TLDR below. This is not financial advice.
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MakerDAO is one of the core project on DeFi. The foundation of the project is built on the Ethereum blockchain. The two main components are $DAI (stablecoin) and $MKR (governance). The protocol creates $DAI that is backed by $ETH using a vault mechanism.
This system is able to regulate and stabilise the price of $DAI stablecoin. This protocol is also the first successful onchain reserve stablecoin.
The mechanisms of stablecoins have changed since 2017 and we’re going to start classifying stablecoins into four different categories:
Check the previous newsletter if you want more clarity.
In MakerDAO’s ecosystem, $DAI is the stablecoin and uses a dual token and reserve mechanism. It is soft pegged to one dollar and uses over-collateralisation to get that one dollar. It uses different kinds of on-chain crypto assets like $ETH, stablecoins, and non-stablecoins.
Dual Token Mechanism
In the dual token model, as the name suggests, there are two tokens in the system. The primary token is stablecoin $DAI which is soft pegged to the US dollar. The secondary token is $MKR. The main function of the secondary token is to absorb volatility in the system. Think of $DAI as your output which is stable and has low volatility, but because there will always be volatility within the system or outside of the system. The volatility needs to go somewhere, so it goes to the other token, $MKR.
Functions of the MKR Token
This is a utility token and functions as a governance token for voting. It can be used to pay off interest accrued in the system, and during insolvency. During crashes or different kinds of liquidation $MKR can be minted and sold for $DAI in the ecosystem. $MKR is a crucial aspect of governing the entire system of $DAI. $DAI is the facilitator that allows people to exchange goods and services. A few months ago MakerDAO moved more of its funds towards the DAO which means that it is no longer mainly controlled by the founders and is now controlled by the community.
This means that the stablecoin or the $DAI is backed by reserves and you can use the $DAI to redeem the underlying collateral. You can redeem $DAI for the underlying crypto assets that you deposited to get $DAI initially.
Creating $DAI: How it Works
You can create $DAI in three simple steps:
You have to own the asset.
You deposit that asset into a vault.
Based on the amount of value in the vault you can mint some $DAI out and then can use it in some other system.
The only thing that you have to be careful about is the minimum collateralisation ratio. If I have $150 worth of $ETH and I put it in my vault then I can take out a maximum of 100 $DAI from this vault and spend it somewhere else. My $150 worth of $ETH sits in the vault. I cannot touch it until I repay the amount that I borrowed, which is 100 $DAI.
What happens when your $ETH falls in value?
I put $150 worth of $ETH in the vault but if the value falls to $100 then my collateralisation ratio is 100% which is less than the ideal amount of 150%. Now I will have to either repay the loan (instead of borrowing 100 $DAI I must repay 33 $DAI) or I will have to add $50 worth of $ETH into the collateral so that the minimum collateralisation ratio or the c-ratio is balanced.
In conventional banking we have fiat money where central banks use interest rates via open market operations to maintain stability. Central banks have long term strategies for understanding what is going on in the market and then applying various monetary policies to deal with it. This is fine but there are also some problems because monetary policy is quite laggy. The market moves much faster and sometimes the monetary policy is not reflective of the market conditions.
Unlike fiat money, programmable money like stablecoins allows you to programme some level of monetary policy into the code and execute that code according to the market conditions.
There are two scenarios where $DAI is not stable:
When $DAI > $1
When $DAI is more than one dollar there are two ways to deal with it:
Outside the system people may be trading at one dollar and five cents but the system always views it as one dollar. If I can mint it at one dollar and trade it outside at one dollar five cents then I can earn five cents from nothing. This is called arbitrage. People will now take their collateral and deposit it to borrow $DAI out and then sell the $DAI in the secondary market. What is being done here is to increase the total supply of $DAI. When the value is capped the total supply increases and the price of these tokens falls.
When the secondary market is trading at one dollar five cents then to get it back to one dollar you need to increase supply and the system can not just print free money and free $DAI for everyone. Therefore, some economic agents are incentivised to earn via this arbitrage and will borrow or get $ETH and mint $DAI and trade in the secondary market. They will then come back and close their vaults which increases the total $DAI supply and the prices fall back to one dollar.
In the long run, there are two possible ways:
The first one is to decrease the $DAI savings rate. It is currently at zero, but in the future they are looking at creating something where a small number of fees will be generated if you deposit $DAI in the system. It is zero now but in the long run, you can decrease it. This incentivises people to not remove their liquidity which then increases the supply of the system.
