The process of lending and borrowing assets, goods, commodities and valuables has characterised societal economies for centuries, if not millennia. From the incredibly outdated, somewhat prehistoric barter system to the most avant-garde, 21st century FinTech development, the financial incentive to exchange, trade, lend and borrow assets, or anything of value, has always constituted a timeless component of human culture and of its economic modus operandi.
Today, in an ever-changing world filled with dynamic applications and relentless technological advancements, financial ecosystems find themselves being on the cusp of a major internal revolution, spearheaded by the proposition of Decentralised Finance. DeFi, in fact, has come to encapsulate a whole new environment of alternative economic structures and financial paradigms, and is very likely destined to utterly disrupt the way people engage with money, value and traditional banking systems.
The infrastructure put forward by protocols in the DeFi space is therefore set to potentially refashion the deeply-rooted mechanisms inherent in traditional financial systems, forging a more sophisticated, cutting-edge and transparent economic framework.
In the post-Bitcoin era, new DeFi-influenced value propositions are being architected on a regular basis, with lending and borrowing protocols, decentralised exchanges (DEXes), yield farming and staking programs being at the forefront of the 21st century financial revolution.
Apart from blockchain-enabled decentralised and trustless lending and borrowing protocols, among the many other DeFi-related things, it is important to emphasise the vital role played by stablecoins in the digital asset economy. This is because, without stablecoins, DeFi and the whole crypto space would not be able to function nor operate correctly.
In fact, stablecoins such as USDC, USDT and DAI, offer traders and investors a way out of the crypto market volatility and provide stability within the digital asset economy. At present, there exists a very exciting protocol looking to merge both stablecoin generation, as asset-backed collateral, and DeFi lending and borrowing, synthesising the perfect environment for the development of DeFi and, subsequently, of Finance 2.0.
MakerDAO is an organisation developing technology for borrowing and savings, as well as a stablecoin crypto asset called DAI on the Ethereum blockchain. MakerDAO has created a protocol allowing anyone with ETH and a Metamask wallet to lend themselves money in the form of DAI stablecoin. By locking up some ETH in MakerDAO’s smart contracts, network participants can create a certain amount of DAI, with the more ETH locked up, the more DAI generated.
When users want to unlock their ETH, which serves as collateral for their DAI loan, they simply pay back the loan alongside any existing fees. Thus, MakerDAO can be described as a decentralised organisation dedicated to bringing stability to the cryptocurrency economy through the DAI stablecoin.
The Maker Protocol employs a two-token model, with the first being the collateral-backed DAI stablecoin, and the second being the protocol’s governance token MKR. The Maker Foundation, together with the MakerDAO community, strongly believe that a decentralised stablecoin is required for any individual or blockchain business to leverage and take advantage of the benefits offered by digital capital.
The second component of Maker’s two-token system is MKR, a governance token that is utilised by stakeholders to maintain the system and manage the DAI stablecoin, making MKR holders the true decision-makers when it comes to MakerDAO’s governance.
Ultimately, MakerDAO seeks to unlock the power of DeFi for anyone around the globe by creating an inclusive infrastructure for individual economic empowerment, allowing users to gain access to its permissionless borrowing marketplace and trustless financial applications. Before diving deep into the functionalities and use cases of the Maker Protocol and the DAI stablecoin, a brief introduction to the project seems productive.
A Brief History Of MakerDAO
Technically speaking, MakerDAO originates as an Ethereum-based, open-source project operating as a Decentralised Autonomous Organisation (DAO) system, hence its name. A Decentralised Autonomous Organisation, or DAO, is defined as an organisation represented by rules encoded as a computer program that is fully transparent, controlled by the organisation’s members and disintermediated from the influence of a central government.
While a complete implementation of DAO infrastructures is yet to be fully realised, DAOs embody the heart and soul of decentralisation in blockchain and, more specifically, in smart contract ecosystems.
