MakerDAO Full Review: How Its Shaping the Future of Stablecoins

cd

MakerDAO is a pioneering decentralized autonomous organization and smart contract platform running on the Ethereum blockchain. It is responsible for managing and issuing DAI, a stablecoin pegged to the US dollar, aimed at maintaining its value approximately equal to one US dollar. MakerDAO employs a series of dynamic stabilization mechanisms and smart contracts to achieve this goal.

As the DeFi (Decentralized Finance) ecosystem has evolved, MakerDAO and DAI have played a significant role in providing a stable currency for decentralized finance applications, supporting a range of financial services including lending, leverage trading, and liquidity provision.

What is MakerDAO?

MakerDAO originated from an open-source project on Ethereum, operating as a decentralized autonomous organization (DAO), hence the name. A decentralized autonomous organization (DAO) is defined as an organization represented by rules encoded as computer programs, completely transparent, and controlled by the members of the organization, uninfluenced by a central government.

Although the full implementation of the DAO infrastructure has not been completely realized yet, DAOs embody the core and soul of decentralization in the blockchain, more specifically, the smart contract ecosystem.

The MakerDAO project was launched in 2015, beginning to collaborate with developers worldwide on the first iterations of code, concept proofing, architecture, and primary documentation. In December 2017, the first MakerDAO whitepaper was published, introducing the initial DAI stablecoin system. The 2017 whitepaper described how anyone could use Ethereum as collateral through a unique smart contract known as a Collateralized Debt Position (CDP) to generate DAI stablecoins through MakerDAO.

Given that Ethereum was the only available collateral asset on the Maker protocol, the generated DAI was named Single Collateral DAI (SCD) or SAI. Furthermore, the 2017 whitepaper described the team’s intention to upgrade Maker’s SCD to a Multi-Collateral DAI (MCD) system, an intention that was later realized in November 2019. Currently, the DAI stablecoin system accepts any ERC-20 asset as collateral that has been approved by MKR token holders, who must first vote on the risk level of each ERC-20 before it can be added to the Maker protocol.

The core components of MakerDAO include two tokens: MKR and DAI. MKR is Maker system’s governance token, allowing holders to vote on key parameters of the system, such as the Stability Fee (interest rates) and the system’s debt ceiling, among others. DAI, on the other hand, is the stablecoin, whose stable value is due to a series of complex smart contracts and collateral mechanisms.

Users can generate DAI by depositing cryptocurrency assets (such as ETH) as collateral, a process commonly referred to as opening a Collateralized Debt Position (CDP). If the value of the collateral falls to a certain level, the position will be liquidated to ensure the stability of DAI. This system not only provides a relatively stable cryptocurrency but also allows users to access liquidity by collateralizing assets without having to sell their cryptocurrency.

Maker Protocol

MakerDAO is one of the largest and most comprehensive dApps on the Ethereum blockchain, occupying a considerable portion of the total liquidity in the DeFi ecosystem. In fact, when the total value locked (TVL) in DeFi in ETH first surpassed the $1 billion mark in June 2020, approximately 60% of the ETH was held by the MakerDAO protocol.

Currently, the Maker protocol is managed by individuals worldwide who hold its native governance token, MKR. Through MakerDAO’s governance system, based on executive voting and governance polling, MKR holders can manage, operate, and govern the protocol as well as the financial risks of DAI to ensure its stability, efficiency, and network transparency.

The Dual-Token System of Maker

The Maker governance token, MKR, was created by the MakerDAO protocol to fundamentally support the stability of the DAI stablecoin and enable the governance of the DAI credit system. MKR is an ERC-20 asset running on the Ethereum blockchain, which can be minted or burned proportionally depending on how closely the DAI stablecoin tracks the US dollar.

This essentially means that the creation of MKR is dependent on the overall stability of DAI. For example, if DAI remains stable, more MKR will be burned, thus reducing the total supply, while if DAI’s volatility strays too far from the dollar peg, more MKR will be minted, thereby increasing the total supply.

Since MKR holders benefit economically from the stability of the MakerDAO system and the DAI stablecoin, they are incentivized to act in the best interests of the MakerDAO protocol. Therefore, MKR holders can vote on governance decisions and proposals, such as setting how high fees should be and which types of collateral can be accepted by the protocol. In the MakerDAO ecosystem, one MKR token equals one vote, meaning entities and organizations holding a large amount of MKR can have a more significant impact on the outcome of votes.

