Humans have been borrowing things from each other for a long time. We’ve spent the majority of our evolution--some 70,000 years--in tribes of 100-200 members, so borrowing most likely took place using the IOU method that we still use today between familiar persons. That changed with the Neolithic Revolution and the emergence of agriculture. An increased food supply meant that humans could gather into cities, and for the first time our ancestors were forced to interact, and transact, with individuals that fell outside their sphere of personal acquaintance. Unfortunately, the IOU method of account breaks down when there is no trust between the debtor and creditor, so it doesn’t work well with strangers. Humanity then needed a new method to keep track of debts.
The solution may seem obvious to us, but imbuing a physical substance with value to quantify debts was an alien idea to those first urban dwellers. Nevertheless, the concept of money was born, and humanity found one of its primary drivers for large-scale cooperation. The need to record debts probably led to the first written language. In fact, the earliest examples of writing were records of debts with many ruins previously serving as debt-keeping institutions. We can speculate on the role these institutions played in early economic growth because access to credit has historically resulted in investment and entrepreneurship. Christian tradition so abhorred lending, that Dante’s Divine Comedy places usurers in the inner ring of the seventh circle of hell, but the repeal of usury laws led to an economic boom in medieval Europe nonetheless.
In spite of its ancient origins, the structure of credit lending institutions has not changed much through the millenia. Today these institutions are recognized as banks, however if a modern day banker were to switch positions with one of his ancient credit issuing counterparts, both would find themselves in a relatively familiar position. Sure, our modern “monopoly man” would need a crash course in ancient Sumerian, and our antiquated ancestor would undoubtedly require an education in modern financial instruments (as well as electricity, modern transportation, and the internet), but both would intuitively understand their role. Once comfortable, they would again exercise complete control over factors such as interest rates on loans and the criteria for lending. Society needs these institutions because strangers seeking to transact do not trust each other, thus, a third party must act as an intermediate. The medium with which both our modern and ancient bankers deal is not money or greed, but trust.
We have historically bestowed our trust in financial institutions because up until now, there has been little alternative. The problem is that this trust is sometimes misplaced. One needs to look no further than the 2008 financial crisis to question the level of influence these banks and financial institutions wield. However, with the emergence of the internet and more recently blockchain technology we may have discovered a solution. Blockchain has provided a trustless framework in which individuals or businesses can transact directly, and has opened an array of financial tools. We can bestow our trust not in fallible institutions and the humans that run them, but instead in cryptographic proofs. We can take the uncertain factors such as interest rates and democratize the decision of their value. We can do the entire process autonomously, with added safety mechanisms designed to reward those who uphold the system; Welcome to the future of collateralized lending.
MakerDao is an collateralized loan protocol that allows users to take leveraged positions using digital assets. It is decentralized, meaning no single person or organization can influence it’s mechanics. It is autonomous and engineered so that its governing rules are decided via a democratic vote, and voters are rewarded for their administrative services. It accomplishes this using a unique two-token ecosystem comprising of a stable asset (Dai), and an administrative token (MKR). This system is a financial tool that may be accessed by anyone on the planet with only a smartphone and an internet connection. For the first time in a millennia, we have discovered a system where neither our modern nor primitive debt collector can exercise their influence.
Collateralized Loans on the Dai Ecosystem
Most Americans are introduced to collateralized loans through a car loan or a property mortgage. After a down payment is provided a bank will loan a much larger sum and charge interest on the repayments. The MakerDao protocol fulfills a similar function with a few key differences.
- Users do not transact in dollars but instead send Ether (ETH) collateral to a decentralized smart contract on the Ethereum blockchain called a Collateralized Debt Position (CDP). You can think of a CDP as a decentralized bank where the rules of lending are decided by the users.
- The CDP will respond by sending up to 50% of the provided collateral to the user in the form of the stable coin Dai. The user can use the Dai to purchase other digital assets. Dai is considered stable because its value is soft-pegged to one US dollar.
- When the user wants to retrieve his ETH collateral, he must return his borrowed Dai plus a small amount of interest in the form of the administrative token MKR.
When a user sends ETH collateral to a CDP he generates Dai. The supply of Dai is inflated or deflated to keep the value of one Dai pegged to a single US dollar. The user can then use his volatility-free Dai to purchase more ETH, or another digital asset without selling his original collateral. If a user opens a CDP and purchases ETH with his generated Dai, he will increase his exposure to ETH by up to 50%. He has leveraged his position with his only direct expense being the MKR interest accrued on his debt. This is the first instance of leverage trading without the need for a bank, credit score, and with negligible overhead cost. Billions of people do not have access to reliable financial infrastructure, but the doors to margin positions with digital assets have been blown wide open.
Under the Hood
Gutenberg’s printing press broke the church’s monopoly over the written word in 1439 by facilitating cheap and widespread printing. Similarly, The MakerDao protocol will break centralized institution’s monopoly of financial services. But if we’re going to circumvent the old architecture then what will we design in its stead? MakerDao’s developers chose a democratized version of our current system that distributes power and voting rights among its users. To accomplish this several mechanisms are included that both protect users and incentivise specific behavior.
