MakerDAO Review: What Is MakerDAO And How Does It Work?

Brief History of MakerDAO

Lending and borrowing have always been widely used features and use cases of every asset class. However, cryptocurrencies as a new asset class were for long regarded as too volatile, and their price movement too excessive for them to be used for credit operations. Once a comprehensive global market of crypto assets was established, a new need emerged – a need for creating a crypto lending platform that would successfully overcome the key issue of crypto volatility. A concrete answer to that need was conceived in 2015, named MakerDAO.

MakerDAO was one of the first DeFi (decentralized finance) projects to be initiated. Its creator was a Danish entrepreneur Rune Christensen, who launched it in March 2015, long before the crypto fever swept the globe. He is still the head of the MakerDAO team, managing its constant development in the always choppy waters of crypto markets.

Christensen’s vision was simple, yet brilliant: creating a DAO – Decentralized Autonomous Organization on the Ethereum platform with the purpose of minting DAI stablecoins pegged to the US Dollar, the key element of the MakerDAO system which would enable people to easily lend and borrow crypto assets.

So, what came first was the community. After performing his own research, the first step was the establishment of the Maker Foundation in 2014, with the key role to develop and manage the entire project. Early followers that wanted to join the project could expect unique opportunities for them as participants of this novel investment protocol and as those who would set up and maintain its governance using blockchain technology.

In the summer of 2015, the Maker protocol and its governance token MKR were launched as an important part of the MakerDAO ecosystem, serving as the basis for the governance of the protocol. In late 2017, the world’s first DAI stablecoin was born, making way for a completely new array of decentralized finance services and relations between the people holding and using crypto assets.

What is MakerDAO Used For?

Crediting – Lending and Borrowing

MakerDAO is a community that consists of equal peers and a structured organization based on the Ethereum platform that allows its users to lend and borrow cryptocurrencies. The transactions are automated and impartial, as their running is performed by ERC-20 smart contracts.

Token of Choice for Humanitarian Activities

MakerDao’s DAI stablecoin is used for a large number of concrete applications. Among others, DAI can be donated to various humanitarian organizations and fundraising entities. The Dignity Network, for example, is an open-source platform for explorations of blockchain technology for social impact, powered by UNICEF France. Launched in 2018, the platform selected the Dai token to be the cryptocurrency used for making donations for it.

Other institutions and fundraising platforms followed suit, selecting $DAI to be the coin of choice for the new domain of humanitarian work – the crypto community.

Maker as the Inspiration for DAOs

Right after MakerDAO gained substantial traction, it inspired numerous cryptocurrency-funded groups that started to emerge in the form of DAO (decentralized autonomous organization). Organized loosely around a common goal, DAOs represent entities that combine crowdfunding with cryptocurrencies. Governed by holders of cryptocurrency tokens, these DAOs employ smart contracts that make democratic decisions through online votes by all participants who wish to take part. So, MakerDAO may be the most prominent one, but certainly not the only DAO operating in the crypto space.

Role in Gaming and NFTs

Several notable representatives from the gaming industry use Dai tokens for creating digital in-game properties and earning rewards. Gaming apps that are willing to integrate the support for DAI can turn to the Maker’s Dai Gaming Initiative – a project aimed at promoting Dai as the favorite digital currency for the virtual world.

Long before the latest NFT-related hype, MakerDAO stepped into the world of digital art. Rune Christensen, the co-founder of MakerDAO, once emphasized that the very nature of Dai gives artists, collectors, and other aficionados a chance to focus solely on the art, rather than the burdensome and menial tasks of transferring money from account to account.

Global Ambition and Ability

As the threat of global hyperinflation is looming, the MakerDAO system could be taken into consideration for becoming a viable alternative to traditional fiat money, with its currency used within or between countries. As El Salvador became the world’s first land to recognize Bitcoin as a legal tender, there are no conceptually relevant obstacles that would prevent any sovereign government from adopting a cryptocurrency as a legal tender, and DAI is certainly a fine candidate for being one.

DAI Stablecoin

DAI is an Ethereum-based stablecoin that is tied to the US Dollar and one of two monetary components of the MakerDAO platform.

