What Is MakerDAO (DAI)?

08/04/2022 By Author

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TL;DR

MakerDAO is a Decentralized Finance (DeFi) project with a crypto-collateralized, stablecoin DAI pegged to the US dollar. Its community manages the coin via a Decentralized Autonomous Organization (DAO). Users generate DAI by locking cryptocurrency in a Maker Vault at a certain Liquidation Ratio. For example, a 125% Liquidation Ratio requires $1.25 of crypto collateral value for each $1 of DAI.

The stablecoin is overcollateralized to account for crypto’s volatile prices, and a Stability Fee is also charged. Your crypto is liquidated and used to recover any losses if your collateral drops below the Liquidation Ratio.

DAI remains stable as its DAO controls the Stability Fee and Dai Savings Rate. The Stability Fee affects DAI’s supply by changing the cost of minting DAI. The DAI Savings Rate affects the coin’s demand, changing investors’ returns on staking DAI. When DAI moves from its peg, the DAO uses these two mechanisms to bring it back.

DAI has similar benefits as other stablecoins and crypto assets. It can be easily transferred worldwide, used to make payments, or lock in profits and losses. You can also use DAI as leverage and invest it in the DAI Savings Rate contract for interest.

To participate in Governance Polls and Executive Votes, users purchase MKR tokens that provide them voting power. These are used to alter the Stability Fee, DAI Savings Fee, team, smart contracts, and other topics.

Stablecoins are hugely popular cryptocurrencies that offer a middle ground between traditional finance and digital assets. As they mimic fiat currency while operating like cryptocurrencies, these blockchain-based tokens are attractive for “locking in” profits or losses.

To date, the largest market cap stablecoins have been fiat-backed. These operate by keeping a supply of reserves that back up the stablecoin. However, crypto-backed stablecoins are also popular. In this article, we’ll examine one of the most famous examples, MakerDAO, and exactly how it maintains a $1 peg with volatile collateral.

MakerDAO is an Ethereum (ETH) project launched in December 2017 by Rune Christensen. It focuses on creating DAI, a crypto-collateralized stablecoin pegged to the US dollar. Rather than be run by a group of developers or a single entity, the MakerDAO ecosystem uses the governance token MKR for project proposals and decisions. This governance model is known as a DAO (decentralized autonomous organization).

Users access MakerDAO via the Oasis DApp. Here they can create collateral loans, take part in governance, and manage their existing Maker Vaults. These interactions rely on smart contracts and game theory, allowing DAI to maintain a relatively stable value. DAI can be used identically to fiat-backed stablecoins and provide the same benefits.

DAI is MakerDAO’s stablecoin tied to the US dollar and is among the largest stablecoins and cryptocurrencies by market capitalization. The ERC-20 token has an unlimited supply so long as users keep supplying collateral to generate more DAI.

MakerDAO uses crypto-collateralization to maintain its peg rather than a vault of fiat reserves. It might be a bit puzzling how crypto, known for its volatility, can provide the backing for a stablecoin. Simply put, the crypto a user deposits to create DAI has a much higher value than the stablecoin they receive. This allows extra room for downwards price movements in the crypto collateral.

Just like any other stablecoin, DAI has several benefits when used:

1. It’s more suitable for expenditures that require stability. Retailers and individuals don’t always want payment in cryptocurrencies that can change value overnight.

2. DAI benefits from all the advantages of the blockchain. Stablecoins are transferable worldwide without a bank account. They are also incredibly secure if stored correctly.

3. You can use it to lock in profits or losses and hedge risk. DAI will offset some of your portfolio’s overall risk and is a helpful way to enter or exit positions without going off-chain.

Collateral is a common concept in traditional finance you’ll likely have come across before. When taking out a loan, you’ll need to provide something of value as collateral. This is used to cover the loan if you cannot repay it.

Physical and fiat collateral

A pawnshop is a good example. You can hand over jewelry (collateral) in exchange for a cash loan. You can then either pay the loan back plus a fee to return your collateral or allow the pawnshop to keep the collateral and recoup their loss. Collateral acts as a safety net, and the same concept applies to mortgages and car finance. In these cases, the goods (property or car) act as collateral.

Fiat-backed stablecoins like BUSD are collateralized with fiat currency. A user hands over their cash (the collateral) and receives tokens in return. They can return those tokens to the issuer if they want, but the issuer still has the money if they don’t. This mechanism allows for arbitrage that keeps the stablecoin pegged. You can read more about this in our What Is a Stablecoin?.

Crypto collateral

Crypto-collateralized stablecoin like DAI accept crypto as collateral rather than fiat. A smart contract with rules manages these funds: issue X amount of stablecoin tokens for Y amount of ETH deposited. Return Z amount of ETH when the X amount of stablecoin is given back. The exact amount of collateral needed is up to the project issuing the token. This ratio will depend mainly on the collateral asset’s volatility and risk.

