What’s MakerDAO and what’s going on with it? Explained with pictures.

What is MakerDAO?

MakerDAO is a protocol behind the stable coin DAI — a cryptocurrency that maintains a 1:1 peg to the USD. Think of 1 DAI as $1. What makes it unique is each DAI is backed by Ether instead of a 3rd party claiming to have the required collateral. Since Ether is volatile this poses some interesting challenges to maintain the peg.

The project was started in 2015 and did not conduct an ICO, instead choosing to privately sell MKR tokens to fund development over time. Maker’s DAI stable coin launched at the start of 2018 and has experienced significant traction since then.

Why do we need DAI?

Dealing with crypto’s volatility is a problem. As many in the blockchain space know, DAI is not the first stable coin in the space. Predecessors include Tether, TrueUSD and a few others. However the risk of all of these projects is that the custodial party holding the real US dollars will refuse redemption of the stable coin for any regulatory reasons. This goes against the ethos of crypto being permissionless. Furthermore, we have to trust that the custodial solution actually has the correct amount of US dollars and not creating artificial inflation.

Who’s using it?

DAI is arguably the most successful project built on Ethereum at this point in time. It currently holds 2% of all Ether inside its smart contracts and has issued over $77 MM in DAI (debt) in its system. In addition, Maker continues to see perpetual 20% month-on-month growth in terms of the DAI issued with 71% of users spending their DAI as soon as they acquire it. This signals a shift of usage rather than speculation.

Source: https://medium.com/makerdao/dai-in-numbers-2710d8a5633a

How does it work?

The basics of the system, work like this:

You deposit/send Ether to Maker’s smart contract, creating a Collateralised Debt Position (CDP).

Say you deposited 1 ETH (worth $100), this will allow you to take up to 40 DAI (assuming a 150% collateralisation rate $100/1.50) against your $100. However, if the price of Ether drops below $100 your CDP will be forcefully closed. To stop this from happening you need to put in more Ether or take out less DAI in the first place. This is to ensure there’s always enough capital locked against the amount of money being taken out.

If you want your Ether back, you need to pay back the amount you took out with the addition of a minor fee.

It can be a bit overwhelming.

Here’s a few simple examples of how the lifecycle of a CDP might play out assuming the price of Ethereum is $150 and you deposit 1 ETH at this price:

You decide to take out 50 DAI which means your CDP is collateralised 300%. As long as the price of Ethereum doesn’t drop below $75 (50 * 150%) your position will be safe. After one year, you decide to pay back the 50 DAI and retrieve your Ether locked up. Upon closing the position or other interactions with your CDP, you’ll pay the annual stability fee (set at 3**.5%** as of March 2019).
You decide to take out 100 DAI which means your CDP is collateralise at just 150%. The price of Ethereum drops to $100 which means your CDP is under-collateralised by $50 ($100*1.5 = $150 < $100). A 3rd party will realise that you don’t have enough collateral and liquidate your CDP on your behalf. This results in your position being liquidated by 3rd parties with a penalty. These 3rd parties have various ways to profit from your position being liquidated.
You decide to take out 75 DAI which means your CDP is collateralised at 200%. The price of Ethereum rises to $300 due to the bull market starting. Your CDP is now collateralised at 400%. Since you’re an ETH bull and you think the price won’t go down, you decide to draw an extra 100 extra DAI putting your CDP ratio at 175%.

Who Controls the System?

Inside the MakerDAO ecosystem, their native MKR token allows token holders to influence certain aspects of the protocol such as:

What should the be the annual borrowing fee be (stability fee)?
How much collateral should be backing each CDP (collateralisation ratio)?
Shutting down the protocol in the case of a flash crash of the price of Ether or any other unforeseen situation (emergency shutdown)?

One important piece of information I haven’t mentioned so far is the fact that when the stability fee is paid, a dollar equivalent amount of MKR is purchased off the market to pay the stability fee. This means that MKR is actually a deflationary currency.

At its core, MakerDAO is like a credit facility that issues loans with a certain interest rate. If the interest rate (stability fee) is low, people are encouraged to borrow more (lock up more ETH). If the interest rate is high, the cost of capital is high making it less attractive to borrow (close out CDPs). Recently, DAI has been consistently been trading on exchanges below $1. A big reason for this is because there is significant pressure from DAI holders to sell. DAI can only be generated via the opening of CDPs. To bring the peg back to its correct target price, MKR holders voted to increase the stability fee from 1% to 3.5% in hopes that it reduces the incentive to open CDP (and close existing CDPs) to increase the buy pressure. In the future the Maker team plans to introduce the Dai Savings Rate, which will allow DAI holders to lock up their DAI and earn interest. The interest paid to holders is financed from the stability fee that currently goes to purchase and burn MKR.

Now in the case that the MakerDAO system contains less collateral than it’s supposed to (flash crash of Ether), additional MKR is issued and sold on the open market to pay back ETH and DAI holders. It is for this reason that MKR holders don’t want to set the collateralisation ratio too low as they’re the buyers of last resort. However, they don’t want to set it too high as the cost to borrow increases.

Positive ETH Feedback Loop

A type of behaviour that we can’t confirm but can speculate happens is CDP holders doubling down on their positions (or going “long” on ETH).

Essentially it goes a little like this:

Open a CDP with a 200% collateralisation ratio
Wait for the price of Ethereum to appreciate
Draw more DAI from your CDP (because you can without decreasing your collateralisation ratio)
Purchase more ETH with your newly minted DAI
Add ETH to your CDP to over collateralise your CDP to safeguard against any market down turns

While it sounds quite harmless, tomorrow if ETH appreciates to $500 from its current $150 price, the current 250% collateralisation ratio (average) would increase to 75900%. Based on current numbers it means 150M dai could be minted which could cause significant buy pressure on Ether causing a positive feedback loop. The current 100M debt ceiling limits this from happening but will most likely be increase with the introduction of multi-collateral DAI.

Multi-Collateral DAI

So far the MakerDAO experiment seems to be a success amongst the community and is growing every month. However a big limitation is you can only use Ether to collateralise your CDPs. With the introduction of multi-collateral DAI you could use any ERC20 token to collateralise your CDP. You could actually use your wrapped Bitcoin to collateralise your CDP!

While it all sounds good there’s two implications which Maker fans should be aware of:

Using custodial assets such as wrapped Bitcoin (backed by BitGo) could result in undercollateralised CDPs if issuers are forced to freeze assets. An example of this is authorities telling BitGo they’d like to blacklist wrapped Bitcoin from MakerDAO’s addresses. This means that the value of the Bitcoin backing the CDP is worthless.
Since Ethereum isn’t the only asset inside the collateral, it means that any positive feedback loops from the ETH price can’t be realised as there’s less ETH to actually contribute. I don’t see this necessarily being a bad thing but it’s worth being aware of.

Final Remarks

Thing such as the positive ETH feedback loop and Dai Saving Rate are going to be really exciting to see come to life as we’ve never seen anything like it at scale. Coupled with all the other open finance projects, this experiment is going to be exciting to see play out!

I personally think Maker is the third most successful experiment after Bitcoin and Ethereum. The team has stayed true to the values of crypto, engages with the community and has shipped a meaningful contribution to the entire space.

They also throw amazing parties but that’s for another time.