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What is MakerDAO (MKR) and DAI stablecoin?

1 year ago

What is MakerDAO?

MakerDAO is an Ethereum-based smart contract platform that allows you to issue Dai stablecoin against cryptocurrencies and real assets. The name of the platform comes from the term market maker.
MakerDAO ranks first among the DeFi protocols in the Ethereum ecosystem in terms of the amount of liquidity locked up. Dai is one of the top five stablecoins.
The project works and develops on a completely decentralized basis with the help of DAO. Maker (MKR) acts as the governance token of MakerDAO.

Who created MakerDAO?

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

In 2014, Christensen founded and led 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 building a decentralized platform that would allow users to borrow cryptocurrency-backed stablecoins.

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

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

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

How the Dai stablecoin works and how it is backed?

The developers of MakerDAO managed to create a unique stablecoin called Dai. Unlike centralized projects, it is entirely built on Ethereum smart contracts.

Dai stablecoins are issued by protocol users themselves. To do this, they must block a certain amount of cryptocurrency as collateral in a special smart contract called Vault. In return, they receive a certain amount of Dai in a certain ratio to the locked cryptocurrencies.

Due to the volatility of cryptocurrency prices, MakerDAO operates the principle of overcollateralization, that is, the amount of collateral must be higher than the issued Dai stablecoins.

In the first version of MakerDAO, only ETH could be deposited as collateral, and the collateral rate was 150%. This means that $100 worth of Dai could be issued against $150 worth of Ether coins.

In November 2019, the project community decided to switch to a multi-collateral system, that is, to allow users to use different cryptocurrencies for collateral. Currently, the following assets can be pledged in MakerDAO (data from Daistats):

CryptoCollateral rate (liquidation threshold)

In addition, the tokens of some pools (LP) in Uniswap and Curve can also act as collateral. Also in July 2022, MakerDAO became the first DeFi protocol to accept shares of public companies as collateral.

According to Daistats at the end of September 2022, about 40% of all collateral in MakerDAO is denominated in USDC. Next in popularity is ETH. The total amount of pledges is more than $8.67 billion. In terms of blocked liquidity, MakerDAO ranks first among all projects in the Ethereum ecosystem.

What is collateral liquidation in MakerDAO and why is it needed

Liquidation is the process of selling collateral to cover the funds in DAI that users generate from their Vaults. The Liquidation Price is the price at which the Vault is liquidated. Users can lower the liquidation price by posting additional collateral or returning DAI to the Vault.

System viability is supported by Vault liquidations when the value of collateral for debt positions falls below the Liquidation Ratio.

The liquidation ratio is the minimum collateral level for each type of Vault. In fact, this is the rate of collateral, which differs depending on the cryptocurrency used in collateral. If it is not reached, the user’s Vault is considered unsecured and subject to liquidation.

The Maker Protocol oracles provide a system with price data used to track Vaults’ liquidation rate mismatch. The latter is set based on the risk profile of the collateral and the stabilization fee.

If the value of the collateral falls below the required collateral rate, it will be liquidated to cover the generated DAI. In addition, a so-called liquidation fine is imposed.

DAI tokens are effectively collateralized debt to MakerDAO. The collateral always exceeds the amount of the loan.

If the value of the collateral falls below a certain borrowing value, an auction is initiated in which network members, known as liquidators, buy the collateral for DAI. After that, the system burns the received stablecoins, reducing the emission. This mechanism is designed to provide a peg to the dollar.

Getting passive income from Dai deposits

In addition to Vault, MakerDAO also runs a smart contract called the DAI Savings Rate (DSR), which is a variable rate of accruals from DAI tokens locked in a DSR smart contract.

Vaults users receive rewards automatically while maintaining control over tokens. The DSR smart contract has no limit on withdrawal and deposit of funds and no liquidity restrictions. The rate is set and adjusted by holders of MKR tokens through the on-chain management system.

DSR is a global parameter that can go up or down, affecting the demand for DAI. An increase in DSR motivates users to hold more DAI, a decrease leads to a drop in demand for tokens.

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

Dai stabilization mechanisms

MakerDAO has a special Stability Fee that is continuously charged to DAI holders using Vaults. A portion of the funds raised will be used to support the operation of the Maker Protocol, including covering the costs of running the DSR, Risk Teams, and other mechanisms.

The stabilization fee for Vaults of all types is subject to a vote by the MKR holders who govern the protocol. The decisions they make are based on Risk Teams recommendations that evaluate the risk of the software used in the system. Risk Teams may update their proposed stabilization fees when the underlying asset or the entire system changes in a fundamental way.

Stability Fees are accumulated in the internal balance of the Maker Protocol. Once the maximum liquidation balance is reached, the system automatically sends DAI to the residual auction (Surplus Auction). During the auction, Keepers bid higher in MKR for DAI. The winner of the auction receives stablecoins, and the MKR paid to them is burned.

As stated in the project whitepaper, the DAI target value on the Maker platform has two main functions:

  • Calculation of the ratio of collateral to debt Vault;
  • Determining the value of collateral assets in a global settlement situation.

In case of severe market volatility, the Target Rate Feedback Mechanism (TRFM) may be activated in future versions of the platform. It changes the target rate, motivating market participants to maintain the DAI rate at the target value level.

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

With TRFM, the target rate rises if the DAI market price falls below a certain mark. Against the backdrop of rising prices, the generation of a stablecoin becomes more expensive. It also increases the attractiveness of holding DAI, driving demand for the coin. The combination of decreased supply and increased demand causes the stablecoin’s market price to rise towards its target.

Conversely, if the DAI market price exceeds the target price, the target rate decreases, leading to an increase in

the effectiveness of generation and a decrease in the demand for holding a stablecoin. As a result, the DAI market price decreases towards the target price.