Smart contracts are extremely useful for automating transactional processes, and for reducing the input that humans must supply for relatively simple tasks. The goal of a Decentralised Autonomous Organisation isn’t just to reduce human inputs—it’s to eliminate them entirely. Though still largely an on-paper idea rather than one that’s been perfected in practice, a DAO is effectively a business that uses an interconnected web of smart contracts to automate all its essential and non-essential processes. ‘DAOs, Blockchain, and the Potential of Ownerless Business’, Investopedia
Launching in 2015, the MakerDAO project began operating with developers around the world working together on the first iterations of code, proof of concept, architecture and primary documentation. In December 2017, the first MakerDAO Whitepaper was published, introducing the original DAI stablecoin system. The 2017 Whitepaper described how anyone could generate DAI stablecoin through MakerDAO by leveraging Ethereum as collateral via unique smart contracts known as Collateralised Debt Positions (CDPs).
Given that Ethereum was the only available asset for collateralisation on the Maker Protocol, the DAI generated was named Single-Collateral DAI (SCD), or SAI. Furthermore, the 2017 Whitepaper also described the team’s intention to upgrade Maker’s SCD to a Multi-Collateral DAI (MCD) system, an intention which then materialised in November 2019. At present, 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 levels of each ERC-20 before they are on-boarded onto the Maker Protocol.
The Maker Protocol
MakerDAO is one of the largest, most well-established dApps on the Ethereum blockchain, and it holds a considerable percentage of the total liquidity in the DeFi ecosystem. In fact, when the Total Value Locked (TVL) of ETH in DeFi first surpassed the $1 billion mark in June 2020, around 60% of ETH was held by the MakerDAO protocol.
As it stands, the Maker Protocol is managed by people around the globe who hold its native governance token, MKR. Through MakerDAO’s governance system, based on Executive Voting and Governance Polling, MKR holders can manage, run and govern the Protocol as well as the financial risks of DAI to ensure its stability, efficiency and network transparency.
Maker’s Two-Token System
The Maker governance token, MKR, was created by the MakerDAO Protocol in order to essentially support the stability of the DAI stablecoin and enable governance for the DAI credit system. MKR is an ERC-20 asset running on the Ethereum blockchain and it can be minted or burned proportionally to how close the DAI stablecoin is to the US dollar.
This inherently means that the creation of MKR is dependent on the stability of DAI as a whole. For instance, if DAI remains stable, more MKR is burned decreasing the total supply, whereas, if DAI fluctuates too far from the one dollar peg, more MKR is minted subsequently increasing the total supply.
Since MKR holders benefit financially from the stability of the MakerDAO system and the DAI stablecoin, holders are incentivised to act in the best interest of the MakerDAO protocol. Thus, MKR holders can vote on governance decisions and proposals such as how high to set fees and which collateral types can be accepted as collateral by the protocol. In the MakerDAO ecosystem, one MKR token equates to one vote so entities and organisations with substantial MKR holdings can have a larger influence on voting outcomes.
The DAI Stablecoin
The DAI stablecoin is the second monetary component in MakerDAO’s two-token model, after MKR. Stablecoins emerged as somewhat of a middle ground between the legacy financial market and the nascent digital asset one.
Tracking the value of fiat currencies while operating as cryptographic assets, these blockchain-based tokens were initially attractive to traders as a way to lock-in and realise their profits. At present, the most popular forms of stablecoins are fiat-backed ones such as USDC and USDT, which are typically collateralised by the US dollar, but commodity-backed stablecoins do also exist.
When Bitcoin first emerged, the message was clear: Pure disruption of dysfunctional centralised financial systems through decentralised currency and blockchain. By distributing data across a network of computers, the first instance of blockchain technology allowed any group of individuals to embrace economic transparency as opposed to central entity control.
