What are MakerDAO and DAI? How do they work?

The MakerDAO protocol has undoubtedly marked a turning point in the new journey of Decentralized Finance (DeFi). When it comes to writing the history of DeFi, MakerDAO is definitely at the top of the list. In this article, we explore what are MakerDAO and DAI and how they work.

The foundation is DAI, a decentralized stablecoin with a market capitalization of over 8.7 billion dollars (as of April 2022). DAI has become the most popular stablecoin among millions of users. It is also used in a variety of initiatives such as project financing and liquidity provision for decentralized exchanges. DAI is also among the main digital assets used as collateral in decentralized lending protocols. Even small businesses are beginning to accept it as a payment method.

What Is MakerDAO?

MakerDAO is a decentralized peer-to-contract lending platform based on Ethereum (that is, between users and smart contracts without an intermediary). With MakerDAO, you can use cryptocurrencies (mainly ETH as well as other ERC20 tokens) to open collateralized debt positions and create stablecoin DAI (stablecoin fixed to US dollars).

DAI stability is achieved not only by systems that control open CDP (collateralized debt position) collateralization thresholds but also by autonomous feedback mechanisms and incentives from external actors. DAIs can be freely sent to others, used as a payment currency for goods and services, and stored for long-term savings after they are generated.

To understand what MakerDAO is, you first need to understand DAI, the first product of the Maker organization.

What is DAI?

DAI is pegged to the US dollar which means one DAI equals one dollar. In general, stablecoins like Tether, TrueUSD, and others are backed by projects that have USD in bank accounts and issue tokens on the blockchain that is collateralized by these dollars, i.e that is given as collateral.

The issue is that in these cases, we must trust that this third-party intermediary has the correct amount of USD and is not causing artificial inflation. Furthermore, any of these projects may refuse to exchange their crypto-currencies for dollars for any regulatory reason, and your bank accounts could be frozen.

This contradicts the crypto spirit, which is defined by its lack of permission (that is, it does not require the permission of a third party).

Maker DAI is a stablecoin that lives entirely on the blockchain, and its stability is not tied to an intermediary, so there is no need to trust the legal system; however, because Ether is volatile, maintaining the correlation with the USD presents interesting challenges.

A Brief History of MakerDAO

The Maker protocol is an open-source project that began in 2014 to develop a permissionless credit system that would allow users to obtain loans secured by cryptocurrencies. These loans are made possible by smart contracts that generate DAI, a stablecoin tied to the US dollar.

The protocol was developed by the Maker Foundation in collaboration with various external teams, and over time, the foundation gradually gave up control to a decentralized autonomous organization (DAO) known as MakerDAO, which governs the protocol. The DAO is made up of people from all over the world who own the MKR token, which allows its holders to vote on major changes.

The project began in 2015 and did not hold an ICO, instead opting to sell MKR tokens privately to fund development. Maker’s DAI stablecoin debuted in early 2018 and has gained considerable traction since then.

DAI was initially only backed by Ether (Single Collateral DAI), and because it was the only stablecoin that did not require a company to back it with US dollars, it quickly became an important part of the expanding DeFi ecosystem.

While the SCD proved effective, the intended goal was to transition to Multi Collateral DAI (MCD), which could accept other assets as collateral to generate DAI and implement other key design changes.

In November 2019, DAI reached its maximum debt ceiling of 100 million tokens, and multi-collateral DAI (MCD) was introduced, with BAT (Basic Attention token) as the first additional collateral available. From then on, DAI began to be backed by multiple assets, and while these two modalities coexisted after the introduction of the MCD, the plan is to completely eliminate the system of single collateral DAI (SCD).

The new multi-collateralized tokens were renamed “DAI,” while those collateralized only by ETH were renamed “Sai.” Additionally, CDPs collateralized by different assets began to be referred to as “Vaults,” with the ETH deposited as collateral to generate DAI being stored in an Ether Vault.

Aside from that, other significant design changes were put in place, such as the introduction of the DAI Savings Rate (DSR), which allows DAI holders to generate a return, and collateral auctions, which created a competitive market for CDP settlements.

MKR, as of April 2022, has a market capitalization of $1.6 billion. The Total Value Locked according to DeFi Pulse is $14.4 billion, with among others, 2.16M ETH locked as collateral.

How do MakerDAO and DAI work?

The Maker system works essentially as follows:

The user deposits Ether or another permitted token into the Maker smart contract, resulting in the creation of a CDP (Collateral Debt Position, or Guaranteed Debt Position).

The collateralization ratio is 150 percent, which means that the ETH deposited must be worth 150 percent of the DAI lent. If we want them to lend us 100 DAI, for example, we must deposit $150 in ETH or other supported types of collateral (remember that 1 DAI is equal to one US dollar).

As previously stated, ETH is a highly volatile asset, so its price can quickly rise or fall. If the price of Ether falls below the collateralization ratio, in this case, $150, the CDP will automatically close. This is done to ensure that there is always sufficient capital backing the amount of DAI lent.

If the value of the ETH held as collateral is less than the number of DAI it is supposed to back, DAI will be worthless and the system will crash.

Maker combats this by liquidating the CDPs and auctioning off the ETH before the value of Ether is less than the number of DAI it is backing, lowering the price of ETH below the collateralization ratio (150 percent). The CDP is “liquidated,” and the ether within the CDP is auctioned off for DAI until the DAI mined from the CDP is recovered. This action is carried out by traders known as “keepers,” who use programs to track the blockchain in search of CDPs that are at risk.