Pegged to US$, Fully Collateralized

Being the MakerDAO’s native token, DAI can be borrowed by the network users against their cryptocurrency collateral deposited. DAI is minted by taking out a loan on MakerDAO. Once created, DAI has the properties of any other cryptocurrency. Its 1:1 ratio towards the US$ has been firm even when some other stablecoins failed. The majority of crypto trading platforms and decentralized exchanges support DAI.

The Dai stablecoin is a collateral-backed cryptocurrency that is soft-pegged to the USD, meaning that the exact exchange rate is set by the market, but within very narrow limits.

Minting DAI and Keeping It Stable

Dai is created and kept stable by collateral assets deposited into Maker Vaults (previously known as Collateralized Credit Positions or CDPs) – a smart contract on the Maker Protocol.

Every Dai in circulation is backed by excess collateral, meaning that the value of the collateral is higher than the value of the Dai debt.

Maker’s Dai stablecoin can be used for the same things as any other cryptocurrency – it can be sent to others, used as a payment method for goods and services, and even held as savings through a special feature of the Maker Protocol called the Dai Savings Rate (DSR).

Difference Between Centralized and Decentralized Stablecoins

Stablecoins are cryptocurrencies whose value is tied to that of another currency, commodity, or financial instrument. They are a countermeasure to the high volatility of other cryptocurrencies and a means for performing crypto trading more easily and predictably. Today, they are an indispensable component of managing riskier assets and a part of everyone’s crypto portfolio. Serving as a more user-friendly medium of exchange, centralized ones pursue price stability by maintaining reserve assets as collateral or through algorithmic formulas that are supposed to control supply (AMOs).

Centralized stablecoins (e.g. Tether or USD Coin) require the faith of the entire community that a third-party issuer holds sufficient matching collaterals. On the other hand, decentralized stablecoins are completely transparent, non-custodial, and have no or only limited third-party control. Various DeFi platforms use both types of stablecoins to counter the crypto market volatility.

DAI is created, backed, and stabilized by the usage of Ethereum-based collateral assets put into MakerDAO’s vaults. The stored funds serve as collateral. As the real value of collaterals surpasses the value of issued DAIs, DAI remains stable, being tied to the US dollar at a 1-to-1 proportion.

DAI Stablecoins and Maker Vaults for Depositing Collaterals

Besides DAI, the MakerDAO protocol has another native token, called Maker – MKR token. MKR token is essential to the platform’s existence and operation as it provides liquidity and resolves concerns brought by the accumulation of bad debt.

MKR token is used for exercising governance rights. It is also the ultimate resort for borrowers n jeopardy – if the collateralized assets cannot cover the amount of DAI in circulation, the system automatically starts minting new MKRs and selling it so that the borrowers can be reimbursed in full and kept safe from suffering losses.

Maker Vault itself is the virtual place where digital assets are deposited and stored as collateral for issuing DAIs. Besides Ether, any other Ethereum (ERC-20) asset (token, NFT) can be used as collateral. The only thing needed for an asset to be approved is the voting of the authorized network participants.

The Maker Vaults are smart contracts to deposit and leverage assets that will be used as collateral for taking a loan indexed and executed in DAI. The access to the Maker Protocol is quite simple and various interfaces have been created by the community. Maker Vaults are non-custodial and users can interact with the Protocol without an intermediary.

MakerDAO’s Risk and Collateral Mechanisms

To qualify for getting a vote on any changes to the Maker protocol, one has to hold a certain amount of MKR governance token.

But, even those with a valid ETH address – MKR token holders or not – can submit a proposal to change the protocol. Off-chain governance refers to processes for making decisions that do not require on-chain voting and gathering feedback prior to on-chain voting. Anyone can participate in off-chain governance, which is a strong additional democratic feature of MakerDAO.

The spectrum of voting rights of MKR token holders is wide and includes adding a new ETH-based asset as collateral, altering the risk parameters of existing loans, and many others.

One of the most important decisions qualified voters have to reach through their decentralized organization (DAO) is assigning the risk parameters to each valid collateral type because it will define the amount of debt that can be produced- the debt ceiling. They also decide what happens if the value of a specified collateral asset drops so sharply that it no longer covers the amount of issued debt and has to be liquidated.

The liquidation of an asset is done automatically. Robotic traders called Keepers (automated market actors) bid in Dai for the collateral from a liquidated vault. That Dai is later used for repaying the vault’s debt and a liquidation penalty fee. If there is enough DAIs for both repayment and paying the fee, the leftover collateral is returned to the vault owner.

