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Picking up where we left off in the last edition of Digital Dives, let’s continue our analysis of Maker’s 2022 year-end financial disclosure. However, this week, we’ll extend our discussion to contemplate the protocol’s experience relative to traditional businesses like banks and technology firms.
Last year was challenging for participants across the real-world and digital asset economies. The pain is evident in the respective token and equity price performance:
The authors of Maker’s annual report commented that profitability could have been enhanced had the governance module elected to increase risk tolerance and exercise better asset-liability management (ALM).
At a bank, the principal objective of the ALM function is to manage interest rate and liquidity hazard. This has been extremely topical lately. Maker’s balance sheet was sub-optimal because it carried excessive holdings of short-dated and liquid collateral to back its liabilities (DAI). Because they’re lower risk, such assets carry meager returns, resulting in a profitability headwind. In practice, many DAI holders own the tokens for long periods of time. Therefore, Maker could venture further out on the risk spectrum and boost Net Income while still having sufficient liquidity to satisfy redemptions due to credit, market, rate, or competitive forces.
Despite missing out on some additional earnings, the group continues to favor conservatism as they collect data for underwriting loan activity and DAI redemptions over the course of market cycles. This is sound risk management.
One of the most important developments in DeFi has been the representation of traditional assets on-chain. Expanding the types of collateral backing DAI to include real-world assets is another lever at Maker’s disposal to amplify returns in a risk-efficient manner. Higher interest rates in the real-world economy have been a momentous catalyst for driving change. Maker was busy diversifying last year and has continued at a frenetic pace.
Source: Dune Analytics (@SebVentures)
The Q4-2022 commentary out of bank executives made frequent mention of consumer spending which has been more resilient than expected. This is attributed to the excess savings built-up over the course of the pandemic. While large-ticket purchases have declined meaningfully, spending on dinners and travel remains robust.
Banks and their customers are adjusting their behaviour because prices are rising, and interest rates are meaningfully above zero for the first time in over a decade. The result is an environment with significant competition for deposits as savers seek out higher returns amid higher living costs and borrowing rates. Remember ALM? If a bank loses deposits in excess of its reserves, then it will be forced to dispose some of its asset book. However, this can result in losses, potentially impairing the institution’s capital and causing solvency issues. More here or in recent news. To retain cash, traditional banks have increased the rates in savings products, which reduces their profitability. In December 2022, the interest rate paid on DAI was boosted from 0.1% to 1.0%.
But wait, there’s more…
Fighting for deposits is a game that banks have played for countless cycles. They know that ancillary services (wealth management, mortgages, discount brokerage, etc.) create implicit switching costs, protecting the client relationship.
Subsequent to year-end, Maker competitor, Aave, announced their own DAI-like stablecoin, GHO. This development is meant to lure/preserve assets within the Aave ecosystem, generating additional revenues for the protocol. Interestingly, Maker recently unveiled plans for a new project called Spark Lend, which uses Aave’s codebase and will create a broader platform to attract/retain assets. It’s no coincidence that both protocols have adopted additional (and competitive) features. In fact, it’s a noticeable theme across DeFi.
Our digital asset economy is becoming progressively intertwined with traditional macro forces and bringing more real-world assets on-chain will intensify this trend. As the systems converge, it might be interesting to compare protocols to corporations. Let’s begin with the price-to-sales (P/S) of Maker against the S&P 500 Bank and Technology indices:
This is a massive divergence, which underscores how early we are in cryptoassets. Undeniably, there is substantial upside being priced-in today. For Maker to grow into the average Tech or Bank multiple, its revenue would have to increase between 9x – 43x. Using a 1% Return on Assets (ROA) and a 25% profit margin, implies a balance sheet of roughly $15B at the high-end, which would place the company just outside the Top 100 U.S. banks. That said, the protocol had nearly $20B of total value locked for a period during the last bull market.
Maker has noted that its balance sheet could be optimized for greater profitability. Compared to the S&P 500 Banks Index, it’s demonstrated a mixed Return on Assets (ROA) and a lower Net Interest Margin (NIM):
Finally, a common screening tool when conducting a quick assessment of different banks is to assess the amount being paid for $1 of book value (Price-to-Book, P/B) versus the return being generated on that book value (Return on Equity, ROE). This gives the analyst an idea of relative valuation in the context of each lender’s profitability:
Maker has a significant edge in ROE, but a 6x price-to-book is an outlier in traditional banking, implying considerable valuation risk.
Analyzing financials across companies involves both art and science. This gets complicated further when we extend the study to include decentralized financial protocols. Typically, relative analysis is only one of many approaches taken to evaluate a possible future investment. We’ve had a look at some metrics of the Maker protocol through the lens of a public market observer, but the examination is incomplete and somewhat flawed. None of this should be taken as financial advice. Mind you, the current valuation of Maker contemplates considerable future growth and ignores the fact that tokens do not represent equity.
When Benjamin Graham penned his seminal “Security Analysis” there was no internet or spreadsheet software. Back in those days, financial analysts were armed with the newspaper and perspicacity. U.S. Steel did publish the first ever annual report in 1903, but the SEC only began to require semi-annual reporting in 1955 and in 1970, they mandated quarterly reporting for all publicly traded companies under their purview. Today we have sensors and satellites recording more bytes of data than there are grains of sand on the earth. Subject matter experts use machine learning algorithms to uncover relationships within that information. The business of alternative data has grown to at least $1B.
We’ve seen that public blockchains provide for nearly real-time updates of a lender’s financial condition and the factors which affect large financial institutions have considerable overlap with digital asset lending platforms. We’re still a way off from being able to stream elements of a traditional bank’s financial performance like we can with blockchain lending protocols. However, as more real-world assets are brought on-chain, traditional bank investors might be able to gain important insights related to the equities in their portfolio. Executives, economists, and consultants also stand to benefit from expanding the scope of their work to include this robust and relevant new source of insight. Like the intrepid analyst who uses satellites to observe parking trends when forecasting sales for a retailer, tomorrow’s stock/token picker is likely to be an on-chain data sleuth.
