Target Rate Feedback Mechanism

Maker controls the Dai-USD peg with its Target Rate Feedback Mechanism (TRFM). The Target Rate determines the price changes needed for Dai to reach the Target Price of $1 during market volatility. For example, if Dai is trading at less than $1, the TRFM will increase, causing the price of Dai to increase, which then causes the generation of Dai through CDPs to become more expensive. This effect concurrently causes Dai holders to gain a profit which will increase the demand for Dai. This newly increased demand for Dai causes the price of Dai to be pushed back up to its Target Price.

The TRFM and Target Rate are determined by exogenous market supply and demand dynamics. However, MKR voters can dictate the Sensitivity Parameter of the TRFM. The Sensitivity Parameter determines how quickly and to what extent the response of the TRFM should be when the Dai price deviates from $1. This Sensitivity Parameter (and the limitations voted on by MKR voters) ensures there is an adequate amount of response time to trigger a global settlement in the event of a network attack.

Peg Stability Module (PSM)

MakerDAO creates DAI primarily when users deposit collateral to permissionless vaults at an overcollateralized ratio. However, the minting technique alone does not protect against price swings across DeFi and DEXs. MakerDAO uses a combination of interest rate policy (via the Dai Savings Rate, which is now 0.01 percent) and open market operations (termed Price Stability Mechanism) in order to peg DAI to USD. 

Additionally, the Maker protocol offers a Peg Stability Module (PSM) that enables users to swap collateral directly for Dai at a fixed rate rather than borrowing Dai. The PSM was designed just like a regular vault but for stablecoin collateral. If users swap stablecoins for Dai, they experience no stability fee and a liquidation ratio of 100%. Unlike the case with regular vaults, users of PSM don't retain ownership of the asset and borrow Dai. Instead, they swap the asset directly for Dai. From the user perspective, the PSM is simply a DEX for swapping stablecoins at the best rates.

Via the Price Stability Mechanism, MakerDAO commits to swapping one unit of USD for one unit of DAI at a 1:1 ratio, allowing arbitrageurs to benefit if DAI moves above the peg. This algorithmic technique aims to dampen any excess demand for DAI by diluting the circulating supply. The strategy proved effective at limiting DAI's upside relative to the peg, while the downside is mostly managed through over-collateralization.

The PSM was designed to help keep the Dai peg close to $1 during times when Dai demand outstrips Dai supply. One other difference between a PSM versus a traditional vault is that the PSM allows Governance to collect fees on stablecoins at the point of the swap rather than over time. Another difference is ​​​​​​the stablecoins deposited into the PSM by users as collateral are allocated in the same big liquidity pool i.e. no siloed vaults.  This pool is known as PSM reserves. Essentially, a PSM is just a stablecoin vault type in the Maker Protocol and all the parameters that apply to vault types also apply to a PSM. 

The PSM offers several advantages:

• Increased stability due to the instant arbitrage opportunity when the Dai price diverges from the price of the collateral type underlying the PSM
• Fees are taken upfront 
• Because a PSM has no slippage (stablecoin to stablecoin), it attracts and executes significantly more volume than vaults

Maker requires oracles to provide real-time market price information to the system to adjust the Target Rate when needed. Oracles and Global Settlers are external actors and not native to the platform. Another key exogenous actor in the Maker ecosystem is Keepers. Keepers are independent entities, incentivized by profitable opportunities within the Maker system to contribute to the system. Keepers can also make a profit trading Dai and arbitraging the spread when Dai deviates from its $1 peg.

MakerDAO protocol, being an Ethereum dApp, is subject to the blockchain’s latency. The current block time of Ethereum’s blockchain is ~12 seconds with the network able to process ~25 transactions per second. Because Dai is an ERC-20 token that is built and exists on the Ethereum blockchain, and thus, Ethereum provides the infrastructure for consensus. 

Liquidations

Liquidation is the process of selling collateral to cover the amount of Dai a user has minted from their Vault when the loan-to-value (LTV) ratio crosses the predetermined threshold. It ensures that Dai is always backed by enough collateral (in USD terms)  by closing-out Vaults that are under their minimum required Collateralization Ratio. Liquidations are triggered automatically by the protocol in which the protocol sells/auctions enough of the collateral off to service the debt plus a Liquidation Penalty. The Protocol determines after comparing the Liquidation Ratio to the current collateral-to-debt ratio of a Vault. Each Vault type has its own Liquidation Ratio, and each ratio is determined by MKR voters based on the risk profile of the particular collateral asset type.

In May of 2021, Maker introduced Liquidations 2.0  after deficiencies in its prior liquidation method became apparent. The liquidation is actually an auction that anyone can participate in, and bidders in these auctions are known as Auction Keepers. They are external actors that are incentivized by profit to automate certain operations around the Ethereum blockchain. Proceeds from Liquidation Penalties are put towards the Surplus Auctions, which result in burned MKR.

Since then, liquidations are not handled via a single Dutch auction. In a Dutch auction, the collateral is initially priced at a high bid that gradually decreases until a buyer is buys at that price. If no buyer is present, the collateral continues to be discounted up to a predefined limit or until the auction ends.

In this scenario, potential liquidators must constantly decide whether to purchase at the present price or wait until the discount increases. If the second option is selected, the potential liquidator risks losing the asset to a competitor who is willing to purchase at a slightly higher rate. Thus, liquidators will choose to liquidate when the bid is profitable enough for them to accept.

Dutch auctions enable larger loans to be profitably liquidated at a reduced discount percentage compared to smaller loans.  Consequently, the discount can scale more effectively with gas prices over that period. During periods of network congestion, a greater percentage discount will be required to conclude the auction than during periods of network slack, all else being equal.

Source: Delphi Digital

Direct Deposit Module (D3M)

The Direct Deposit Module (D3M) allows the Maker ecosystem to interface with third-party loan pools. For instance, the DirectDepositAaveDai smart contract enables the transfer of DAI tokens from Maker to the corresponding loan pool of Aave. This smart contract's primary purpose is to ensure that the maximum variable interest rate for borrowing remains below an interest rate set by the Maker governance. In Aave, the variable interest rate of a pool is dependent on the pool's utilization, which is the ratio of total debt accepted to total liquidity contributed to the pool. Therefore, when pool utilization increases, the variable interest rate also increases. When utilization is high, this method encourages liquidity providers to deposit funds into the pool.