What are MakerDAO (MKR) and the DAI stablecoin?

28.09.2022

Beginner

#DeFi #Lending #MakerDAO

What is MakerDAO?

MakerDAO is an Ethereum-based smart-contract platform that allows the issuance of the Dai stablecoin against cryptocurrency and real-world assets as collateral. The platform’s name derives from the term market maker.
Within Ethereum’s DeFi ecosystem, MakerDAO ranks first by total value locked. Dai is among the five largest stablecoins.
The project is run and developed on a fully decentralised basis via a DAO. Maker (MKR) serves as the governance token of MakerDAO.

Who created MakerDAO

The creator of MakerDAO is the Dane Rune Christensen. He studied biochemistry and international trade before co-founding the international recruiting company Try China.

In 2014 Christensen founded and headed the Maker Foundation, headquartered in Santa Cruz, California.

In March 2015 Christensen, former Amazon software engineer Andy Milenius and a number of other developers began work on a decentralised platform that would allow users to borrow stablecoins secured by cryptocurrency.

On March 26, 2015, Christensen published an article in which he introduced the concept of eDollar — a stablecoin on the Ethereum blockchain.

Christensen proposed incentivising market makers, later called Keepers, by rewarding them with Maker (MKR) utility tokens for providing liquidity.

The first version of MakerDAO launched in December 2017. The central element of the protocol then was Single Collateral Dai (SCD, mono-collateral Dai), launched in December 2017. The only asset used as collateral for loans was Ether (ETH).

How the Dai stablecoin works and what backs it

MakerDAO’s developers created a distinctive stablecoin, called Dai. Unlike centralised projects, it is built entirely on Ethereum smart contracts.

Dai is issued by the protocol’s users themselves. To do so, they must lock a certain amount of cryptocurrency as collateral in a special smart contract called a Vault. In return, they receive a certain amount of Dai at a set ratio to the locked collateral.

Because crypto prices are volatile, MakerDAO applies the principle of overcollateralisation: the value of the collateral must be higher than the amount of Dai issued.

In the first version of MakerDAO only ETH could be posted as collateral, and the collateralisation ratio was 150%. That is, with $150 worth of ether as collateral, users could mint $100 worth of Dai.

In November 2019 the community decided to move to a multi-collateral system — allowing users to post different cryptocurrencies. Today MakerDAO accepts the following assets (data from Daistats):

Cryptocurrency	Collateralisation ratio (liquidation threshold)
ETH	130-170%
USDC	101%
WBTC	130-175%
MANA	175%
USDP	101%
LINK	165%
YFI	165%
GUSD	101%
renBTC	165%
MATIC	175%

In addition, tokens from certain liquidity pools (LP) on Uniswap and Curve can also serve as collateral. Also in July 2022 MakerDAO became the first DeFi protocol that began accepting shares of public companies as collateral.

According to Daistats at the end of September 2022, roughly 40% of all collateral in MakerDAO is denominated in USDC. ETH comes next by popularity. Total collateral exceeds $8.67bn. By total value locked, MakerDAO ranks first among all projects in the Ethereum ecosystem.

What collateral liquidation is in MakerDAO and why it is needed

Liquidation is the process of selling collateral to cover the DAI that users generate from their Vaults. The liquidation price is the price at which a Vault is liquidated. Users can lower the liquidation price by adding more collateral or repaying DAI into the Vault.

The system’s viability is maintained by liquidating Vaults when the value of their collateralised debt positions falls below the Liquidation Ratio.

The Liquidation Ratio is the minimum collateralisation level for each type of Vault. In effect, it is the collateralisation requirement, which differs depending on the cryptocurrency used as collateral. If it is not met, a user’s Vault is considered undercollateralised and becomes subject to liquidation.

Maker Protocol oracles provide price data used to track Vaults against the Liquidation Ratio. The latter is set based on the collateral’s risk profile and the Stability Fee.

If the value of collateral falls below the required level, it is liquidated to cover the DAI generated. A liquidation penalty is also applied.

DAI tokens effectively represent collateral-backed debt owed to MakerDAO. At the same time, collateral always exceeds the loan size.