While BTC has greatly succeeded as a crypto asset on many different levels, it isn’t however the most optimal medium of exchange due to its fixed supply and volatility. The DAI stablecoin, on the other hand, succeeds where Bitcoin has perhaps failed, in that it is literally designed to minimise price volatility and reduce aggressive price fluctuations.
Maker’s DAI stablecoin is a decentralised, unbiased, collateral-backed crypto asset that is softly-pegged to the US dollar. On the MakerDAO protocol, users can generate DAI by depositing collateral ERC-20 assets into Maker Vaults, creating the liquidity necessary to take out loans on the protocol.
Once bought, received or generated, DAI can be deployed just like any other crypto asset, meaning that it can be sent to other users, traded and exchanged for other cryptos, used as payment for services or even held as savings through Maker’s DAI Savings Rate (DSR).
It is important to note that every DAI token in circulation is backed by excess collateral, meaning that 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.
DAI’s Financial Properties
As an Ethereum-based stablecoin, DAI is designed to perform 4 main functions in the broader crypto space and, more specifically, in the MakerDAO ecosystem. These functions include:
- Store Of Value: With DAI being a stablecoin, it can function as a store of value by preserving relative stability in the volatile crypto markets.
- Medium Of Exchange: The DAI stablecoin is widely used across the crypto and DeFi space as an efficient medium of transaction and exchange.
- Unit Of Account: DAI has a target price of $1, as it is softly-pegged to the US dollar. Within the MakerDAO protocol, DAI functions as the go-to unit of account.
- Standard Of Deferred Payment: DAI is used to settle debts in the MakerDAO protocol.
Maker Collateral Vaults
DAI is generated and kept stable through the collateral assets deposited into Maker Vaults on the MakerDAO Protocol. Maker’s collateral assets are ERC-20 tokens which have been voted on and approved by MKR token holders through governance.
In order for an ERC-20 token to be accepted as collateral on Maker, MKR holders must first approve its Risk Parametres and deem it a safe asset for collateralisation. Network participants can generate DAI by opening a Maker Collateral Vault via MakerDAO’s Oasis App dashboard and depositing collateral.
These Maker Vaults, previously referred to as Collateralised Debt Positions (CDPs), are smart contracts that run on the Ethereum blockchain and hold collateral in escrow until the borrowed DAI is returned. The value of the collateral deposited must exceed the value of the DAI issued to the user and, while this might seem quite disadvantageous, the benefit of locking up collateral is that users can put in riskier assets and receive stablecoin in return, mitigating their risk exposure overall.
Some common examples of accepted ERC-20 collateral assets on Maker are ZRX, BAT, OMG and ETH, among many others. Thus, once users have deposited their collateral assets, they can redeem their borrowed DAI and redeploy them in other DeFi protocols for staking, yield farming or trade them for other assets or NFTs, for instance.
Opening A Maker Vault
Opening a Collateral Vault on MakerDAO is actually a rather straightforward process. In order to open Maker Vaults, users will need to:
- Head To Oasis.App. Oasis is a platform where users can Trade, Borrow or Save using DAI.
- Connect Preferred Wallet. Oasis accepts a variety of different wallets including Metamask, WalletConnect, Coinbase Wallet, Portis, MyEtherWallet, Ledger and Trezor.
- Users Can View Their Active Vaults On The ‘Your Vaults’ Tab.
- To Open A New Vault, Click ‘Open new vault’.
- At this stage, users will be able to see all the available Vaults on Oasis/MakerDAO, including DAI availability for the Vault, Stability Fees, Minimum Collateral Ratios and the Amounts Deposited.
- Select Preferred Vault And Click ‘Open Vault’.
- After having selected their preferred Vault, users will be able to see their Liquidation Prices and Ratios, Value Of Their DAI Debt, Stability Fees and Liquidation Penalties.
- Configure Vault And Deposit Desired Amount.
- Click ‘Enter Amount’.
- Confirm Transaction On Metamask And Receive DAI In Wallet.
