MakerDAO is a financial application (Dapp) that runs on top of the Ethereum blockchain. Maker, as it’s often called, is the first DeFi application and to this day Maker remains the largest DeFi protocol on Ethereum.
Maker is important because it mints the decentralized stablecoin DAI, a token that’s widely used throughout the DeFi ecosystem. Before we explain how DAI is created, first we have to look at the two types of stablecoins that exist today.
Types of Stablecoins
Broadly speaking there are two types of stablecoins that run on top of Ethereum.
A company like Circle or Paxos issues a centralized stablecoin. These stablecoins have value because they are backed up by dollars in a bank account. At any time a stablecoin holder can redeem their stablecoin for dollars.
Tether (USDT) is the most popular centralized stablecoin, followed by USDC.
Rather than dollars in a bank account, decentralized stablecoins are backed up by cryptocurrency collateral. I.e. users lock up Ether in MakerDAO and the value of DAI is supported by the value of Ether.
DAI is the most popular decentralized stablecoin, followed by SUSD.
How MakerDAO Works
MakerDAO is actually relatively simple to understand. Here’s how the protocol works.
- A trader deposits collateral with MakerDAO. Maker accepts many types of collateral, including coins like WBTC and BAT. However, for this article we’ll focus exclusively on ETH, since Ethereum is the most popular form of collateral in Maker.
- Once the collateral has been deposited in Maker, the trader can generate a certain amount of DAI. The more collateral a trader deposits, the more DAI they can mint.
When locking Ethereum, there is a minimum collateralization ratio of 150%. This means that for every $1 of DAI created, there must be at least $1.50 of collateral (ETH) backing it. However, most traders keep a 300 to 400% collateralization ratio, given how volatile cryptocurrency prices are. If the collateralization ratio drops below 150% the trader’s collateral will be liquidated to pay off their loan.
- The DAI loan accrues interest the entire time it’s active. To close out the loan, the trader must deposit DAI with MakerDAO. There is no limit on the duration of loans.
Drawing an analogy to the real world, a collateralized Maker DAI loan is similar to a mortgage or car loan. In both of these cases, the collateral (house / car) backs up the loan. In the event of nonpayment, the bank can seize the collateral.
- MakerDAO is a financial protocol that lets traders lock up ETH (and other assets) in order to generate the stablecoin DAI
- DAI has value because it’s backed by the collateral that traders deposit with Maker. If a loan falls below the minimum 150% collateralization ratio the loan will be liquidated
Why MakerDAO is Awesome
Even though MakerDAO mints DAI, it cannot control what anyone does with the token. This is different from how centralized stablecoins operate. We’ve seen examples of Tether and USDC freezing accounts, blocking transactions, etc. These centralized companies have control over how their stablecoins are used.
Unlike USDC, DAI transactions cannot be censored or stopped. Anyone in the world can initiate a MakerDAO loan and print new DAI. There’s no KYC or geographical restrictions that block users from certain countries.
Furthermore, taking out a loan on MakerDAO is currently quite cheap compared to other forms of leverage. As of publication, the interest rate on a Maker loan is just 0.5%, well below what traders would pay on a centralized platform.
The MKR Token
The MKR token plays two key roles in the MakerDAO protocol.
Governance - MKR token holders can vote on governance changes to MakerDAO. For example, token holders can vote to change the savings rate or to raise the debt ceiling on MakerDAO.
Backer of last resort - As we’ve mentioned, DAI has value because of the collateral backing each loan. In the event that this collateral cannot be liquidated to pay off a loan, or the collateral is not worth enough to pay off the loan, MakerDAO will mint MKR and sell it on the open market. The proceeds from that sale can be used to pay off the DAI loan.
Why would anyone hold the MKR token?
Traders who take out a MakerDAO loan have to pay interest. Those interest payments are collected by MakerDAO and are used to buy MKR. These MKR coins are then “destroyed,” thus reducing the supply of tokens. The result is a steady demand for MKR and a gradual reduction in supply.
The benefit for token holders is that as interest payments are used to buy and destroy MKR, the price of the token should rise. That’s especially the case as more traders take out MakerDAO loans. The risk is that in the event of an insolvency event, MKR will be printed and sold on the open market. That will introduce selling pressure and the price of MKR will likely fall.
What’s Wrong with MakerDAO?
MakerDAO is a revolutionary product, the backbone of a new decentralized financial system. That being said, Maker is relatively young and there are plenty of bugs to work out still. For example...
The DAI peg is not always steady at $1. Sometimes the peg is broken in a fairly significant way, as happened in September of 2020 when DAI was selling for $1.04. Other times there is a minor discrepancy in the peg. For example, sometimes DAI trades for $0.995 or $1.005. That might not sound like a problem, but for traders moving millions of dollars even a small deviation from the $1 peg can add up.
The reason the peg deviates is a mismatch between supply and demand. The problem with DAI is that it’s not very flexible as compared to other stablecoins. For example, if there is a lot of demand for USDC it’s easy for someone to deposit dollars and mint more USDC.
Generating DAI is more complex. There is protocol risk and the risk associated with the volatile price of the ETH collateralizing the loans.
Being a relatively new software protocol, there’s always the chance that something goes wrong with Maker. We saw a painful example of this in March of 2020, when Ether’s value fell by approximately 50% in one day.
That price collapse in ETH caused hundreds of loans to fall below the 150% collateralization rate. Normally when this happens the loans would be liquidated and traders would get back approximately 80% of their collateral. However, a bug in the protocol allowed someone to claim this collateral, such that everyone who had their loan liquidated lost 100% of their collateral instead of just 20%.
Black swan events like this are the primary risk associated with MakerDAO. The Maker team have responded to this issue though, by implementing an improved liquidation mechanism and a number of stable coins as accepted collateral in maker vaults, making it easier for users to increase their collateralization rate in a volatile market. It has also introduced ‘multi-collateral DAI’, which allows users to deposit a host of other Ethereum-based assets, such as Basic Attention Token, Kyber Network and 0x, at a collateralization rate of 175%.
The Future of MakerDAO
MakerDAO is an exciting project, and one that has grown rapidly in the last year. For MakerDAO to gain global adoptance what we really need is time. We need more code audits and a longer track record in order to show that the platform is as secure as it needs to be.
If MakerDAO can prove that it’s secure there is a tremendous potential upside. It’s not a stretch to imagine the day where there is $100 billion locked up in MakerDAO.
A decentralized lending platform is a tremendous technological achievement and MakerDAO is at the forefront of offering decentralized financial services to people all over the world.
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.