If the value of collateral drops below a certain share of the debt, an auction begins in which network participants, known as liquidators, buy the collateral for DAI. The system then burns the stablecoins received, reducing issuance. This mechanism is designed to maintain the dollar peg.

Earning passive income from Dai deposits

Alongside Vaults, MakerDAO also runs a smart contract called the DAI Savings Rate (DSR) — a variable rate earned on DAI locked in the DSR smart contract.

Users of Vaults receive the accrual automatically while retaining control over their tokens. The DSR smart contract has no limits on deposits or withdrawals and no liquidity constraints. The rate is set and adjusted by MKR holders through the on-chain governance system.

The DSR is a global parameter that can be lowered or raised, influencing demand for DAI. Raising the DSR encourages users to hold more DAI; lowering it reduces demand.

These changes are reflected in the market price of DAI. If the stablecoin trades below one dollar, the DSR can be raised to increase demand for DAI and, accordingly, its price. If DAI trades above one dollar, the DSR can be lowered to decrease demand and reduce its price. As of the end of September 2022, the DSR is 0.01%.

Mechanisms stabilising Dai

MakerDAO levies a Stability Fee, which continually accrues to DAI users employing Vaults. Part of the funds collected supports the operation of the Maker Protocol, including covering the costs of the DSR, Risk Teams and other mechanisms.

The Stability Fee for all Vault types is changed based on votes by MKR holders who govern the protocol. Their decisions are based on recommendations from Risk Teams, which assess the risk of the collateral used in the system. Risk Teams may update the fees they propose when the underlying asset or the entire system changes in a fundamental way.

Stability Fees accumulate on the Maker Protocol’s internal balance. Once the maximum surplus level is reached, the system automatically sends DAI to a Surplus Auction. In the auction, Keepers bid a higher price in MKR for DAI. The winner receives the stablecoins, and the MKR paid is burned.

As stated in the project’s whitepaper, the target price of DAI on the Maker platform has two main functions:

Calculating a Vault’s collateral-to-debt ratio;
Determining the value of collateral assets during global settlement.

In the event of severe market instability, future versions of the platform may activate the Target Rate Feedback Mechanism (TRFM). It changes the target rate, incentivising market participants to keep DAI near the target price.

When TRFM is enabled, parameters change dynamically, balancing supply and demand for DAI. Gradually the mechanism moves the market price of the stablecoin towards the target price.

With TRFM, the target rate rises if DAI’s market price falls below a certain level. As the target rate rises, generating the stablecoin becomes more expensive. This also increases the appeal of holding DAI, supporting demand for the coin. The combination of reduced supply and increased demand pushes the market price up towards the target.

Conversely, if DAI’s market price exceeds the target, the target rate decreases, making generation more attractive and holding less so. As a result, DAI’s market price falls towards the target.

Use cases for Dai

Maker representatives cite four areas that could benefit from using the Dai stablecoin:

Betting markets. It makes little sense to place long-term bets in volatile cryptocurrencies. That entails not only the risk of a reduced stake but also a decline in the prices of the underlying assets. Using a price-stable asset limits risk to the simple probability of loss.
Financial markets. Price-stable collateral is well suited for derivatives built on smart contracts.
International trade. Cross-border payments can be expensive. By removing intermediaries, DAI helps cut costs to a reasonable level.
Transparent accounting systems. Thanks to verifiable transactions, DAI allows organisations to improve efficiency and reduces the likelihood of abuse.

The Maker (MKR) cryptocurrency and MakerDAO governance

Besides the Dai stablecoin, the platform uses Maker (MKR) — MakerDAO’s native ERC-20 token.

Maker Foundation first issued MKR in 2017. The tokens were distributed among early users and sold across three private rounds for a total of $64.5m.

MKR acts as the “fuel” for paying fees to use the system’s smart contracts. After fees are paid, MKR is burned.

MKR is destroyed when the MakerDAO system’s surplus exceeds the minimum threshold. Excess DAI is sold at auction for MKR, which is then burned. Conversely, when Maker Protocol has a deficit and system debt exceeds the maximum threshold, new MKR is created and sold at auction to recapitalise the system.