Ways to Use Dai

Maker representatives give an example of four areas that can benefit from the use of the DAI stablecoin:

  • gambling markets. It makes no sense to make long-term bets using cryptocurrencies subject to volatility. This carries not only the risk of reducing the size of the rate, but also lowering the prices of underlying assets. Using an asset that is stable in price allows you to limit the risk to the usual probability of losing.
  • Financial markets. Price stable collateral is well suited for smart contract derivatives.
  • International trade. The cost of cross-border payments can be quite high. By eliminating intermediaries, DAI reduces costs to an adequate level.
  • Transparent accounting systems. Through verifiable transactions, DAI enables organizations to improve operational efficiency and reduce the potential for abuse.

Maker Cryptocurrency (MKR) and MakerDAO Management System

In addition to the DAI stablecoin, the platform uses Maker (MKR), a native MakerDAO ERC-20 token.

The Maker Foundation first released MKR back in 2017. They were distributed among the first users and sold out during three rounds of closed sales for a total of $64.5 million.

MKR acts as a “fuel” to pay off fees for using the system’s smart contracts. After paying the commission, MKR tokens are burned.

MKRs are destroyed when the liquidation balance of the MakerDAO system exceeds the minimum threshold. Excess DAI is auctioned off for MKR tokens, which are then burned. Conversely, when the Maker Protocol is in deficit and the system debt exceeds the maximum threshold, MKR tokens are created and auctioned off to recapitalize the system.

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

In addition, MKR performs a governance function – the token is used in voting for risk management mechanisms and platform business logic. The proposal that receives the most votes automatically receives the status of “important”, thereby influencing the further development of the entire project.

MKR holders vote on four key Vault risk dimensions to ensure the stability of the Maker system:

  • Debt ceiling – the maximum amount of debt that can be created by one type of Vault;
  • Liquidation Ratio – The ratio of collateral to debt at which Vault becomes vulnerable to liquidation;
  • Stability Fee – An additional fee calculated as an annual interest rate on top of the Vault principal;
  • The penalty rate is a measure of the maximum amount of DAI that can be charged in the event of debt liquidation.

Thus, MKR holders are the highest authority in MakerDAO. They manage the system and participate in the distribution of profits, but are forced to bear losses if the decisions made are unsuccessful.

What are the risks associated with MakerDAO

The creators of MakerDAO describe the platform’s biggest risk factors and offer a list of actions to mitigate them.

  • Malicious hacker attack. If there is any vulnerability in smart contracts, an attacker can try to steal collateral from the Maker platform.
  • Competition. The decentralized DAI stablecoin system is quite complex, so users may prefer simpler centralized stablecoin systems.
  • Market irrationality. Extended periods of market irrationality can cause users to lose confidence in the stability and liquidity of the system. To solve this problem, it is necessary to attract a large pool of capital. This will improve the rationality and efficiency of markets.
  • regulatory risks. According to representatives of the US Securities and Exchange Commission (SEC), some stablecoins may be subject to securities laws. According to the SEC classification, one stablecoin can be pegged to real assets like gold or real estate, another to fiat currency, and the third can use various “financial mechanisms that maintain price stability.” The third category, which includes DAI, may become the object of close scrutiny by the regulator.

How MakerDAO is evolving

MakerDAO was one of the first successful decentralized finance projects.

By March 2020, the process of transferring control of the project into the hands of the community was completed: the Maker Foundation transferred all control MKR tokens to users, and MKR holders got the opportunity to vote on the issue and destruction of tokens, as well as on future changes in the set of rights to this contract.

In the second half of 2020, the activity of the crypto market and DeFi increased significantly, as a result, the capitalization of Dai increased by more than 20 times. MakerDAO became the first DeFi protocol with a total value of funds locked (TVL) of $1 billion.

The MakerDAO protocol has also been used in traditional finance. In April 2021, real estate recovery investment company New Silver opened a $5 million line of credit to issue Dai.

In the summer of 2021, Rune Christensen, the creator of MakerDAO, announced the end of the decentralization process for the protocol. As a result, the developers closed the Maker Foundation and transferred the right to make all decisions to the DAO.

In the spring of 2022, the MakerDAO community decided to implement the Ethereum layer 2 protocol called StarkNet, which made it possible to reduce fees for operations with smart contracts and increase the speed of the protocol.

In the summer of 2022, several big shocks occurred in the cryptocurrency market at once. One of them was the bankruptcy of the centralized lending platform Celsius Network.

To solve financial problems, she tried to take out a $100 million Dai loan secured by stETH. As a result, MakerDAO removed the Aave protocol from its system, which provided such a service. In addition, Celsius Network was a major Dai holder. As a result, the platform redeemed the stablecoins and withdrew the collateral from MakerDAO.

The project community reacted to the crisis by moving $500 million in reserves into US government and corporate bonds.

Proposal to depeg Dai to the US dollar

In July 2022, the US authorities imposed sanctions on the Ethereum mixer Tornado Cash and froze the assets of its users for several hundred million dollars. The American company Circle, which issues the USDC stablecoin, also obeyed the decision of the authorities – these coins were blocked on Tornado Cash accounts.

In response, Rune Christensen, founder of MakerDAO, made a radical proposal to the community: make the DAI stablecoin a free-floating, decoupled from the US dollar, as well as stop accepting USDC, which serves as the most popular collateral in the protocol. In his opinion, in this way the project could avoid regulatory risks.

Christensen’s proposal was critically acclaimed. In particular, Ethereum founder Vitalik Buterin called it a “terrible idea.” Community members were also skeptical about the proposal – they call it radical, utopian and extremely risky, pointing to the possibility of the collapse of the Dai stablecoin.

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