Now that users have locked up their preferred collateral assets and received DAI, they are presented with a few options. For instance, let’s assume that a user locked up ETH as collateral on MakerDAO to generate DAI. They could, potentially:
- Use DAI to buy ETH again and deposit it into a Vault.
- Redeploy DAI in other DeFi applications, such as farming or high APY staking.
- Lend DAI on DeFi platforms such as Compound to earn interest.
- Create Collateral Leverage.
Using Maker Vaults To Create Collateral Leverage
Perhaps one of the most efficient ways to use DAI generated from Maker Vaults is to create collateral leverage. For example, a user redeploys the DAI generated to buy more ETH as collateral and deposits it into a Maker Vault. If the price of ETH increases, the Vault owner stands the profit. The user could also borrow from the Vault as a form of decentralised leverage. Because Maker Vaults require a minimum of 150% collateralisation for ETH lockups, the maximum leverage available is 3x. Let’s now consider the following scenario:
- 1 ETH is worth $100, for simplicity, and User X deposits 15 ETH worth $1,500 into their Maker Vault.
- User X generates 1,000 DAI against it, the maximum possible given the 150% collateralisation requirement. (1500/3 = 500; 1500-500 = 1000)
- User X redeploys the 1,000 DAI and buys 10 ETH this time, which they deposit into another Vault.
- User X can now generate an additional 667 DAI against the extra $1,000 in ETH collateral.
- Purchasing $667 of ETH allows User X to generate a further 444 DAI. Repeating this process provides User X with a further 296 DAI, then 198 DAI, 131 DAI, 88 DAI and 59 DAI.
- Ultimately, this equates to a total of 3,000 DAI that can be generated against the original 15 ETH, enabling User X to leverage the initial stake by 200%.
MakerDAO’s Risk And Collateral Mechanisms
Through the DAO, MKR token holders assign Risk Parametres to each collateral asset that outline the amount of debt that can be created by that collateral type, the amount of volatility the asset is expect to experience, and what happens if the collateral needs to be liquidated in the event that it cannot any longer cover the outstanding DAI debt borrowed against it.
In the event that there is increased market volatility and the collateral deposited no longer covers the outstanding debt, the collateral will be liquidated via an automated process. Automated market actors, called Keepers, who take advantage of arbitrage opportunities bid in DAI for the collateral from a liquidated vault. This DAI is then utilised to pay back the vault’s debt, plus a liquidation fee.
Keepers bid in DAI for the vault’s collateral through an auction process, and if there is enough DAI received in the auction to cover both the debt repayment and the penalty fee, the leftover collateral will be returned to the respective vault owner. Moreover, in the Maker Protocol, Keepers represent those market participants that help DAI maintain its stability and $1 target price, as they buy DAI when the market price is below the $1 level and sell it when the market price is above it.
On the other hand, if the auction fails to accumulate enough DAI to cover the vault owner’s debt, this debt then becomes ‘protocol debt’ and is covered by the Maker Buffer, a liquidity pool containing the fees denominated in DAI and paid on collateral withdrawals in addition to the proceeds from the collateral auction. If there is insufficient DAI in the Maker Buffer pool, a debt auction will be triggered and the protocol will mint MKR and sell it to bidders for DAI to recapitalise the pool and repay the outstanding debt.
Thus, DAI, MKR and ERC-20 collateral assets work as an automatic system of checks and balances, with each functioning to counteract the other and maintain the system’s stability and decentralisation.
Maker’s Price Oracles
Oracles play a fundamental role in MakerDAO’s collateral assessments. In fact, in order to assess the collateral deposited on the platform, Maker must have information on the price of collateral ERC-20 assets. To do this, Maker leverages a decentralised network of trusted oracles selected through governance by MKR token holders. However, for security reasons, the protocol does not actually receive price data directly and instantaneously from these trusted oracles.
Instead, it receives 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 periodically feed delayed prices to the MakerDAO protocol for a particular collateral type.