The DAI Stablecoin

DAI is the second component of MakerDAO’s dual-token model, following MKR. As a stablecoin, DAI serves as a bridge between traditional financial markets and the emerging digital asset market.

These blockchain-based tokens operate as digital assets while tracking the value of fiat currencies, initially appealing to traders as a way to lock in profits and stabilize portfolios. The most common form of stablecoins currently are fiat-backed stablecoins, such as USDC and USDT, which are typically collateralized by dollars, though commodity-backed stablecoins also exist.

When Bitcoin first emerged, the message was clear: disrupt the dysfunctional centralized financial system with decentralized currency and blockchain. By distributing data across a computer network, the first instance of blockchain technology allowed any group of individuals to embrace economic transparency, instead of control by a central entity.

Despite Bitcoin’s tremendous success as a crypto asset on many different levels, its fixed supply and volatility made it less than ideal as a medium of exchange. On the other hand, the DAI stablecoin succeeded where Bitcoin may have failed, as it was designed to minimize price fluctuations and reduce severe volatility.

Maker’s DAI stablecoin is a decentralized, fair, collateral-backed crypto asset that softly pegs to the US dollar. Within the MakerDAO protocol, users can generate DAI by depositing ERC-20 assets as collateral into Maker Vaults, thus creating the liquidity needed for loans on the protocol.

Once purchased, received, or generated, DAI can be deployed like any other crypto asset, meaning it can be sent to others, traded and exchanged for other cryptocurrencies, used as payment for services, or even saved through Maker’s DAI Savings Rate (DSR).

Notably, every DAI token in circulation is over-collateralized, meaning the value of the collateral is higher than the DAI debt, and every transaction with DAI is publicly visible and verifiable on the Ethereum blockchain.

The Financial Attributes of DAI

As an Ethereum-based stablecoin, DAI is designed to perform four main functions within the broader crypto space, more specifically, within the MakerDAO ecosystem. These functions include:

Maker Collateral Vaults

DAI maintains stability and is generated by depositing collateral assets into Maker Vaults on the MakerDAO protocol. The collateral assets for Maker are ERC-20 tokens, approved by MKR token holders through governance voting.

For an ERC-20 token to be accepted by Maker as collateral, MKR holders must first approve its risk parameters and deem it a safe asset to be used for collateral. Network participants can open Maker Vaults and deposit collateral to generate DAI through the Oasis App dashboard of MakerDAO.

These Maker Vaults, formerly known as Collateralized Debt Positions (CDPs), are smart contracts running on the Ethereum blockchain and hold collateral until the borrowed DAI is repaid. The value of the deposited collateral must exceed the value of the DAI issued to the user, although this may seem disadvantageous, the benefit of locking up collateral is that users can invest in higher-risk assets and receive stablecoins in return, thus mitigating overall risk exposure.

Some common examples of ERC-20 collateral assets accepted on Maker include ZRX, BAT, OMG, and ETH, among others. Therefore, once users deposit collateral assets, they can redeem the borrowed DAI and redeploy it into other DeFi protocols for staking, liquidity mining, or trade it for other assets or NFTs.

Opening a MakerDAO Vault

Opening a Vault on MakerDAO is actually a relatively straightforward process. To open a Maker Vault, users need to:

At this stage, users will be able to see all the available Vaults on Oasis/MakerDAO, including the DAI availability for the Vault, the Stability Fee, the Minimum Collateral Ratio, and the amount to be deposited.

After selecting their preferred Vault, users will be able to see their liquidation price and ratio, the value of their DAI debt, the stability fee, and the liquidation penalty.

Now that users have locked their preferred collateral asset and received DAI, they face several choices. For instance, assume a user locks ETH as collateral on MakerDAO to generate DAI. They might:

Creating Collateral Leverage Using Maker Vaults

One of the most effective uses of DAI generated from Maker Vaults is to create leverage on the collateral. For example, users redeploy the generated DAI to buy more ETH as collateral and deposit it into a Maker Vault. If the price of ETH increases, the Vault owner profits. Users can also borrow from the Vault as a form of decentralized leverage. Since Maker Vaults require a minimum of 150% collateral to lock ETH, the maximum available leverage is 3x. Now, let’s consider the following scenario:

Risks and Collateral Mechanisms in MakerDAO

Via the DAO, MKR token holders allocate risk parameters for each type of collateral asset, outlining the amount of debt that type of collateral can generate, the expected volatility of the asset, and what happens if the collateral needs to be liquidated if it can no longer pay back the DAI debt it borrowed against.

