are weighted differently. In particular, Ethereum — B are considered to be weighted at 200% (CDPs of maximum 15M DAI, with SF = 4% and Liquidation Rate = 130%) and Ethereum — C are weighted at 50% (CDPs of maximum 2M DAI, with SF = 3.5% and Liquidation Rate = 175%).

However, and considering the approach taken by the banking solvency framework, the weightings do not take into account the collateral included in each of the loans, which are defined under the Credit Risk Mitigation Technique or CRMT. Under the CRMT framework, any asset that has an associated collateral, must reduce the value of the asset’s exposure or EAD (Exposure At Default) by the value of that collateral, which is also adjusted for volatility, exchange rate and maturity. In the case of the MakerDAO protocol, as these are overcollateralized loans, in which the value of the collateral is always higher than the value of the loan, the application of the CRMT framework would mean that the risk of the operation is 0, as the collateral covers the potential loss derived from the borrower’s default on the loan.

Therefore, and without assessing the value of other assets forming part of MakerDAO’s balance sheet beyond the collateralized loans, MakerDAO’s Risk Weighted Assets should be equal to 0, and therefore maintain very high solvency or CET1 ratios. In contrast, the application of the leverage ratio, which is a ratio that in not based on risk, takes the book value of assets as the denominator. Consequently, it should be analyzed as the MakerDAO standard metric, since the book value of loans is not affected by the existence of collateral, which is recorded in the entity’s financial statements in memorandum accounts.