Let’s say they lend us 80 DAI for 1 ETH at $150 (borrowing 100 would be very risky because any drop in the price of ETH below $150 would automatically liquidate the CDP), with 80 DAIs lent, the value of the collateralized ETH has to be at least $120 (150 percent of 80), and if the price of ETH falls to $118 and the user hasn’t had time to re-collateralize it, the CDP will automatically close.

In such a case, the user keeps their DAI and recovers the ETH left over after the auction (if any), minus a 13 percent penalty that goes to MakerDAO, the DAI recovered after the ETH is auctioned. The locked CDP that has been canceled burns and disappears.

Another scenario is that the CDP is not closed because the collateralization ratio is maintained, and after the user considers that they can voluntarily close their debt position by repaying the borrowed DAI plus an interest called “stability fee,” which can fluctuate and is determined by the DAO after voting by MKR holders.

The stability fee is used as a mechanism to keep the DAI pegged to the USD, effectively acting as a monetary policy tool.

If the supply of DAI increases, its price about the USD falls, and in that case, the DAO could vote to increase the stability fee, making it more expensive for users to generate new DAI and incentivizing the closing of CDPs (the stability fee is linked to time, it is annual, so if it increases, the longer the CDP is open, the more interest you have to pay), in this way its supply would be reduced and the price would rise to reach the exact monetary value. 

The MakerDAO system received a major update in November 2019. The update introduced several new concepts, including the DAI Savings Rate, which is an interest rate that applies to all DAI deposited in a specific smart contract. This interest rate is paid with funds generated by stability fees, and its rate is also determined through voting on MakerDAO.

DSR adds another tool to MakerDAO governance. Instead of maintaining the DAI/USD parity through a supply reduction/expansion mechanism, the DSR could now be used to influence DAI demand. An increase in the DAI savings rate would increase demand for buying DAI on an exchange, depositing the purchased DAI into the DSR contract, and earning interest. Lowering the rate, on the other hand, would encourage users to sell DAI and invest elsewhere.

What is the Utility of MKR token

The DAO (decentralized autonomous organization) is backed by a second token in the system, MKR, whose value is not stable but is used to help maintain the DAI’s stability.

MKR is a token that, like the rest of the Maker ecosystem, runs on the Ethereum blockchain and has governance rights over Maker smart contracts. MKR is also used on Maker to facilitate a variety of fee-related lending processes. The stability fee and the liquidation penalty are the two most important fees on Maker involving MKR.

The stability fee is a complicated term used by Maker to represent the “interest rate.” Each debt position on Maker accrues interest, which is repayable by the vault owner when the position is closed. For example, if you borrowed 100 DAI from the protocol and the stability fee is 2% per year, your total debt to the protocol after one year will be 102 DAI.

Maker continuously collects stability and liquidation fees from its user base, and then sends the accumulated fees in DAI to a Surplus Auction, where the collected DAI is sold for MKR. The protocol then burns the MKR obtained from the sale to reduce the token’s supply. The primary goal of burning the obtained supply is to keep MKR’s price from falling.

How does the Governance of MakerDAO work?

The primary function of MKR on Maker is governance. All proposed changes and other governance issues on the protocol are decided by MKR holders. While DAI is an important component of the Maker platform, DAI ownership grants you virtually no governance or decision-making authority over the protocol.

One MKR token is equivalent to one formal vote. As a result, the more MKR you possess, the greater your ability to influence decision-making. In theory, this leaves Maker vulnerable to a 51 percent attack, in which an actor with more than half of the total MKR supply can dictate the platform’s rules.

However, Maker’s governance model allows anyone with at least 50,000 MKR to initiate an Emergency Shutdown procedure if there is a danger or suspicion of such a takeover occurring. The sum of 50,000 MKR represents approximately 5% of the total token supply, implying that even some of the platform’s minor players can cause the shutdown.

Maker employs both on-chain and off-chain governance mechanisms, though off-chain discussions carry far less weight on the platform because they are non-binding and are frequently hindered by MKR holders’ preferences during the formal on-chain process.

How to buy MKR?

DeFi users or Investors who wish to buy Maker’s governance token $MKR, can buy and sell $MKR on many Centralized Exchanges such as Binance or Coinbase. Another alternative, if you are already on Ethereum Network you can buy $MKR tokens on the Decentralized Exchange Uniswap.

Closing Thoughts

The MakerDAO protocol is definitely one of the most popular and currently among the Top 5 Ethereum DeFi protocols by TVL. Its stablecoin DAI is also a widely used stablecoin across networks and decentralized applications. Both DAI and MakerDAO face fierce competition from other stablecoins and DeFi protocols.

Despite all competition, MakerDAO is now working on bridging traditional finance with DeFi, by allowing Real Estate to be used as collateral. Only time will tell if this attempt is going to be successful. If it does, its definitely going to be a huge innovation and turning point in decentralized finance.

Aris Ioannou
Aris Ioannouhttps://coinavalon.io
Aris created Coinavalon with the purpose of helping the average person navigate the decentralized web. Aris has been passively in the space since 2017 and full time since late 2020. Before Coinavalon, Aris worked as a Business & IT Architect in the financial services sector. Aris holds an MSc in Advanced Computing from Imperial College London, a BSc in Computer Engineering from University of Cyprus and currently pursuing an MBA degree from CIIM.

Related Articles

Latest Articles