If market volatility intensifies and the deposited collateral no longer covers the outstanding debt, the collateral will be liquidated through an automated process. Automated market participants known as Keepers exploit arbitrage opportunities to buy collateral from liquidated Vaults with DAI bids. This DAI is then used to pay off the Vault owner’s debt along with a liquidation fee.

Keepers purchase the collateral of the Vault through an auction process with DAI bids. If the DAI received in the auction is sufficient to cover debt repayment and penalties, any remaining collateral is returned to the respective Vault owner. Moreover, in the Maker protocol, Keepers represent those market participants who help keep DAI stable and at its $1 target price by buying DAI when its market price falls below $1 and selling when it rises above $1.

On the other hand, if the auction fails to accumulate enough DAI to pay the Vault owner’s debt, that debt becomes “protocol debt” and is covered by the Maker Buffer, a liquidity pool containing fees paid in DAI upon collateral withdrawal in addition to the proceeds from the collateral auction. If the Maker Buffer pool is insufficient in DAI, a debt auction is triggered, where the protocol mints MKR and sells it to the bidders of DAI to recapitalize the pool and pay off the outstanding debt.

Thus, DAI, MKR, and ERC-20 collateral assets act as an automatically rebalancing system, offsetting each other to maintain the system’s stability and decentralization.

MakerDAO Price Oracles

Oracles play a crucial role in the valuation of collateral on MakerDAO. Indeed, to evaluate the collateral stored on the platform, Maker must have access to price information for the ERC-20 collateral assets. For this, Maker utilizes a decentralized network of trusted oracles selected and governed by MKR token holders. However, for security reasons, the protocol does not actually receive price data from these trusted oracles in real-time.

Instead, it receives information through the Oracle Security Module (OSM), a smart contract that delays the receipt and communication of prices by 1 hour. The primary goal of the Oracle Security Module is to provide delayed price information to the MakerDAO protocol for specific types of collateral at regular intervals.

This oracle price delay feature allows emergency of their DAI debt, the stability fee, and liquidation penalty.

Now, with their preferred collateral asset locked and DAI received, users are faced with several choices. For instance, suppose a user locks ETH as collateral on MakerDAO to generate DAI. They potentially can:

Creating Collateral Leverage with Maker Vault

One of the most effective uses of DAI generated from Maker Vaults might be to create leverage on collateral. For example, a user redeploying the generated DAI to purchase more ETH as collateral and depositing it back into a Maker Vault. If the price of ETH increases, the Vault owner profits. Users can also borrow from the Vault as a form of decentralized leverage. Since Maker Vaults require at least 150% collateral to lock ETH, the maximum available leverage is 3x. Now consider the following scenario:

Risks and Collateral Mechanisms in MakerDAO

Via the DAO, MKR token holders allocate risk parameters for each collateral asset, outlining the amount of debt the collateral type can generate, the expected degree of volatility the asset might experience, and what happens if the collateral needs to be liquidated if it can no longer repay the outstanding DAI debt borrowed against it.

If market volatility increases and the deposited collateral no longer covers the outstanding debt, the collateral will be liquidated through an automated process. Automated market participants known as Keepers capitalize on arbitrage opportunities to buy collateral from liquidated Vaults at DAI bids. The DAI received from the auction is then used to pay off the Vault’s debt and liquidation fee.

Keepers bid DAI to purchase collateral from the Vault at auction, and if the DAI received is sufficient to pay off the debt and penalties, the remaining collateral is returned to the respective Vault owner. Additionally, in the Maker protocol, Keepers represent market participants who help stabilize DAI and maintain its 1 US dollar target price by buying DAI when its market price falls below 1 dollar and selling when it rises above.

On the other hand, if the auction fails to accumulate enough DAI to pay off the Vault owner’s debt, that debt becomes “bad debt” and is covered by the Maker Buffer, a liquidity pool containing DAI priced in fees paid upon collateral withdrawal besides the revenue from collateral auctions. If the DAI in the Maker Buffer pool is insufficient, a debt auction is triggered, where the protocol mints MKR and sells it to bidders for DAI, to recapitalize the pool and pay off the unpaid debt.

