How Does MakerDAO Work?

MakerDAO is a decentralized finance (DeFi) project that operates through a Decentralized Autonomous Organization (DAO) to manage its stablecoin called DAI. DAI is designed to maintain a stable value by being pegged to the US dollar. Users can generate DAI by locking their cryptocurrency assets in a Maker Vault, with the amount of collateral required determined by a specific Liquidation Ratio. This ensures that the value of the collateral exceeds the value of the generated DAI, providing a safety net against potential losses.

The governance of MakerDAO's operations is carried out through its DAO, which controls critical parameters such as the Stability Fee and the Dai Savings Rate. The Stability Fee influences the supply of DAI by adjusting the cost of minting the stablecoin, while the Dai Savings Rate affects the demand for DAI by altering the returns for those who stake their DAI. By utilizing these mechanisms, the DAO aims to maintain the stability of DAI and ensure it remains pegged to the US dollar.

DAI offers various benefits similar to other stablecoins and cryptocurrency assets, allowing for easy global transfers, serving as a medium of exchange, and providing opportunities for leveraging and earning interest through the DAI Savings Rate contract. Active participation in MakerDAO's governance involves owning MKR tokens, which grant holders voting power to influence important decisions that shape the future of MakerDAO and DAI.

Basics

MakerDAO is a renowned example of a crypto-backed stablecoin, which has gained significant popularity in the realm of digital assets. Stablecoins, a hybrid between traditional finance and cryptocurrencies, have emerged as highly favored tokens. They serve as a bridge between fiat currencies and blockchain technology, enabling users to secure their gains or mitigate losses effectively.

While fiat reserves back most stablecoins in the market, crypto-backed stablecoins have garnered substantial attention. In this article, we will explore the dynamics of MakerDAO, one of the prominent players in the field, and delve into its meticulous approach to maintaining a stable value pegged to $1, despite the inherent volatility of its collateral.

What Is MakerDAO?

MakerDAO is a decentralized project built on Ethereum that focuses on creating DAI, a stablecoin pegged to the US dollar. Governed by the MKR token, MakerDAO operates as a decentralized autonomous organization. Users can access MakerDAO through the Oasis DApp to engage in collateral loans, governance participation, and manage Maker Vaults. DAI offers similar benefits to fiat-backed stablecoins.

How Does the DAI Token Work?

DAI, MakerDAO's stablecoin, has emerged as one of the largest stablecoins and cryptocurrencies in terms of market capitalization. Unlike traditional stablecoins backed by fiat reserves, DAI utilizes crypto-collateralization. This approach may appear counterintuitive since cryptocurrencies are known for their volatility. However, the value of the deposited crypto used to generate DAI exceeds the value of the stablecoin received, allowing for downward price movements in the collateral.

The advantages of using DAI are manifold.

• Firstly, it provides stability, making it suitable for transactions where consistent value is desired. This is particularly beneficial for retailers and individuals who prefer not to deal with cryptocurrencies that can experience significant value fluctuations.
• Secondly, DAI leverages the advantages of blockchain technology, allowing for global transferability without the need for a traditional bank account. Moreover, DAI offers enhanced security when stored appropriately.
• Lastly, DAI enables users to lock in profits or losses, serving as a risk hedge. By including DAI in their portfolios, individuals can mitigate overall risk and conveniently enter or exit positions without relying on off-chain mechanisms.

How Does Crypto Collateral Work?

In the realm of traditional finance, collateral is a familiar concept that often arises when securing a loan. As a borrower, you are required to offer an asset of value as collateral, which serves as a form of protection for the lender in case you are unable to fulfill your repayment obligations.

Collateral serves as a safety net in financial transactions. For instance, when borrowing from a pawnshop, you can provide jewelry as collateral in exchange for a cash loan. If you repay the loan along with a fee, you can retrieve your collateral; otherwise, the pawnshop keeps it to cover their losses. Collateral also plays a role in mortgages and car finance, where the property or vehicle acts as security.

In the realm of stablecoins, collateral takes different forms. Fiat-backed stablecoins, like USDT, rely on fiat currency as collateral. Users provide cash and receive tokens in return, with the issuer retaining the collateral. On the other hand, crypto-collateralized stablecoins, such as DAI, accept cryptocurrency as collateral. Smart contracts manage these funds, issuing stablecoin tokens based on the deposited crypto. The collateral is returned upon the redemption of the stablecoin. The specific collateral ratio depends on the project and considers factors like the volatility and risk associated with the collateral asset.

What Is DAI Overcollateralization?

When lenders ask for collateral, they usually prefer assets that are stable and low-risk, like cash, gold, or property. But using cryptocurrencies as collateral is riskier because their value can change a lot.

For example, let's say someone wants to borrow 500 tokens that are worth $1 each and they offer $500 worth of Bitcoin as collateral. If the value of Bitcoin suddenly goes down, the lender might not be able to get enough money from selling the Bitcoin to cover the loan. To avoid this problem, lenders can ask for more collateral than the loan amount. This is called "overcollateralization." For example, the lender might ask for $750 worth of Bitcoin instead of $500, to make sure they have enough money if the value of Bitcoin drops.

