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MakerDAO: how does it work?

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Maker is the protocol used to generate and manage the decentralized algorithmic stablecoin DAI.

The MakerDao Project

The MakerDAO project was launched in 2015 with the private sale of the MKR token, while DAI’s ERC-20 token was launched in early 2018. Its operation is quite complex, with DAI using ETH, or other ERC-20 tokens such as BAT, as collateral, but its value is kept algorithmically stable at parity with the US dollar (1 DAI equals 1 USD).

Since the value of ETH, BAT, or other ERC-20 tokens is not only not as stable as that of the US dollar, but it varies significantly, and since MakerDAO is a decentralized protocol, it is necessary to have special algorithms imposing almost forcibly that its value is always in line with that of the US dollar, regardless of price fluctuations of ETH or other collateral.

To generate DAI tokens it is first necessary to lock ETH tokens, or other ERC-20 tokens such as BAT, which will constitute the collateral of the DAI generated, and act as a guarantee of their value.

This was initially allowed by the so-called CDPs, the Collateralized Debt Positions that could be created through the MakerDAO smart contract. However, since the old DAI token, collateralized only in ETH, has been renamed to SAI, whereas the DAI ticker has been reassigned to a new token multicollateralized with various ERC-20 tokens, the old CDPs can only be used to obtain SAI, while to obtain the new DAI it is necessary to use the so-called Vault.

Moreover, there are now only just over 21 million SAIs in circulation, while the new DAI are now over 122 million. In other words, the process of conversion from SAI to DAI is still underway, and has already reached 84% of supply. The Vault makes it possible to obtain DAI tokens by locking collateral funds, which can then be released and reimbursed again by returning the DAI tokens obtained.

The Value of DAI

Source: Blockonomi

The DAI must be overcollateralized, i.e. the value of the funds locked as collateral must be higher than the value of the DAI tokens that are obtained in return. This guarantees the value of the DAI tokens even in the event of a significant drop in the value of the reserves themselves, so as to protect the value of the DAI tokens even in the event of a collapse in the cryptocurrency market. The value of DAI must remain constant around 1 USD even in the event of a significant drop in the US dollar value of ETH, for example, and the only way to achieve this is to overcollateralize it.

In general the liquidation ratio on the basis of which it is necessary to overcollateralize DAI is 150%, so for example with this ratio it is necessary to lock in the Vault funds for at least $1.5 to create a single DAI token worth $1. Ever since DAI was put on the market in early 2018, the value of ETH has fallen from over $1,300 to less than $90 in December of the same year, before rising to over $300 in June 2019, and despite these huge fluctuations the value of DAI has always remained very close to $1.

Therefore the old CDP, and the new Vault system, have proved to be able to withstand very strong fluctuations in the prices of collateral without adversely affecting the value of the algorithmic stablecoin, precisely because of the overcollateralization. The process of generating DAI tokens with the locking of a collateral corresponds in fact to taking out a loan. The loan is provided by the Vault itself, i.e. by an element of a decentralized smart contract.

In other words, it is a loan without a single lender, managed entirely by a decentralized and virtually unchangeable computer code. This allows anyone to obtain a DAI loan by locking ETH or other ERC-20 tokens in the Vault and paying off the loan by returning the DAI tokens to recover the funds locked up as collateral, without any hindrance or limitation.

This is possible at any time, and without any time limitation, but the debt repayment process involves not only the repayment of the DAI created, but also of the Stability Commissions. This is a variable-rate, non-retroactive commission, the percentage of which is decided by the MakerDAO governing body by means of special votes. During the entire duration of the loan, stability commissions are constantly accumulated and must be repaid in full when the debt is repaid. In addition, if the total amount of the debt position, including stability commissions, exceeds the value of the fixed assets as collateral, the debt position itself is automatically liquidated with the sale of all collateral and the immediate repayment of the loan. In this case, the user who locked the funds in the Vault in order to borrow the DAI loses possession of the funds locked in the Vault and is no longer able to recover them in full.

In such cases there is also a liquidation penalty which is paid by using the funds locked as collateral. These liquidations happen through auctions that take place through the Maker protocol. A portion of the Vault collateral that is no longer sufficiently guaranteed is auctioned so that the debt position can be completely extinguished and the liquidation penalty is paid with what is collected from the auction. Any unsold collateral is returned to the owner, and any DAI generated with the Vault is burned.

Obviously this means that whoever starts a loan generating DAI with the Vault must pay particular attention to the amount of funds locked up as collateral, and to the variation of their value over time, in order to avoid automatic liquidation. Alternatively, they can voluntarily settle the debt position by destroying the DAI created and recovering the entire collateral after deducting the stability commissions accumulated over time.

Therefore, owning a Vault is an operation with a certain degree of risk, which can be reduced for example by overcollateralizing the DAI well over 150%. To keep the value of DAI as close as possible to that of the US dollar, the so-called DSR, i.e. the DAI savings rate, is employed. This is a variable rate whose value is controlled by MKR token holders through the MakerDAO governance platform.

Source: Cryptonomist

The regulation of this rate is able to increase, or reduce, the demand for DAI on the market, and this makes it possible to offset any imbalance in the price of DAI in dollars by increasing it when it is too low, or reducing it when it is too high. In particular, increasing the DSR increases demand for DAI, while reducing it, lowers demand. This is enough to keep the price of DAI consistently close to USD 1.

The DSR is the interest rate perceived by those who lock their DAI into the smart contract of the DSR. Holders of DAI tokens can lock them into the DSR’s smart contract in order to receive interest from the stability commission paid by those who borrow DAI by opening a Vault. The change in this rate causes DAI holders to lock the tokens in the smart contract, affecting the market supply and demand for the token.

As a result, variation in the DSR allows the demand and supply of DAI tokens on the market to vary. By carrying out these changes in the DSR rate properly, it is possible to keep its value pegged to the US dollar through the process described above. Moreover, it is currently not possible to set a negative RSR, although the owners of MKR tokens could vote for a change to make it possible. The DAI locked in the DSR smart contract cannot be used in any other way.

First decentralized algorithmic stablecoin

This complex system, based on variable rate loans and decentralized smart contracts, allows DAI to be the first decentralized algorithmic stablecoin in history, with a value that hardly deviates from that of the US dollar.

For example, since the release of the new multicollateralized DAI, its value has peaked at a minimum of $0.968 for a single day on January 16th, while on December 17th, 2019 it peaked at a maximum of $1.02. It does actually have a higher volatility than, for example, USDT, another stablecoin pegged to the US dollar, but centralized. In other words, DAI sacrifices a little bit of stability in order to be decentralized.

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