There is an interest rate that is accrued when you are depositing $ETH into the vault and borrowing $DAI out. This is called the stability fee. When $DAI is more than one dollar we want to incentivise the increase of supply and decrease the stability fee or the interest rates so that more people will be borrowing and more people will increase the supply of $DAI in the system.
When $DAI < $1
In the short run, people will use $DAI to repay their debt so people buy $DAI and use it to repay the debt and close the vault or just repay the stability fee. This reduces the supply which increases the price.
In the long run, we can increase the $DAI savings rate because then people want to put money in to earn the interest or the savings rate, which reduces the total supply.
You can increase the stability fee which makes it more costly for people to be printing or creating more $DAI which reduces the demand for available $DAI.
Crashes and Liquidations
It is important to think about what happens when the market crashes. Because these assets are backed by reserves, when the value of the reserves fluctuate the mechanisms to maintain that stability become ite volatile.
There are two ways to manage that kind of volatility:
Emergency Shutdown: The whole system stops minting $DAI and you can basically start closing your vaults because you start repaying the system.
Liquidation Mechanism: For people who cannot afford to repay their vaults the vault itself will be liquidated through auction mechanisms. They will auction out the vaults and the fees earned will be used to close and cover that vault and repay the system.
The system right now is still quite new and things can still be quite volatile. That is why there is a high percentage of collateral ratio of 150% but this can go all the way up to 175%. Any fluctuation in the collateral can greatly affect the stability of the token so having a higher collateralisation ratio reduces the impact that the volatility of the collateral will have on the stablecoin.
Maker VS Lending/Borrowing
Maker is quite similar to lending and borrowing but the difference is that the value of the asset that you are borrowing, or the stablecoin, is not managed by a secondary party but by the system itself. This allows for more customisation, more mechanisms, and more incentives to be programmed into the entire system.
By having all assets on-chain you have transparency as you can verify the data on-chain. This allows people to do risk calculations and to understand what is the total amount that is being capitalised or collateralised in the system, and compare it to other kinds of asset classes or different kinds of protocols.
Transparency is actually a very big plus because when everything is on-chain you cannot fake the data. Yes, you can have some transparency even if everything’s off-chain, but you can still fake your data. When everything is on-chain no one has control over the data and it is all 100% transparent for everyone to see. This is the major benefit of on-chain versus off-chain collateral.
Instead of $DAI being backed by just one asset ($ETH), they are backed by a variety of assets.
The thing to think about is the recovery rate of these assets. When they fall, they are correlated but have different recovery rates. That means that some assets recover really quickly while others do not. This happens because macroeconomic activities cause the market to fall, but the speed of recovery is related to the microeconomic activities within the ecosystem itself.
For example, Yearn fell and rose quite quickly then fell and rose again and that’s because of the strength of the community. The token is adding value to different people so they are demanding it.
When your collaterals are uncorrelated in the sense that the recovery rates are different, then that can help the stability of $DAI quite a bit.
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Maker is an alternative source of leverage. It is an alternative way to gain access to leverage for those who do not wish to lodge assets with a centralised exchange. Borrowing from Maker could also be cheaper when stability fees are low.
Besides, any losses incurred by $DAI holders are backstopped implicitly by $MKR holders, who will be diluted in case the system as a whole becomes under-collateralised. This is a major advantage that Maker has versus other lending platforms on the market, where any losses are borne by the lender.
However, MakerDao has some disadvantages. The governance process can take some time before changes can happen, and $DAI could trade away from the peg for sustained periods if governance does not react quickly enough.
There are risks in collateral prices falling too quickly so that the system cannot liquidate in time. In these cases, the system can become under-collateralised, leading to losses for $MKR or $DAI holders (depending on the whether $MKR holders/stakers are willing to assume losses). During periods when the price of collateral is falling rapidly, vault creators tend to rush to buy $DAI to close out their vault positions, leading to high $DAI prices relative to the peg. This can lead to a relative weakening of peg.
MakerDAO is a novel and innovative protocol that allows for on-chain collateralised borrowing, while also creating a reasonably effective stablecoin. This gives the crypto community an alternative to fiat-backed stablecoins like $USDT. Furthermore, $MKR holders continue to make continual improvements to the protocol, so it is very likely that the risks we have outlined could largely be mitigated in the future.