However, if the collateral auction fails to produce enough DAIs for the settlement of obligations created by the vault’s outstanding debt, it becomes the “protocol debt” and is covered by Maker Buffer – a pool that contains the fees generated from approved collateral withdrawals, together with the proceeds from the auction. If the amount in the Buffer is also insufficient, a debt auction is triggered and new MKRs are minted and sold to bidders for DAI for the sole purpose of re-capitalizing the system.

The other risk management decisions MKR holders have to reach include:

• Stability​ ​Fees:​ annual percentage yields calculated on top of how much Dai has been generated against assets placed into the Maker Collateral Vault. The fee is paid in Dai and then sent into the Maker Buffer;
• Liquidation​ ​Ratio:​ ​A low Liquidation Ratio indicates that the governing body of network participants expects low price volatility of the collateral, while a high Liquidation Ratio means high volatility is expected;
• Liquidation Penalty:​ This is a fee added to a Vault when a Liquidation occurs. The Liquidation Penalty is used to encourage Vault owners to maintain appropriate collateral levels.

How Are MKR Tokens Produced?

The initial supply of MKR tokens was 1 million. At this moment, there are approximately 980,000 MKRs in circulation with a market cap of 870M US$. But the total supply of Maker tokens varies, depending on market prices and conditions.

If cryptocurrencies stored in the Maker collateral vaults suddenly drop in price, they may no longer have sufficient value to collateralize the generated DAI stablecoin, leading to liquidation.

In the case that Dai raised in the auctions is not enough to cover the vault’s obligations, new MKRs will be minted. Oppositely, if more than necessary DAIs are generated, they are used to buy back MKR tokens and burn them. That is why the MKR changes dynamically, with the single goal of keeping 1 $DAI pegged at $1 US$.

Is MakerDAO Regulated?

As we have seen, MakerDAO is a digital community that has transparent rules adopted democratically and enforced mostly automatically. These sets of rules cover all aspects of the functioning of the Organization and its operations, especially those connected with the realm of supported financial transactions and services. The transparency, predictability, and impartiality of the ecosystem guarantee the firm reputation of MakerDAO protocol, even in times of hardship for the entire crypto world.

The external regulations affecting MakerDAO protocol may originate from various national governments or industry stakeholders, but those regulations apply to all similar entities where MakerDAO is not any kind of exception.

Is MakerDAO Trustworthy?

According to its founder, the key element of MakerDAO’s trustworthiness is its full decentralization. to go a step further, Rune Christensen even dissolved The Maker Foundation, giving the community 100% of the power of self-regulation and self-administration.

The structural setup has kept the system and its products up and running smoothly. However, there are a few inherent risks that might jeopardize it. Malicious hack attacks against smart-contract infrastructure may occur, but MakerDAO is no exception and that can happen to any similar platform. On the other hand, unforeseen adverse events may involve one, or more, collateralized assets (including the market meltdown), putting the system at risk of collapse.

How Does DAI Make Money?

Upon the debt repayment, a predetermined number of DAIs is destroyed – the same amount that was generated when the loan was issued. Users have to pay an interest fee denominated in MKR which leads to its destruction, thus reducing the quantity of MKR tokens in circulation and increasing its price.

If the demand to generate DAI increases, users are incentivized to create more loans by depositing collateral assets into vaults and subsequently closing the positions. As the number of DAIs gets bigger, more MKRs are burnt. This concept and specific deflationary environment are attractive to investors who can buy MKR in the open market.

The deflationary environment leads to the scarcity of the token. As it increases, the price of MKR goes up. MKR is therefore lucrative to borrowers as well. This is because as a user, you can lend yourself a DAI loan by locking up your ETH collateral and creating a Collateralized Debt Position.

The largest systemic risk for the Maker protocol and the entire Dai credit system is that the price of Ethereum crashes, making all the collateral in the Maker ecosystem worthless.

There is also the risk that the number of bad loans can increase to the point where the price of MKR tokens decreases significantly.

Choosing Maker

Maker was the first DeFi ecosystem to achieve significant adoption in the DeFi industry and is run efficiently by a community of MKR holders. Those MKR holders make MakerDAO work smoothly, allowing it to strive for new forms of application such as cross-border transactions for international business trade, for example. Being the DeFi ecosystem with proven use cases, Maker’s future should be bright.