MakerDAO is a Decentralized Finance (DeFi) project with a crypto-collateralized, stablecoin DAI pegged to the US dollar. Its community manages the coin via a Decentralized Autonomous Organization (DAO). Users generate DAI by locking cryptocurrency in a Maker Vault at a certain Liquidation Ratio. For example, a 125% Liquidation Ratio requires $1.25 of crypto collateral value for each $1 of DAI.
The stablecoin is overcollateralized to account for crypto's volatile prices, and a Stability Fee is also charged. Your crypto is liquidated and used to recover any losses if your collateral drops below the Liquidation Ratio.
DAI remains stable as its DAO controls the Stability Fee and Dai Savings Rate. The Stability Fee affects DAI's supply by changing the cost of minting DAI. The DAI Savings Rate affects the coin's demand, changing investors' returns on staking DAI. When DAI moves from its peg, the DAO uses these two mechanisms to bring it back.
DAI has similar benefits as other stablecoins and crypto assets. It can be easily transferred worldwide, used to make payments, or lock in profits and losses. You can also use DAI as leverage and invest it in the DAI Savings Rate contract for interest.
To participate in Governance Polls and Executive Votes, users purchase MKR tokens that provide them voting power. These are used to alter the Stability Fee, DAI Savings Fee, team, smart contracts, and other topics.
Stablecoins are hugely popular cryptocurrencies that offer a middle ground between traditional finance and digital assets. As they mimic fiat currency while operating like cryptocurrencies, these blockchain-based tokens are attractive for "locking in" profits or losses.
To date, the largest market cap stablecoins have been fiat-backed. These operate by keeping a supply of reserves that back up the stablecoin. However, crypto-backed stablecoins are also popular. In this article, we'll examine one of the most famous examples, MakerDAO, and exactly how it maintains a $1 peg with volatile collateral.
What is MakerDAO?
Users access MakerDAO via the Oasis DApp. Here they can create collateral loans, take part in governance, and manage their existing Maker Vaults. These interactions rely on smart contracts and game theory, allowing DAI to maintain a relatively stable value. DAI can be used identically to fiat-backed stablecoins and provide the same benefits.
What is DAI?
Just like any other stablecoin, DAI has several benefits when used:
How does crypto collateral work?
Physical and fiat collateral
A pawnshop is a good example. You can hand over jewelry (collateral) in exchange for a cash loan. You can then either pay the loan back plus a fee to return your collateral or allow the pawnshop to keep the collateral and recoup their loss. Collateral acts as a safety net, and the same concept applies to mortgages and car finance. In these cases, the goods (property or car) act as collateral.
Crypto-collateralized stablecoin like DAI accept crypto as collateral rather than fiat. A smart contract with rules manages these funds: issue X amount of stablecoin tokens for Y amount of ETH deposited. Return Z amount of ETH when the X amount of stablecoin is given back. The exact amount of collateral needed is up to the project issuing the token. This ratio will depend mainly on the collateral asset's volatility and risk.
What is DAI overcollateralization?
Stable and relatively low-risk assets like fiat, precious metals, and property are the usual favorites for collateral. As we mentioned, using crypto as collateral is riskier for lenders as its price can change wildly. Imagine a project that asks for $400 of ETH in collateral for 400 tokens pegged to USD.
What are collateralized debt positions (CDP)?
What are Maker Vaults?
1. You deposit supported cryptocurrencies to the Maker Protocol.
2. The deposit opens a Maker Vault position.
3. You can withdraw Dai determined by your collateral amount. You will also need to pay the Stability Fee.
4. To get your crypto collateral back, repay the withdrawn DAI.
You're free to generate or return Dai and add or withdraw your collateral at any time. You must, however, maintain the Liquidation Ratio shown in the Vault. If you drop below this ratio, the Vault will liquidate your collateral.
How does the DAI's value remain stable?
Apart from reducing the risk for MakerDAO as lenders, the CDP mechanism helps peg DAI to USD. MakerDAO can also vote to alter the Stability Fee and DAI Savings Rate (interest paid to stakers in the DAI Savings Rate smart contract) to manipulate supply and demand for DAI. These three tools work together to maintain DAI's $1 peg. Let's see exactly how it happens:
1. When DAI dips below the peg, the system makes it attractive for users to repay their debts, retrieve their collateral, and burn their DAI. This can be achieved by raising the Stability Fee, which makes borrowing more expensive. The DAO could also increase the DAI Savings Rate, increasing demand for investment in the token.
2. When DAI is above its peg, the opposite occurs. The DAO creates incentives to generate DAI if the Stability Fee is lowered. This creates new DAI and increases the total supply, lowering the price. MakerDAO could also decrease DAI's demand by reducing the DAI Savings Rate, meaning investors look elsewhere to earn interest.
DAI's use cases
As mentioned, DAI is used like any other stablecoin and shares the same benefits. You don't even need to generate it yourself and can purchase DAI on the crypto market, like with Binance. DAI also has a couple of unique use cases:
Where can I buy DAI?
How do I participate in MakerDAO's governance system?
As the dominant crypto-collateralized stablecoin, DAI has been a proven success. The system mitigates the volatility of crypto all without fiat collateralization, which is quite a feat. You also shouldn't forget its importance in the history of DAOs. It's one of the longest-running and largest DAOs that paved the way for many others. If you decide to experiment with DAI, don't forget that it runs the same risks as other stablecoins.