What Are Collateralized Debt Positions (CDP)?

By implementing overcollateralization, MakerDAO has effectively maintained a stable peg for its DAI stablecoin over an extended period. The DAI generation process operates autonomously through smart contracts, eliminating the need for human intervention. When individuals wish to borrow DAI, they secure it by locking up their cryptocurrency in a CDP (Collateralized Debt Position) smart contract. To establish a safety buffer, the CDP specifies a Liquidation Ratio, such as 1.5x. For instance, to borrow $100 worth of DAI, the user must provide $150 worth of BTC as collateral. Users have the option to add additional collateral to reduce their risk exposure. However, if the collateral value falls below 150%, they may incur a penalty fee. Failure to repay the borrowed DAI, along with the accrued interest rate known as the Stability Fee, puts the user at risk of liquidation.

How Do Maker Vaults Work?

Users can utilize Maker Vaults to secure their cryptocurrency assets and generate DAI stablecoin. These Vaults support multiple cryptocurrencies as collateral simultaneously. The process of using Maker Vaults involves the following steps:

1. Deposit supported cryptocurrencies into the Maker Protocol.
2. The deposited amount opens a Maker Vault position for you.
3. You can withdraw DAI based on your collateral value, while also paying the applicable Stability Fee.
4. To reclaim your crypto collateral, simply repay the withdrawn DAI.

Flexibility is provided to generate or return DAI, as well as add or withdraw collateral at any time. However, it is crucial to maintain the Liquidation Ratio indicated in the Vault. Dropping below this ratio may lead to the liquidation of your collateral.

How Does the DAI Price Hold Up?

MakerDAO utilizes various tools to maintain the stability of its token, DAI. When DAI deviates from its target value, MakerDAO adjusts the Stability Fee and DAI Savings Rate to influence supply and demand.

To bring DAI back to its target value, the Stability Fee can be increased, making borrowing more expensive and encouraging users to repay their debts. Alternatively, the Stability Fee can be lowered to incentivize the generation of new DAI when its value is above the target. Additionally, MakerDAO can adjust the DAI Savings Rate to attract or discourage investment in DAI. Through these adjustments, MakerDAO strives to ensure that DAI remains pegged to its intended value, maintaining stability in the cryptocurrency market.

How Can You Use DAI?

DAI offers the same benefits as other stablecoins and can be acquired on the crypto market. In addition, it presents unique use cases:

1. Leverage: If you believe the price of a cryptocurrency like ETH will increase but lack additional funds to make a purchase, you can utilize your existing ETH as collateral to generate DAI. With DAI, you can buy more of the desired cryptocurrency. When you decide to cash out, you can sell some of the cryptocurrency for DAI and retrieve your collateral.
   1. DAI Savings Rate: Depositing DAI into the DAI Savings Rate smart contract enables you to earn interest. This interest rate varies as the DAO regulates DAI's price.

MakerDAO's Governance

To actively participate in MakerDAO's decision-making process, one must possess the project's governance token, MKR. With a maximum supply of 1,005,577 MKR, around 40% was initially allocated to the team and early investors during deployment, while the remaining tokens were held by the DAO for future sales.

Holders of MKR have the privilege of voting on various aspects of the platform, including the Stability Fee, DAI Savings Rate, Liquidation Ratio, and other important matters. The weight of their vote is determined by the amount of MKR they possess. To stay informed and engage in ongoing votes, you can visit MakerDAO's governance portal.

By holding MKR tokens, individuals actively contribute to shaping the governance and policies of MakerDAO, influencing the platform's stability and development.

Governance and Executive Votes

In MakerDAO, the decision-making process involves two types of voting: Governance Polls and Executive Votes.

• Governance Polls provide an avenue for users to propose non-technical changes that require the input of MKR holders. These proposals can cover a wide range of topics, including governance adjustments, goals, team composition, or budget allocations. To determine the preferred option among multiple choices, the Instant Run-off mechanism is utilized, enabling participants to rank their preferences.
• Executive Votes focus on technical modifications to the smart contract. Through a Continuous Approval Voting system, new proposals can always be introduced, allowing for competition among different proposals. The outcome of an Executive Vote leads to concrete changes in the smart contract code, such as fee adjustments or collateral level modifications. It is often necessary to implement the changes that have been approved through Governance Polls.

Through these two voting processes, MakerDAO ensures that both non-technical and technical aspects of the platform are collectively decided by MKR holders, fostering transparency and community involvement in shaping the future of the project.

Conclusion

With its effective management of crypto volatility without relying on fiat collateralization, DAI has become the leading crypto-collateralized stablecoin. This achievement sets it apart in the stablecoin landscape. Furthermore, it holds significant historical significance as one of the earliest and largest DAOs, serving as an inspiration for subsequent projects. While considering DAI for your own ventures, it is essential to acknowledge that it carries similar risks as other stablecoins.