Collateralizing a loan is actually a two step process. A CDP can only be collateralized with PETH, an intermediate medium designed as a buffer against catastrophic ETH devaluation. The MakerDao protocol cannot control the supply of ETH that is injected by users, but it can artificially inflate or deflate the supply of PETH. In the event of a market crash where the price of ETH drops considerably, many CDP’s will likely approach the fatal 150% debt/collateral ratio that signifies liquidation. The protocol can create PETH and distribute it to at-risk CDP’s to increase their collateral value, thus decreasing the debt/collateral ratio and throwing a life preserver to the drowning contracts. Inflating the PETH supply does not create value as the relative claim of each PETH to the pooled ETH supply diminishes. The sole purpose of this mechanism is to protect users from volatility.
You may also be wondering about the purpose of the second member of the ecosystem, the MKR token. MKR holders are the administrators of the system. They vote to determine important parameters such as the Stability Fee, or the interest accrued on outstanding debt. If the price of one Dai is consistently under the target price of $1, then MKR holders may vote to increase the Stability Fee. A higher interest rate on debt corresponds to less users opening CDP’s to generate Dai, reducing supply. This governance mechanism coincides nicely with natural market behaviors. Users that had previously generated Dai through a CDP and sold it for other digital assets will take advantage of the momentary price lapse by buying back their Dai to pay off their debts at a discount. The combined forces of decreased supply and increased demand will bring the market price of Dai into equilibrium with the target price.
The inverse is also true. If the price of Dai is under the target price of $1 then MKR voters can vote to decrease the stability fee. Cheap money encourages more borrowing and a swollen supply. At the same time Dai holders will sell in order to take advantage of the additional buying power of their tokens. The Stability Fee has varied between 0.5 - 3.5% based on MKR voting since the MakerDao protocol went live in late 2017.
One MKR token equals one vote. MKR holders can also vote on criteria such as:
- Add a new CDP Type: Create a new CDP with unique risk parameters or a different form of collateral.
- Modify existing CDP’s: Alter the parameters for already existing CDP’s.
- Modify Sensitivity Parameter: Determines the magnitude of the response of the Target Rate Feedback Mechanism that keeps the value of one Dai soft-pegged to one US dollar.
- Vote to implement Global Settlement
MKR holders are also rewarded for their administrative “services”. Unlike the supply of Dai which is inflated or deflated based on user demand, the supply of MKR is capped at one million. However, MKR tokens get burned as users pay off their debts. Recall that to retrieve collateral a user must repay his borrowed Dai and also the accrued Stability Fee (interest) in the form of MKR. Once the debt and Stability Fee are paid, both the returned Dai and MKR tokens are burned. Therefore all the Dai that are ever generated will eventually be burned. This ensures an ever dwindling supply of MKR in which the remaining tokens have an increased claim to the value of the system. The caveat is that this only holds true as long as the protocol attracts users.
You may be questioning the longevity of a ecosystem that continually burns its medium while refusing to supply more. Sooner or later we’re going to run out of gas, and while this is true it will take a very long time. The MKR Burn Rate is equal to the Stability Fee times the total amount of debt that is repaid to CDP’s. This can be hard to quantify because although we know how many CDP’s are open, we do not know when they will be repaid. We can estimate the Burn Rate by multiplying the outstanding Dai debt from all users by the current interest rate.
Dai debt (95,000,000) x Current Stability Fee of 3.5% (0.035) = Burn Rate (3,325,000)
If the number of CDP’s being repaid and Stability Fee remain constant, then 3,325,000 Dai worth of MKR will be burned annually. At the market price of $705.81 as of 3/20/19, that is 4,700 MKR removed from the total supply every year, or 0.47%. This system is not intended to make MKR tokens rocket in price. It is a slow burn that was designed to increase the MKR token value and voting power at a rate proportional to usage. The good news is that the number of open CDP’s has been increasing as the protocol attracts users.
If you believe that MakerDao system will continue to attract users or if you want a voice in the governance of the system then it makes sense to hold the MKR token. There is currently 2,200,000 ETH, or about 2% of the entire Ether supply locked into CDP’s. That has resulted in the issuing of 94,000,000 Dai stable coins in loans. The platform is gaining traction but its potential is just beginning to be realized. The developers are planning to transition the protocol from the ETH-only collateral to a multi-collateral system. If this is implemented then the PETH safety mechanism will be discarded, but users will be able to lock any digital asset into a CDP as collateral.
The MakerDao protocol is complicated, but once broken into its individual components it’s easier to digest. The Dai stable coin’s value is backed by collateral held in the smart contract. The burn mechanism is designed so that the administrators of the system are rewarded over time for their efforts, and in the doomsday scenario of catastrophic market collapse or if the system is compromised then a Global Settlement mechanism shuts down all the system operations and returns the pooled collateral to users. Therefore, the greatest danger posed to users is liquidation.
The fun thing about blockchain and the internet is that they allow anyone to work on open source projects. If you can conceive a tool or a website then you can build it. The MakerDao team is one group that’s doing it right. If you believe that financial opportunity should be pervasive, democratic, and fair, then the MakerDao protocol is one step in the right direction.