A Guide to MakerDAO and DAI

TL;DR

Stablecoins are great, aren’t they? It’s nice knowing that you can hold tokens without the risk of their price plunging overnight. Normally, you can do that because an entity promises to redeem each token you have for a fixed dollar amount. For example, you give them ten dollars and they give you ten tokens. Return them later, and you’ll get your money back.

In essence, it’s fiat currency ported onto a blockchain. If we wanted to have this same system without a middleman that we need to trust, we could use DAI. To mint some yourself, you lock your own cryptocurrency in a smart contract. To get it back, you just need to return the DAI along with interest. Of course, if you don’t want to worry about minting, you can just buy DAI on a Binance market, such as USDT/DAI.

Want to learn more? Read on.

Introduction

Stablecoins emerged as something of a middle ground between the legacy financial market and the nascent digital asset one. Mimicking the value of fiat currency while operating like cryptocurrencies, these blockchain-based tokens were initially attractive to traders as a way to “lock-in” their profits.

To date, the most popular kinds of stablecoins have been fiat-backed ones. Typically, these are backed by USD – they maintain their value because there’s a big vault (somewhere) stacked with a dollar bill for each token issued. In other words, each token is worth 1 dollar and should be able to trade these for cash at any time. Some of the most popular stablecoins are USDT, USDC, BUSD, and PAX.

In this article, we’re going to look at a protocol called Maker (or MakerDAO). This innovative stablecoin system focuses on what we call crypto-collateralization. It removes the need for the vault we’ve just described.

What is MakerDAO?

Maker is an Ethereum-based system that allows users to mint DAI, a token that closely tracks the US dollar price. No single entity is in charge. Instead, participants hold the governance token (MKR), which grants them voting rights on changes to be made to the protocol. This is where the DAO (decentralized autonomous organization) part of the name comes from – the protocol is effectively governed by a distributed network of stakeholders that hold MKR tokens.

In this decentralized ecosystem, smart contracts and game theory allow DAI to maintain a relatively stable value. Aside from that, they’re functionally identical to their fiat-backed cousins. You can send them to friends and family, use them to buy goods and services, or stake them in yield farming.

Why is DAI “crypto-collateralized”?

When you provide collateral, you lock up something of value in exchange for a loan. When you repay the loan (plus a fee), you’ll get your item back. Consider a pawnshop, where you can hand over your jewelry (collateral) in exchange for cash. You’re given a period in which you can buy back the jewelry by returning the cash (and a little extra).

If you don’t return the cash, then the pawnshop can simply sell your jewelry to recoup their loss. In this way, the collateral gives them a safety net. You can see the same principle applied by banks – you might choose to collateralize a car or house in exchange for a loan, for example.

Similarly, a fiat-backed stablecoin is collateralized by fiat money. A user hands over their cash (the collateral) and receives tokens in return. They can return those tokens to the issuer if they want, but if they don’t, the issuer still has the cash.

A crypto-collateralized stablecoin – like DAI – does something functionally similar, except you use crypto assets as collateral, and the issuer is just a smart contract. At its core, the contract says something like issue X amount of tokens for every Y amount of ETH deposited. Return Z amount of ETH when the tokens are returned.

Things are a bit more nuanced than that with Maker – let’s check it out.

Overcollateralization and CDPs

You’ve probably noticed that crypto markets are quite volatile. You often see the price of BTC, ETH, and other cryptocurrencies change rapidly. Your holdings could be worth $4,000 when you go to sleep and $3,000 when you wake up the next day. To a lender, that’s pretty risky. At least with gold jewelry, they can expect it to remain relatively stable in value. If you fail to repay your loan, the lender can simply sell your jewelry to reclaim their money.

If you took out a loan of $400 (locking up 1 ETH worth $400 as collateral) and the price of ETH dipped to $300, the lender would be out of luck. They could either ask you to give them more ETH as collateral, or they could liquidate it and eat the loss of $100.

That’s why Maker uses the concept of overcollateralization. It’s a big word, but a simple idea: when a borrower wants to mint the DAI stablecoin, they provide more collateral than the amount they want to take out. That way, even if the price dips, the position should still be covered.

In practice, users lock up their ether (or other supported assets) in something called a collateralized debt position (CDP). At the time of writing, they must provide collateral of at least 150% the value of the DAI they’re borrowing. In other words, if you wanted to mint 400 DAI (remember, each is worth $1), you would need to provide 1.5x that value in collateral – $600 worth of ETH, in this case.

A user can add more than that if they want. In fact, that’s what most users do to stay safe. But, if the amount of collateral falls below 150%, they’ll incur a hefty penalty fee. Eventually, the user risks liquidation if they fail to repay their DAI with interest (called Stability Fee).

How does the value of DAI remain stable?

1 DAI = 1 USD (more or less). But why?

Well, it boils down to incentives and smart contracts. When DAI dips below the peg price, the system makes it attractive for users to close their CDPs by repaying their debts – specifically, because interest rates are raised. This reduces the total DAI supply, as the amount repaid is destroyed. Should the price exceed a dollar, the opposite occurs: users are incentivized to open CDPs as interest rates are lowered. This creates new DAI and increases the total supply.

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DAI’s use cases

As previously mentioned, you can use DAI like any stablecoin – trade it against other cryptocurrencies, use it to pay for things, or even burn it for fun. If the CDP stuff doesn’t sound appealing to you, not to worry. Similar to other cryptocurrencies, DAI can be bought on a crypto exchange like Binance.

MakerDAO was arguably one of the earliest Decentralized Finance (or DeFi) protocols. After all, DAI is a decentralized stablecoin and DeFi is all about building a "financial system, but on the blockchain." It doesn’t get much more DeFi than that.

There is a growing list of products and services that accept DAI. You might have noticed some DeFi-oriented decentralized applications where it can be used. Examples include PoolTogether and SushiSwap, as well as the myriad of yield farming systems.

Closing thoughts

As the dominant crypto-collateralized stablecoin, DAI has proven to be a successful experiment in creating a token that closely tracks the US dollar price. The system mitigates the volatility seen in traditional digital currencies (all without fiat collateralization!), taking a step away from the legacy financial system and towards a native digital one.

Do you still have questions about MKR, DAI or stablecoins? Head over to Ask Academy, where the Binance community will answer them.