The primary responsibility of MKR holders is to ensure the stability of DAI and the health of the system as a whole.

In addition, MKR serves a governance function — the token is used in votes on risk controls and the platform’s business logic. The proposal with the most votes automatically receives an “important” status, thereby influencing the project’s further development.

MKR holders vote on four key Vault risk parameters to keep the Maker system stable:

Debt ceiling — the maximum debt that can be created by a single type of Vault;
Liquidation ratio — the collateral-to-debt ratio at which a Vault becomes vulnerable to liquidation;
Stability fee — an additional charge calculated as an annual rate on top of a Vault’s principal;
Penalty ratio — the maximum amount of DAI that can be levied in the event of debt liquidation.

Thus, MKR holders are the highest authority in MakerDAO. They govern the system and share in profits, but must bear losses if decisions turn out poorly.

What risks are associated with MakerDAO

The creators of MakerDAO describe the platform’s major risk factors and suggest steps to mitigate them.

Malicious hacking. If the smart contracts contain a vulnerability, an attacker could attempt to steal collateral from Maker.
Competition. The decentralised DAI Stablecoin system is fairly complex, so users may opt for simpler centralised stablecoin systems.
Market irrationality. Prolonged periods of market irrationality can erode users’ confidence in the system’s stability and liquidity. Solving this requires attracting a large capital pool to increase market rationality and efficiency.
Regulatory risks. In the view of the U.S. Securities and Exchange Commission (SEC), some stablecoins may fall under securities law. In the SEC’s classification, one stablecoin may be pegged to real assets such as gold or real estate, another to fiat currency, and a third may use various “financial mechanisms that maintain price stability.” The third category, which includes DAI, may attract close regulatory scrutiny.

How MakerDAO is developing

MakerDAO became one of the first successful projects in decentralised finance.

By March 2020 the process of transferring control to the community had been completed: Maker Foundation handed all MKR governance tokens to users, and MKR holders gained the ability to vote on minting and burning tokens as well as future changes to that contract’s rights.

In the second half of 2020 activity in crypto and DeFi surged, and Dai’s market capitalisation rose more than twentyfold. MakerDAO became the first DeFi protocol with $1bn in total value locked (TVL).

The MakerDAO protocol also found uses in traditional finance. In April 2021 New Silver, a company investing in property rehabilitation, opened a $5m credit line to issue Dai.

In the summer of 2021 MakerDAO creator Rune Christensen announced the completion of the protocol’s decentralisation. The developers closed the Maker Foundation and transferred all decision-making to the DAO.

In spring 2022 the MakerDAO community decided to implement Ethereum’s layer-2 protocol StarkNet, reducing fees for smart-contract operations and increasing protocol speed.

In the summer of 2022 the crypto market suffered several major shocks. One was the bankruptcy of the centralised Celsius Network lending platform.

To solve its financial problems, it tried to borrow $100m in Dai against stETH. As a result, MakerDAO disconnected the Aave protocol from its system, which had offered such a service. In addition, Celsius Network was a large Dai holder. Ultimately the platform repaid the stablecoins and withdrew its collateral from MakerDAO.

The project’s community responded to the crisis by moving $500m of reserves into U.S. government and corporate bonds.

A proposal to drop Dai’s peg to the U.S. dollar

In July 2022 U.S. authorities imposed sanctions on the Ethereum mixer Tornado Cash and froze users’ assets worth several hundred million dollars. The U.S. company Circle, which issues the USDC stablecoin, complied with the decision — those coins in Tornado Cash accounts were blocked.

In response, MakerDAO founder Rune Christensen brought a radical proposal to the community: make the DAI stablecoin freely floating, unpegged from the U.S. dollar, and stop accepting USDC, which serves as the most popular collateral in the protocol. In his view, this would help the project avoid regulatory risks.

Christensen’s proposal met with criticism. In particular, Ethereum founder Vitalik Buterin called it “a terrible idea.” Community members were likewise sceptical — they called it radical, utopian and extremely risky, pointing to the possibility of the Dai stablecoin’s collapse.