MakerDAO: What Is It and How Does It Work?

MakerDAO

MakerDAO has risen in prominence as an Ethereum-based central banking protocol that offers crypto lending and borrowing functionalities through its collateralized stablecoin, Dai. In this article, we will explain what MakerDAO is and how the protocol works.

What is MakerDAO?

MakerDAO is a decentralized global reserve bank that resides on the Ethereum blockchain. The Maker protocol leverages Ethereum smart contracts to automate the collateralization and lending of its stablecoin (called DAI), as well as provide other functionalities (like governance, for example).

In essence, MakerDAO has adapted the central banking model to the blockchain and opened up its governance to a network of token holders (MKR holders). As a decentralized central bank running on the blockchain, the protocol provides a stable cryptocurrency, also referred to as a stablecoin.

As it stands in the traditional system, the ability of a central bank to control the supply of money often leads to friction between the bank and fiat currency holders. When a central bank devalues its currency, it negatively impacts the poor disproportionately, who are likely to hold cash. Wealthier folks however are more immune since they have diversified into securities, real estate, and other non-liquid assets. One of the biggest challenges with that is the fact that most central bank decisions are made behind closed doors, lacking any democratic justification.

The Maker protocol solves this problem by issuing Dai (DAI), a fully collateralized stablecoin. Collateralized in this scenario means that a certain amount of ETH is locked in Maker smart contracts. Against this collateral, a user can mint a corresponding amount of DAI. By decentralizing central bank architecture to all MKR (MakerDAO governance token) holders, the protocol can increase or decrease interest rates, determine collateral-worthy assets, increase and reduce the total debt limit, and incentivize or disincentivize savings. Instead of a few technocrats controlling the protocol, everyone can basically become MKR holder and participate in governance.

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What is Dai and how does it work?

Dai (DAI) is a hybrid stablecoin that is backed by a basket of underlying assets, automated mechanisms, and external actors to maintain its stable peg to the USD. For every DAI being minted there is a corresponding amount of ETH held in MakerDAO smart contracts. The contracts are referred to as collateralized debt positions (CDPs). Users can lock up ETH in CDPs and new DAI tokens will be released to them in exchange for the collateral.

Important to note: The value of ETH in the CDPs needs to be greater than the DAI being released. In other words, the CDP must be over-collateralized. For instance, if a user locks up $300 worth of ETH, the CDP contracts will mint less than $300 worth of DAI. The amount of DAI tokens released will depend on the CDP’s collateral-to-debt ratio. Users are able to borrow Dai up to 66% of the collateral’s value, which equals to a collateralization ratio of 150%.

Moreover, should the collateral fall in value below a predetermined margin compared to the value of Dai tokens released, the CDP’s assets will be liquidated by arbitrageurs (called keepers) to keep the MakerDAO system in check. That way, the Maker protocol ensures that there is enough collateral to back all the DAI tokens in circulation.

Should a user wish to withdraw locked collateral, the user has to repay the Dai owed in the CDP, including the accrued stability fee associated with the debt. To do this, the required Dai as well as MKR tokens need to be sent to the CDP to cover the debt and stability fee (in MKR tokens) to retrieve the collateral.

In times of extreme market volatility, Dai uses a Target Rate Feedback Mechanism (TRFM) to dampen volatility and provide liquidity during demand constraints. As such, the MakerDAO protocol emulates what is traditionally referred to as monetary policy done by central banks. Equally important are the key external actors elected by the MKR token holders who are responsible for debt and collateral auctions, feeding accurate price data, and acting as liquidators in the event the Dai system meets catastrophic failure.

Key external actors include keepers, oracles, global settlers (emergency oracles), and Maker community members. Keepers benefit from the economic incentives offered by the protocol and carry out liquidations of undercollateralized debt positions, whereas oracles and global settlers are external actors who provide oracle services. Finally, Maker community members are individuals and organizations that provide ecosystem services like community management, for example.

MakerDAO offers several functionalities including:

  • The protocol offers a deposit option for ETH that are locked in Maker smart contracts and earn yield in the form of minted Dai tokens.
  • MakerDAO allows depositors to earn interest on the DAI they keep in the DAO’s bank. Dai tokens are locked in a DSR (DAI Savings Rate) contract and continuously accrue Dai based on DSR’s interest rate.
  • Lock in ETH, WBTC, LINK, MATIC, MANA, and more into a CDP as collateral and receive a low-interest loan in Dai tokens.

What are the risks and challenges with MakerDAO?

MakerDAO’s governance apparatus made up of MKR holders has come up with a strategy to oversee the liquidation risk from collateral volatility. Should extreme volatility result in the deposited collateral no longer covering the debt, the collateral is liquidated using an automated process enacted by keepers (arbitrageurs). The funds raised from the liquidation process are used to repay the outstanding debt and liquidation penalty fee.

Should the liquidation process fail to generate enough Dai to cover the debt, the debt position is transferred to the “Maker Buffer,” a pool containing fees generated on collateral withdrawals in addition to the liquidation proceeds. If the amount of Dai in the Maker Buffer is insufficient, then a debt auction will be initiated, and the protocol will mint MKR tokens and sell them to bidders to get DAI and recapitalize the system. This way, MKR token holders act as the ultimate backstop in MakerDAO’s decentralized central banking system.

Another threat to MakerDAO’s progress is a risk posed by new semi-decentralized collateral types accepted for its vaults. When it debuted in 2017, the protocol only allowed the use of ETH as the anchor reserve asset for Dai. However, that has changed and currently, more than half of Dai in circulation is backed by centralized stablecoins such as USDC, TrueUSD, and more. As such, the increased reliance on centralized stablecoins to maintain Dai’s 1:1 dollar peg also exposes the protocol to regulatory risk.

Lastly, MakerDAO depends on oracles to feed prices to its smart contracts. However, oracles are prone to spot price deviations as a result of the slow production of blocks needed for price confirmation. Unreliable oracle services can have devastating effects on MakerDAO debt holders as they can be stopped out due to inexact price feeds.

How to participate in MakerDAO

MKR is an ERC-20 token and the native governance token of the Maker Protocol. As explained, the token is also a recapitalization source for the protocol. To incentivize MKR token holders, they are given the privilege to govern the Maker protocol. The roles include adding new collateral types, regulating smart contracts that are enforcing CDPs, and adjusting risk parameters of the protocol including debt ceilings, liquidation ratio, and the stability and savings rate.

MKR token holders who are interested in participating in the governance of the protocol can check the Voter Onboarding Guide on how to begin.

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