Stable and relatively low-risk assets like fiat, precious metals, and property are the usual favorites for collateral. As we mentioned, using crypto as collateral is riskier for lenders as its price can change wildly. Imagine a project that asks for $400 of ETH in collateral for 400 tokens pegged to USD.

If the price of ETH drops suddenly, the lender’s collateral won’t cover the loan they’ve given out. The answer here is to overcollateralize: the lender instead asks for $600 of ETH when loaning out 400 tokens of their USD stablecoin.

MakerDAO has used overcollateralization to maintain a reasonably reliable peg for years. As smart contracts control the DAI generation process, it works efficiently and without human interference. When you want to borrow DAI stablecoin, you lock up crypto in a CDP smart contract. This CDP will set a Liquidation Ratio, for example, 1.5x, meaning you’d need to provide $150 of ETH for $100 of DAI. A user can add more if they want and reduce their risk. If the collateral amount falls below 150% (1.5x), they’ll incur a penalty fee. Eventually, the user risks liquidation if they fail to repay their DAI with the added interest rate (the Stability Fee).

Maker Vaults are where users put up their collateral and generate DAI. These allow you to use multiple, different cryptocurrencies as collateral simultaneously. The Maker Vault also burns DAI once a user returns it. The process is as follows:

1. You deposit supported cryptocurrencies to the Maker Protocol.

2. The deposit opens a Maker Vault position.

3. You can withdraw Dai determined by your collateral amount. You will also need to pay the Stability Fee.

4. To get your crypto collateral back, repay the withdrawn DAI.

You’re free to generate or return Dai and add or withdraw your collateral at any time. You must, however, maintain the Liquidation Ratio shown in the Vault. If you drop below this ratio, the Vault will liquidate your collateral.

Apart from reducing the risk for MakerDAO as lenders, the CDP mechanism helps peg DAI to USD. MakerDAO can also vote to alter the Stability Fee and DAI Savings Rate (interest paid to stakers in the DAI Savings Rate smart contract) to manipulate supply and demand for DAI. These three tools work together to maintain DAI’s $1 peg. Let’s see exactly how it happens:

1. When DAI dips below the peg, the system makes it attractive for users to repay their debts, retrieve their collateral, and burn their DAI. This can be achieved by raising the Stability Fee, which makes borrowing more expensive. The DAO could also increase the DAI Savings Rate, increasing demand for investment in the token.

2. When DAI is above its peg, the opposite occurs. The DAO creates incentives to generate DAI if the Stability Fee is lowered. This creates new DAI and increases the total supply, lowering the price. MakerDAO could also decrease DAI’s demand by reducing the DAI Savings Rate, meaning investors look elsewhere to earn interest.

As mentioned, DAI is used like any other stablecoin and shares the same benefits. You don’t even need to generate it yourself and can purchase DAI on the crypto market, like with Binance. DAI also has a couple of unique use cases:

1. Leverage – Imagine you have $1000 of ETH, and you think the price will rise. However, you currently have no extra funds to buy ETH. You can use your ETH as collateral, generate DAI, and then use that to buy more ETH. If the price of ETH rises and you want to cash out, you can sell some of it for DAI tokens and retrieve your collateral.

2. The DAI Savings Rate – You can earn interest by depositing DAI into the DAI Savings Rate smart contract. This rate varies as the DAO tries to control DAI’s price.

Choose the fiat currency you want to pay in the top field and select DAI at the bottom. You’ll then see clear instructions on adding your card to your account. If you wish, you can also use the exchange view to swap DAI for another cryptocurrency.

To have a say and vote in MakerDAO, you’ll need to hold the project’s governance token MKR. The token has a maximum supply of 1,005,577 MKR, and roughly 40% was distributed to the team and early investors at deployment. The DAO held the rest for future sales.

MKR holders can vote to change the platform’s Stability Fee, DAI Savings Rate, Liquidation Ratio, and other aspects. Their vote is proportional to the amount of MKR they hold. You can head to MakerDAO’s governance portal to see and take part in current votes.

Governance Polls

A Governance Poll allows users to create non-technical proposals for other MKR holders to vote on. For example, this could be a change to governance, goals, team, or budgets. A Governance Poll uses the Instant Run-off mechanism, meaning you can rank your choice from multiple options.

Executive Votes

Executive Votes relate to technical smart contract changes. Proposals use a Continuous Approval Voting system, meaning that new, competing proposals can always be introduced. An Executive Vote will lead to hard changes in the smart contract code, such as adjusting fees or collateral levels. Executive Votes are needed to implement some of the changes voted on in Governance Polls.

As the dominant crypto-collateralized stablecoin, DAI has been a proven success. The system mitigates the volatility of crypto all without fiat collateralization, which is quite a feat. You also shouldn’t forget its importance in the history of DAOs. It’s one of the longest-running and largest DAOs that paved the way for many others. If you decide to experiment with DAI, don’t forget that it runs the same risks as other stablecoins.

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