The MakerDao is a smart contract on the Ethereum blockchain representing a decentralized collateral-backed cryptocurrency (DAI - a stable coin following the value of the US dollar), providing collateral loans, and a community governance system.
The premise for the need for a type of cryptocurrency such as DAI is the fact that Bitcoin and Ethereum, the most popular assets, are extremely volatile. They often gain and lose value at amazing rates, making them unsustainable for everyday transactions.
MakerDao hopes to resolve this issue with the use of DAI, a stablecoin which unlike other counterparts is completely decentralized. DAI is the foundation of the collateral loan system, which we will discuss in greater detail later.
The community governance system relies on another token called MKR, which represents a stake in the decentralized organization. MKR token holders have special rights and abilities in the platform, and are necessary for its continued optimal performance. Think of them as owner stakeholders and decision makers of the system.
Who should be interested in MakerDAO?
In order for any blockchain solution to be useful, it needs to provide value by solving a problem. The main problem that is solved by MakerDAO and DAI is the creation of a cryptocurrency which is price stable. This makes DAI an optimal choice for the entire blockchain industry.
Outside of blockchain, these following businesses can find value in MakerDAO:
- Financial Markets - CDPs allow for permissionless leveraged trading, as such DAI is a great candidate for collateral in options or CFD’s.
- Merchants - International payments and currency exchange, lack of intermediary, and mitigation of foreign currency are all benefits for international merchants looking to improve their bottom line.
- Accounting Systems - For organizations looking for transparent booking can utilize DAI as a main source of income, which will guarantee a clearer track of money movement through the organization.
- Prediction Markets - Making bets on the future with a volatile asset, required the bettor to also bet on the future value of the asset, increasing the risk of making the prediction.
- Gambling applications - Gambling is similarly identifiable. Using Bitcoin or Ethereum to gamble with can be seen as too risky, as their value can change dramatically over the course of a few days. Losing 1 BTC in 2015 meant losing $200-400, but losing one now will cost you $7000-8000.
In this section, you will find information that relates to DAI, the issuance of the token, its role in the ecosystem, the price stabilization mechanism, and DAI savings rates. In general, after reading this section you will be familiar with the tokenomics of these digital assets and be able to clearly understand its role and function.
Collateralized Debt Positions
DAI is the fuel that drives MakerDAO’s collateral loan system through the use of a smart contract called Collateralized Debt Position (CDP). The user can deposit any of the acceptable collateral assets (only ETH at this particular moment) in the system and receive a smaller amount of DAI in return.
When a user activates the CDP smart contract with a deposit, he or she is allowed to generate DAI, but this token generation also creates and an equivalent amount of DAI debt associated with the user’s account. This debt locks down the collateral deposit, which can be released by paying off the debt with DAI. The DAI generated as a result of making a collateral deposit is always of lesser value compared to the collateral. You can read more about this in the “Risk Management” section of this article.
How does the CDP smart contract work?
To better understand how the CDP smart contracts work, MakerDAO describes a four-step process that encapsulates the interaction.
- Activating the CDP by making a collateral deposit. The user that wants to enter a collateralized debt position first needs to make an initial transaction to create a personal CDP smart contract entry. After its creation, the user proceeds to deposit the amount (and eventually the type) of collateral, which serves as the basis for DAI generation. Once complete the CDP is collateralized, and the DAI is ready for generation.
- Generating DAI from the completed CDP. Once the CDP has been fulfilled, the user needs to make a transaction to withdraw the amount of DAI they want from the CDP, at which point they also acquire the equivalent amount of debt, effectively locking the access to the collateral until it has been paid off.
- Retrieving the collateral. Once the user is ready to retrieve their collateral, they need to first settle the debt created by withdrawing DAI (with DAI tokens), and pay a stability fee which is added for maintaining the price of the token (More on this later). Paying the stability fee can be paid in either MKR or DAI (although DAI payments can only be made through the CDP Portal UI). Once both debt and fee are paid, the collateral is released and ready for withdrawal from the CDP.
- Withdrawing the collateral is easy and simple once the debt and fees have been covered. The user can freely retrieve all or some of their deposit back to their wallet by making a simple transaction.