Thus, DAI, MKR, and ERC-20 collateral assets act as an auto-balancing system, offsetting each other to maintain system stability and decentralization.

Maker Price Oracles

Oracles play a crucial role in the valuation of collateral on MakerDAO. In fact, to evaluate the collateral stored on the platform, Maker must have access to price information of the ERC-20 collateral assets. For this, Maker utilizes a decentralized network of trusted oracles, chosen and governed by MKR token holders. However, for security reasons, the protocol does not actually receive price data from these trusted oracles instantaneously.

Instead, it receives the information through the Oracle Security Module (OSM), a smart contract that delays price reception and communication by 1 hour. The main goal of the Oracle Security Module is to provide delayed prices of specific collateral types to the MakerDAO protocol at regular intervals.

This oracle price delay feature allows emergency oracles (a special type of oracle chosen by MKR holders through governance voting) to essentially freeze the original oracle in case its price feed is compromised or corrupted. In fact, emergency oracles can also trigger an emergency shutdown, a mechanism designed to protect the MakerDAO from hacks and external attacks.

MKR Token Economics

As mentioned earlier, MKR is MakerDAO’s native governance token used for voting on governance proposals and protocol updates, and ensuring the stability of the MakerDAO protocol and the DAI stablecoin. The MKR token was launched in 2017, but the MakerDAO team deliberately decided not to hold any specific ICO to kickstart their token. In the words of Jessica Salomon, a member of the MakerDAO team at the time:

Initially, MKR was sold to friends and family as well as investors like Andreessen Horowitz and Polychain through a more personalized process than what you’d see in a typical ICO. The aim was to create a cohesive ownership community committed to long-term success rather than just short-term gains… This goal of having responsible “owners/operators” is part of why Maker never went through the ICO craze. -Jessica Salomon, Hackernoon

As of the time of writing, the native asset of MakerDAO, MKR, is trading at around $3,280, down approximately 48% from its all-time high of $6,339.02 reached in early May 2021. MKR’s market capitalization is equivalent to over $3.2 billion, with a total token supply of 1,005,577 MKR.

The MakerDAO has proven to be an extremely reliable and pragmatic project with some widely adopted use cases in the digital asset ecosystem. The DAI stablecoin is too important for the DeFi sector to be ignored. Therefore, given its lending functionality, collateral assets, and the use of the DAI stablecoin, the MKR token should continue to grow alongside the rest of the MakerDAO ecosystem, creating an overall upward trajectory in the medium to long term prospects.

The Team

The MakerDAO protocol has always kept one fundamental goal in mind: achieving ultimate decentralization through a decentralized autonomous organization (DAO). To accomplish this, Maker has built a strong team around its development over the years, consisting of blockchain engineers, developers, and growth experts to help the project achieve its long-term objectives.

MakerDAO was founded by Rune Christensen, who has been focused on providing organizational structure for the MakerDAO protocol and leading the economic foundation of the DAI stablecoin in DeFi since 2015.

Before venturing into the cryptocurrency field, Christensen founded a company that recruited Westerners to teach English in China, which he continued to manage while studying at the University of Copenhagen and Copenhagen Business School. After discovering Bitcoin in 2011, Christensen sold his company, invested in the asset, became interested in stablecoins, and eventually became the founder of MakerDAO.

Currently, the MakerDAO team consists of:

Bottom Line

Over the past five years or so, the DeFi sector has seen a fascinating protocol emerge that aims to combine stablecoin generation backed by assets as collateral with decentralized lending functionality, and that protocol is MakerDAO.

MakerDAO is one of the largest and most sophisticated dApps on the Ethereum blockchain, occupying a considerable portion of the total liquidity in the DeFi ecosystem. With its dual-token model of MKR and DAI, MakerDAO allows nearly anyone globally to achieve economic empowerment through its trustless, permissionless, DAO-like financial platform.

The Maker protocol enables network participants to lock various different assets as collateral in Maker Vaults and generate DAI stablecoins as a return. Users can then continue to deploy the newly generated DAI into other DeFi protocols for yield farming or staking or redeploy DAI to deposit more assets as collateral into Maker Vaults to leverage their positions.

Looking ahead, MakerDAO has made significant strides since its inception and is likely to continue to develop its infrastructure, expand its use cases and economic utility, and possibly find itself at the forefront of Finance 2.0 in the foreseeable future.

Related Articles
↑
Exit mobile version