This oracle price delay function allows emergency oracles, a special type of oracle selected by MKR holders through governance voting, to essentially freeze the original oracle providing the price feed if it is compromised or corrupt. Emergency oracles, in fact, can also trigger emergency shutdowns, a mechanism put in place to protect MakerDAO from hacks and external attacks.
As previously mentioned, MKR is MakerDAO’s native governance token used to vote on governance proposals and protocol updates, as well as ensure the stability of the MakerDAO Protocol and the DAI stablecoin. The MKR token launched in 2017, but the MakerDAO Team deliberately decided not to hold any particular ICO to bootstrap their token. In fact, in the words of Jessica Salomon, a member of the MakerDAO Team at the time:
Initially MKR were sold via private sales to friends and family, as well as investors like Andreessen Horowitz and Polychain. The process was and has been way more personal that what you see with a typical ICO. The goal was to create an ownership community that is cohesive and committed to long term success and not just short term gain […] The goal of having responsible “owner/operators” is part of the reason Maker never had a wild and crazy ICO. Jessica Salomon, Hackernoon
At the time of writing, MakerDAO’s native asset MKR is trading at approximately $3,280 and is currently down 48% from its all-time-high of $6,339.02, which it reached in early May 2021. The market capitalisation of MKR equates to more than $3.2 billion, and it has a maximum token supply of 1,005,577 MKR.
MakerDAO has proven to be an incredibly solid, functional project with some widely adopted use cases across the digital asset ecosystem. The DAI stablecoin is indeed way too important for the DeFi space for it to be potentially ever neglected. Thus, due to its lending and borrowing functionalities, its collateralised assets and its use of the DAI stablecoin, the MKR token should carry on growing alongside the rest of the MakerDAO ecosystem, resulting in a general upward momentum over the medium to long-term outlook.
The MakerDAO Protocol has always had one fundamental goal in mind: Ultimate Decentralisation Through A Decentralised Autonomous Organisation (DAO). Thus, in order to achieve this, Maker has through the years developed and built a strong team of blockchain engineers, developers and growth experts around it to help the project reach its long-term objectives.
MakerDAO was founded by Rune Christensen who, since 2015, has been focused on delivering the organisational structure of the MakerDAO protocol and dedicated to bootstrapping the economic foundations of the DAI stablecoin in DeFi.
Before diving into the crypto space, Christensen founded a business 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 the business, invested in the asset, became interested in stablecoins and eventually became the founder of MakerDAO.
At present, the MakerDAO Team is composed of:
In today’s world, financial infrastructures are starting to feel the effects of digitisation, technological advancement and, ultimately, DeFi. Decentralised Finance, in fact, is slowly but surely restructuring financial paradigms as we know them through its blockchain-enabled functionalities and decentralised applications.
Over the course of the last 4 years or so, a very intriguing protocol has arisen in the DeFi space looking to merge both stablecoin generation, as asset-backed collateral, and decentralised lending and borrowing functionalities, and this protocol is no other than MakerDAO.
MakerDAO is one of the largest, most well-established dApps on the Ethereum blockchain, and it holds a considerable percentage of the total liquidity in the DeFi ecosystem. With its two-token model, MKR and DAI, MakerDAO allows pretty much anyone around the globe to gain access to economic empowerment through its trustless, permissionless, DAO-like financial platform.
The Maker Protocol enables network participants to lock up a variety of different assets as collateral on Maker Vaults and generate collateral-backed DAI stablecoin in return. Users can then go ahead and deploy their newly generated DAI on other DeFi protocols, engage in yield farming or staking, or even redeploy DAI to deposit more assets as collateral in Maker Vaults to leverage their positions.
In the grand scheme of things, MakerDAO has come such a long way since its inception and, for the foreseeable future, it will most likely carry on developing its infrastructure, expanding its use cases and economic utilities and, potentially, even find itself at the very forefront of Finance 2.0.
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.