Collateral Asset - Pooled Ether
For now, the only type of collateral accepted on the Maker platform is called PETH, which stands for Pooled Ether. In order to open and activate a CDP and generate DAI tokens, users need to obtain PETH. Maker has a special smart contract which pools ETH from all users and provides PETH to the user making the deposit. According to Maker, PETH helps the platform maintain an equivalent relationship with ETH on a global scale. Market effects on ETH price will only affect the exchange ratio between PETH and ETH. In theory, it should work both ways, with the ratio increasing as ETH values rise, and decreasing as ETH values fall.
This is by no means the best explanation of PETH and how it works, so if you have a better understanding than I do, please write a comprehensive comment. I will edit this article in the future to include the best possible explanation for this part of the guide.
How can DAI be considered a stablecoin?
DAI is a stablecoin which strives to have the equivalent value of 1 USD. In order to achieve this in a decentralized manner, there needs to be a mechanism to provide stability to the price of the asset.
In the grand scheme of things a “DAI Savings Rate” (more on this in the “Future” section) will be used to manage the asset’s stability, but since Maker is still in the early stage (Single-Collateral DAI), this feature will not be used. Instead, the stability will be achieved through “Stability Fees” on CDPs, either encouraging or discouraging the creation of new CDPs.
Current Asset Market Prices
MakerDao’s Risk Management
There are a lot of risks involved with any form of asset, and there is a natural tendency to avoid risks. MakerDAO is no different than traditional financial authorities (such as national banks) in the sense that they are able to slightly manipulate the marketplace in order to keep the balance and stability of the DAI asset.
The DAI stablecoin relies on the MakerDao smart contract, which is the decision-making part of this loan machine. MKR token holders have a significant amount of power in this DAO and they are able to vote and perform a variety of important actions.
They can create new CDP types, modify existing CDPs, change the Dai Savings Rate (not implemented yet), choose price and emergency oracle nodes (more on this later), and trigger a safety feature called Emergency Shutdown.
Other ways of managing risk
The main product of MakerDAO is DAI, and the main product of DAI is two-fold. One, the actual DAI token, and two, the CDP smart contracts. There is a lot of risks involved with the creation of CDPs, so in order to enable actual community governance MakerDAO gives power to MKR holders to manage about a dozen different risk parameters that are enforced on CDPs.
It’s up to MKR token holders to vote on risk parameters for each active CDP on the DAI platform. One MKR token gives one vote, and holders can use them to control the parameters and change the risk profile for the CDP.
MKR token holders can vote on:
- Debt Ceiling - Total amount of CDP contracts allowed.
- Liquidation Ratio - Collateral-to-debt ratio (low LR = low expectation of price volatility)
- Stability Fee - Paid by CDP users on top of debt
- Liquidation Penalty - Maximum amount of DAI to be raised from a collateral auction
- Auction Duration - The amount of time an auction runs for before liquidation happens
- Auction Step Size - Minimum increase of a bid during a collateral auction
By managing these parameters for every CDP on the platform, the DAI holders (representing lenders), are able to equalize and eliminate unnecessary risks. Currently, only ETH is used, so there is only one set of risk parameters that are active. In the future when more CDP are possible with other assets, each and every one of them will have their own set of parameters, giving more choice to lenders, as well as borrowers.
What happens when CDPs become too risky?
In order for DAI and MakerDAO to function properly, they need to be able to cover the value of all outstanding debt with collateral in the system. Hence, a CDP can be liquidated if it is considered to be too risky, by a decision from the Maker Platform. Once the ratio becomes 1:1, the Maker Platform will buy the CDP collateral and sell it. For now, this process is automatic, but in the future an auction would be held for each CDP.
The current setup is called a Liquidity Providing Contract, which is a temporary solution as long as DAI is capable of only ETH- CDPs.
The MakerDAO platform has an actual handbrake, which can be used as a last resort by the MKR token holders or Emergency Oracles depending on the phase of the project. It’s designed to close and liquidate all CDPs, effectively enforcing the target price over all DAI and CDP holders. The system then automatically settles all positions and makes sure that everyone receives the net value of the assets they are entitled.
