This piece provides an overview MakerDAO including how it functions and what long-term potential it may have.
What is MakerDAO?
MakerDAO, also known as Maker, is a crypto-collateralized stablecoin that uses a two-token system comprised of Dai, which targets a value of $1 per unit, and Maker (MKR), which is used to pay fees on Dai loans and grants governance input via voting on Maker’s policies, like the collateral ratio required on loans and the amount of fees charged on loans. Maker has a fixed maximum supply and when it is used to repay Dai loan fees it is burned, thereby reducing the circulating supply. To keep the price of a unit of Dai at $1, Maker employs incentive mechanisms that will be detailed later in this piece. For greater context on stablecoins as a category and the different approaches taken by projects, refer to this April 2018 piece that provides an overview.
How MakerDAO Works
As described in the MakerDAO whitepaper, “Maker is a smart contract platform on Ethereum that backs and stabilizes the value of Dai through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.” This piece will examine each of these components in greater detail later, but the takeaway is that Maker allows anyone to use Ethereum as collateral to generate Dai, an asset that is pegged to the value of the dollar by incentivizing external actors. Once Dai is generated, it can be used like any other cryptocurrency: it can be freely sent to others or used as payment for goods or services.
Collateralized Debt Positions (CDPs)
CDPs are a fundamental part of Maker and allow for collateral to be held in a smart contract to generate Dai. CDPs require collateral in excess of the value of Dai borrowed and also determine the terms for interest to be paid on top of the return of Dai.
To initiate a loan, a user takes the following steps:
- A user sends a transaction to Maker to create a CDP. Then, the user sends another transaction to fund the CDP with collateral.
- Next, a user sends a transaction to retrieve the desired amount of Dai from the CDP. The CDP records the debt initiated and locks access to the collateral until the debt is repaid.
- To retrieve the collateral, a user must repay the borrowed Dai plus a “Stability Fee” which can be considered interest on the borrowed Dai. The Stability Fee can only be paid in MKR.
- Once the Dai is repaid along with the Stability Fee, the user can retrieve the collateral by sending a last transaction to Maker.
For now, CDPs can only be collateralized with Ether. To stake Ether, users send an amount to a smart contract that holds all contributed Ether and receive Pooled Ether (PETH) in return, which represents a proportional claim on a share of the pooled contributions. This arrangement of pooling contributions will become relevant later when examining how Maker deals with sudden market crashes. In the future, it will be possible to collateralized CDPs with other assets to create multi-collateralized CDPs.
Stabilizing the Price of Dai
Dai is targeted to a price of 1 USD, the Target Price. The target price is used to find the collateral-to-debt ratio of a CDP and to determine the value of collateral assets Dai holders received in the event of a global settlement scenario, which will be explained in the next section.
The price of Dai is maintained by the Target Rate Feedback Mechanism (TRFM). The TRFM modifies the Target Rate in order to incentivize actors to move the market price of Dai towards the Target Price.
The impact of the TRFM can be seen in the following scenarios:
Dai price at $1: The TRFM is not engaged and the Target Price and Target Rate stay the same.
Dai price below $1: The Target Rate increases, which causes the Target Price to increase at a higher rate, which causes generation of Dai with CDPs to become more expensive. The increased Target Rate causes the capital gains from holding Dai to increase, leading to a corresponding increase in demand for Dai. This combination of reduced supply and increased demand causes the Dai market price to increase, pushing it back towards the Target Price.
Dai price above $1: The Target Rate decreases, which increases demand for generating Dai and decreases demand for holding it. This causes the Dai market price to fall, pushing it toward the Target Price.
Maker has a “sensitivity parameter” that determines the magnitude of the change in the Target Rate in response to a dislocation in the market price and target price for Dai.
In the event that the TRFM is unable to stabilize the price of Dai, global settlement offers a backstop guarantee of the target price to Dai holders. Global settlement refers to an unwinding of the Maker platform and can be triggered via a vote by MKR holders.
The Global Settlement function can be activated by a vote by designated members, as selected by Maker Governance. The Global Settlement function stops CDP creation and halts the price feed at a fixed value which is used to process proportional claims. Global Settlement claims are processed and Dai and CDP holders are able to claim a fixed amount of ETH.
MakerDAO Risk Management
The safety of MakerDAO is a function of a variety of inputs and thresholds that can be modified by MKR holders.
Holders of the MKR token can vote to do the following: add a new CDP type, modify existing CDP types, modify the sensitivity parameter, modify the target rate, choose set of trusted oracles, modify price feed sensitivity, choose the set of global settlers.
These holders can also vote on a variety of risk parameters: debt ceiling (maximum amount of debt that can be created by a single CDP), liquidation ratio (the collateral-to-debt ratio at which a CDP becomes vulnerable to liquidation), stability fee (an annual percentage fee paid by every CDP), penalty ratio (the maximum amount of Dai raised from a liquidation auction that is used to buy up and remove MKR from the supply).
Treatment of Risky CDPs
A CDP can be automatically liquidated if the collateral-to-debt ratio reaches the Liquidation Ratio. In the event that a CDP is automatically liquidated, the Maker Platform will buy the collateral of the CDP and sell it off.
Maker launched in mid-December 2017 and has grown significantly since then. mkr.tools provides great overview statistics.
Maker is an exciting project that is gaining momentum quickly. In 2019, Maker plans to transition from only supporting single-collateral CDPs backed by ETH to the ability to support multi-collateral CDPs backed other assets. As usual for governance issues related to Maker, holders of the Maker token will be able to vote on which new assets should be approved for use within multi-collateral Dai. While the project is still in the early stages of development, its ambitions are bold: one of the project’s stated potential use cases is to serve as a global currency that is accessible by anyone, anywhere.
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An Overview of MakerDAO was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.