A true pioneer of the DeFi world, MakerDAO is an open-source, decentralized autonomous organization (DAO) founded in 2015 by Rune Christensen. The Maker Protocol launched on the Ethereum blockchain in 2017, and was one of the first DeFi projects to offer loans. MakerDAO is unique in that it brings together a DAO and a crypto-collateralized stablecoin, DAI.
MakerDAO is made up of several moving parts, which we’ll briefly outline first. MakerDAO is the decentralized community that oversees and governs the protocol. The Maker Protocol is a decentralized application (dApp) that runs on Ethereum, and supports smart contracts and the generation of DAI. The stablecoin DAI is a collateral-backed crypto, soft-pegged to the US Dollar. MKR is the protocol’s governance token, which allows token holders to vote on key issues. And lastly, the Maker Foundation is the organization created to bolster and guide the Maker protocol until governance could be fully handed over to the Maker community (very soon, actually).
While other crypto exchanges have established their own stablecoins, like Gemini’s GUSD and Coinbase’s USDC, DAI is notable in that it is decentralized and backed by Ethereum-based assets. Despite some price fluctuations in the past, DAI provides a reliable and liquid alternative to other cryptocurrencies. At the time of writing, MakerDAO has $6.8B in TVL and 3.1M ETH locked on its protocol, which is a little over 2% of the total ETH supply!
How Does DAI Work?
Let’s first look at DAI. DAI can be used as a store of value and a medium of exchange, with the added benefit of price stability. However, MakerDAO’s stablecoin has a few key characteristics that distinguishes it from other cryptos. DAI is a crypto-collateralized stablecoin that is also multi-collateral and overcollateralized. So, what does this all mean?
DAI is what we call a crypto-collateralized stablecoin. Stablecoins are crypto assets whose value is linked to an external asset, like a fiat currency or commodity. As a result, they maintain a certain degree of stability through the collateral used to back them. Crypto-collateralized stablecoins are not backed by dollars or gold, but rather by other cryptocurrencies. In DAI’s case, this was initially just ETH.
In November 2019, a new Multi-Collateral DAI token was launched, replacing the original Single-Collateral (SAI) version. After this important shift, DAI was able to support other Ethereum-based cryptocurrencies, besides ETH, as collateral.
However, crypto markets across the board can be considerably volatile. As a result, the speculative value of your $200 crypto collateral could drop to $100 in the span of a day - in which case your loan would either be liquidated, or you’d have to provide more collateral. In order to avoid this, MakerDAO uses a system of overcollateralization.
This relatively simple concept means that, in order to mint DAI, you must provide collateral worth more than your loan. In doing this, the integrity of the entire protocol remains intact and you can stave off liquidation on your loan.
Users can also provide more than the required amount, just to be safe. If the collateral does fall below a certain threshold, the loan is liquidated to repay the borrowed DAI; the risk of liquidation is meant to deter users from over-borrowing and dishonest behavior.
You can borrow or lend DAI on a number of different platforms, including the Maker Foundation’s own platform Oasis, or other lending platforms like AAVE and Compound. You can also buy DAI on Oasis and other platforms using either crypto or fiat currencies. These include popular exchanges like Coinbase or Binance, as well as DEXs like Uniswap and 1inch. There are benefits and drawbacks to each.
We’ve seen how users can generate DAI by providing enough collateral in exchange for a loan. But how is this managed by the protocol? As a decentralized lending protocol, Maker relies on smart contracts in order to execute loans. These are called Maker Vaults, but are more commonly known as collateralized debt positions (CDP).
Remember, smart contracts are automated and execute only if the required conditions are met. This means that Vaults are non-custodial, and allow users to retain control over their collateral. Users can access the protocol and open a Vault using the Oasis Borrow portal. After selecting a collateral type and setting up the Vault, the owner can then choose how much collateral to lock up and how much DAI to generate.
Risk and Liquidation
It is important that users monitor and manage their Vaults, and understand the various risk parameters set by the protocol. Some important ones to take note of are the Stability Fee, Liquidation Ratio and Liquidation Penalty. The Stability Fee is a fee users must pay once the debt is paid down or paid in full - it is essentially an APY calculated on top of the Vault debt.
The Liquidation Ratio refers to the minimum ratio of collateral to debt before the loan is considered undercollateralized. If a Vault’s collateral-to-debt ratio reaches this point, it can be liquidated to protect the protocol. The Liquidation Penalty is the fee paid by users if their collateral reaches the Vault’s Liquidation Price (the price at which the Vault risks liquidation).
The Maker Protocol uses several different auction mechanisms when liquidating undercollateralized Vaults. There are three types of auctions: a Surplus Auction, Collateral Auction, and Debt Auction.
As its name suggests, a Surplus Auction takes place when there is a surplus of DAI in the Maker Buffer - a pool that holds DAI accrued from auctions and stability fees. When this reaches a certain level, the surplus DAI is auctioned to Keepers (bidders), in exchange for MKR. Once the auction ends, the protocol burns the collected MKR and reduces the total MKR in circulation.
A Collateral Auction takes place when the collateral in a liquidated Vault is not enough to cover the debt. The winning keeper pays the needed DAI in exchange for the collateral, and the outstanding debt is settled.
Finally, a Debt Auction refers to a last resort situation where the debt cannot be paid in full by a collateral auction, or covered by surplus DAI in the Maker Buffer. The protocol will then generate MKR and sell it to keepers for DAI, which introduces more MKR into the system.
MKR is another ERC-20 token (like DAI), native to the Maker protocol and a key player in its ecosystem. We’ve already covered how MKR is used as a recapitalization tool, thanks to its pivotal role in the protocol’s auction mechanisms. Yet it also has another integral function within the Maker community as a governance token.
The MKR token gives MKR holders the ability to vote on key proposals (though anyone can submit a proposal for a vote). This can range from adjusting risk parameters like the stability fee or liquidation penalty, to electing individuals for specific roles and adding new assets as collateral. MKR token holders can also choose where to allocate DAI from the Maker Buffer, and even when to activate emergency shutdowns.
Historically, the Maker Foundation has had a major influence on decisions within its ecosystem, but that is about to change. In a major step towards realizing the Maker mission statement, the Maker Foundation is set to dissolve, most likely by the end of 2021. The shutdown will usher in the final phase of Maker governance evolution, and will represent the single biggest exemplar of decentralized governance within the DeFi ecosystem.
MakerDAO is a pillar of the DeFi world, and has set a noteworthy example in the space as a project truly committed to decentralization. Despite some recent instances of price volatility (such as increased interest in yield farming driving up DAI’s price), DAI will continue to play a significant role in the DeFi ecosystem.