Emergency Shutdown would be activated in the case of a security breach, hacking attempts, or market irrationality. The Oracles are chosen by MKR voters. They can initiate an Emergency Shutdown at any time. In the next stage of the Maker platform, this process will be decentralized by allowing MKR voters to initiate the shutdown with a quorum of 50,000 MKR votes.
The whitepaper for MakerDAO explains it like this:
Emergency Shutdown: Step by Step
- Step 1: Emergency Shutdown is triggered and CDP users withdraw assets
- Step 2: Post-Emergency Shutdown auction processing
- Step 3: Dai holders claim the remaining collateral with their Dai
Community and Governance
As you have undoubtedly understood by now, MKR plays a very important role on this platform. MKR token holders are effectively owners of a decentralized loan machine, with executive abilities to change many of the operational parameters for the organization.
In this section, we go a bit deeper into the MKR Token Governance model which influences ETH-based CDPs, and in the future may influence an even larger variety of asset-based CDPs.
How does the MKR Token Governance work?
The Maker Platform can be considered a crypto-democratic entity, with every MKR token holder, a stakeholder in the DAI lending machine.
In order for the Maker Platform to operate, it needs a default set of parameters, which are elected through MKR token voting. Holders can use their tokens (unclear if tokens are lost in this process) to cast approval votes for proposals that they believe are in the best interest of the platform. Once voted by the majority, the proposal is known simply as the “Active Proposal”.
Any Ethereum account can deploy a valid proposal smart contract, which can then be voted to change the existing “Active Proposal” by MKR token holders. To replace the current Active Proposal, a majority of token voters need to support the new solution.
Here comes the interesting part!
Once a new Active Proposal is elected, the modifications of such proposal are postponed for 24 hours, to provide the platform enough time to initiate Emergency Shutdown, in case the Governance System is being used as an attack vector by hackers. Since they affect internal governance and the very fabric of DAI generation, this is serious stuff (and likely a target for such attacks) and malicious governance proposals are definitely one of the ways to completely break the system.
This handbrake system provides a lot of security, but at the same time, it screams centralization. MKR token holders, who in their own right, should have control over their own organization.
The Active Proposal is very important for both MKR and DAI, as it is the sole carrier of administrative access, the only thing that can edit internal governance variables, as well as DAI-related parameters.
In addition to the Active Proposals, there are also other types of decisions that MKR token voters can undertake. Called Proposal Contracts, these “one use only” contracts which immediately take effect after their successful voting, are executed once, then their logic is deleted and they cannot be re-used.
I tried to find more information about the security vulnerabilities and implications regarding this above-mentioned feature, but everything came blank. From my perspective, it’s a vulnerability that needs to be patched.
But the decision making is up to MKR token holders.
Would love to hear your thoughts on this part of the article! Please comment on what you think about MKR’s governance model. Is it good/bad, fair/unfair? If you have any experience being a part of MKR, then this is your moment to shine. :)
Maker Platform relies on incentivized external actors
In order to maintain operations, the Maker Platform relies on more than just smart contracts. It also incorporates input from various external oracles that contribute to the platform. There are three external actors, known as:
- Keepers - Independent entities incentivized by profit opportunity to maintain the target price.
- Price Oracles - Voted entities responsible for feeding the platform with market data. (They are voted by MKR voters)
- Emergency Oracles - Last line of defense in the event of an attack, can trigger the emergency shutdown (They are voted by MKR voters)
Here are a few examples that can be found in the original MakerDAO whitepaper:
- Bob needs a loan, so he decides to generate 100 Dai. He locks an amount of ETH worth significantly more than 100 Dai into a CDP and uses it to generate 100 Dai. The 100 Dai is instantly sent directly to his Ethereum account. Assuming that the Stability Fee is 1% per year, Bob will need 101 Dai to cover the CDP if he decides to retrieve his ETH one year later
- Bob wishes to go margin long on the ETH/DAI pair, so he generates 100 USD worth of Dai by posting 150 USD worth of ETH to a CDP. He then buys another 100 USD worth of ETH with his newly generated Dai, giving him a net 1.66x ETH/USD exposure. He’s free to do whatever he wants with the 100 USD worth of ETH he obtained by selling the Dai. The original ETH collateral (150 USD worth) remains locked in the CDP until the debt plus the Stability Fee is covered.
- Let's assume that there is an Ether CDP type with a Liquidation Ratio of 145%, a Penalty Ratio of 105%, and we have an Ether CDP with a collateral-to-debt ratio of 150% . The Ether price now crashes 10% against the Target Price, causing the collateral-to-debt ratio of the CDP to fall to ~135%. As it falls below the Liquidation Ratio, traders can trigger its Liquidation and begin bidding with Dai for buying MKR in the debt auction. Simultaneously, traders can begin bidding with Dai for buying the ~135 Dai worth of collateral in the collateral auction. Once there is at least 105 Dai being bid on the Ether collateral, traders reverse bid to take the least amount of collateral for 105 Dai. Any remaining collateral is returned to the CDP owner.
The Future of MakerDAO
Progress is the middle name of Blockchain Technology, and MakerDAO is not a stranger to using progress to share future plans. In this section, I’ve gathered all of the information about improvements or changes that are expected to be implemented sometime in the future.
This list is by no means a timeline, and it has not been organized in any particular order.
The change from a single-collateral DAI to a multi-collateral DAI version
Right now, DAI can only be created by using Ether, or rather Pooled Ether. There is a plan in place to upgrade the network to support more than just Ether. This upgrade will enable Bitcoin, Litecoin, or Bitcoin/Ether CDPs to appear on the platform.
Increase of significance for the MKR token
Once the above-mentioned upgrade is complete, MKR will gain additional capabilities, some of which I mentioned in the “Community and Governance” section. MKR will replace PETH as the recapitalization resource. CDPs may become undercollateralized because a market crash has occurred, significantly damaging the price of an asset. In this case, MKR collateral will be sold to make sure that there is enough funds to recapitalize the system. This will only affect MKR used as collateral at the time.
Pooled Ether will be removed completely once the platform reaches the next stage. This will open up the platform for using different types of assets as collateral in their native form.
DAI Market Stability
Once multi-collateral DAI upgrade is passed, a different type of market stability feature comes into play to keep DAI on the target price of $1 USD. Through the use of community governance, the “DAI Savings Rate” will be adjusted to maintain price stability. These changes will influence DAI holder earnings over time, and the price for generating DAI with collateral.
The process is going on weekly voting with MKR Tokens. The current format uses an automatic feature that requires no stakeholder input.
Debt and Collateral Auctions
After the multi-collateral DAI update takes place, the Maker platform will start to buy the CDP collateral and sell it through automatic auctions. To buy the collateral, the platform needs to raise enough DAI to cover the debt. This is the initial Debt Auction, and the system will sell MKR tokens to bidders in an auction format.
At the same time, the CDP collateral is sold in a conveniently named “Collateral Auction” where the CDP value and a Liquidation Penalty fee will be used to buy MKR and remove it from the supply, equalizing the previous auction.
The DAI system and MakerDAO platforms are complicated. They were designed to solve the problem of stable exchange value in Ethereum, and have their sights set on the wider crypto industry.
There is a lot of promise and a good track record to support DAI in the current version, although the performance would need to be followed up in the future, once the update is implemented.
The DAI and MakerDAO platforms are balanced between automation, stakeholder action, and they are incentivizing external parties with rewards to keep the target price stable.
The existence of the Emergency Shutdown enables stakeholders to pull the break and avoid losing a significant amount of value, similar to “The DAO” in the past.
For now, the system functions as a great way to invest more than you have in a particular digital asset, especially if that asset is ETH. You can also assume the role of a “Keeper” and trade DAI according to the target price. If it’s below $1 USD, buy DAI, and when it gets above $1, sell the DAI. How much profit is possible with this type of trading, I do not have an answer, but if you think that the system is functional, give it a shot.
Overall, MakerDAO is a suitable blockchain project that offers real value for users.