Hello guys! Today I will be explaining how MakerDAO works. This is a very long guide, so don't feel pressured to read all of it in one go. 

A look at Tether first

We need to take a look at Tether, which is a stablecoin(a coin whose value is almost always the same and most likely pegged to something)

Tether is the most widely used stablecoin in the world. With a market cap of 6.5 billion dollars, it ranks fourth in the world for market cap. However, it is also controversial. Tether is a coin that is fiat collateralized. Fiat collateralized stablecoins are the most straightforward way to create a stable currency. A certain amount of fiat currency is deposited as a collateral and coins are issued 1:1 against this fiat money.

Although this method is simple and secure, it requires a central party to issue the coin. Regular reviews of the coin are needed to ensure that the coin is indeed fully collateralized. The Tether website states:

“Tether converts cash into digital currency, to anchor or “tether” the value of the coin to the price of national currencies like the US dollar, the Euro, and the Yen.”

This means that each USDT is backed by exactly 1 USD(there are also other coins on the Tether network that are backed by various other fiat currencies). The main purpose of stablecoins are to provide liquidity and stability to cryptocurrency markets. It is an easy way to ensure that your crypto will have the same value on cryptocurrecy-only exchanges.

It also removes the need for KYC/AML practices(since transactions in fiat usually require KYC, but with a crypto that acts like fiat, this isn't a problem). It also removes the problem of the volatility of Bitcoin and Ethereum as the base currency, for example. However, not everything is rosy with Tether. 

Tether's problems

Centralization: Since the Bitfinex team operate Tether, and since USD is a centralised currency, Tether is actually more centralised than you would think.

Peg concerns: The current circulating supply of Tether is 6.5B USD, which is a MASSIVE amount. Many people doubt that Bitfinex has the appropriate collateral to back Tether up. Tether's price is built on trusting Bitfinex, so if Bitfinex revealed that the collateral was less than 6.5B by a substantial amount, then there will be a huge crypto crash. 

BTC price manipulation: Since Tether is such a large cryptocurrency, many people argue that this power can be used to manipulate the price of bitcoin. Some reports have analysed the data and saw that 50% of BTC total rise took place within 2 hours after a new delivery of Tethers.

Which is why people now want a stablecoin without Tether's flaws. 

What is MakerDAO?

MakerDAO is the company that is behind the Dai stablecoin, which like Tether, is unmineable(well pretty much all stablecoins are unmineable)

But this is where the similarities end. Dai is crypto-collateralized as opposed to Tether, and also has a good team.

MakerDAO is lead by Rune Christensen, its CEO and founder. He studied International Business from the Copenhagen Business School. Former Amazon software engineer Andy Milenius is the CTO of the company.

The team seems to be extremely committed towards the project and they have a healthy and thriving community as well.

One platform, two tokens

The MakerDAO platform has two tokens: Maker(MKR) and Dai(DAI). Here's a brief overview for each:

-Makercoin(MKR): This token is not a stablecoin. Its main purpose is to govern the Maker Platform.

-Dai (DAI):  The stablecoin that is suitable for payments, savings, or collateral.

How do you actually get DAI?

DAI is a cryptocurrency-collateralized asset, meaning that you will have to use some of your crypto(Ethereum as of now) and "lock" it up. When you interact with the MakerDAO system, you lock up your Ether in a “collateralized debt position” or CDP for short. CDP is a “smart contract”, and the entire system works because of it. So, it makes sense to take a little detour and understand what a smart contract is and how it works before we continue any further.

A brief guide to smart contracts

Smart contracts are how things get done in the Ethereum ecosystem. Two parties can initiate a smart contract when they want to get a particular task done. Smart contacts were conceptualised by Nick Szabo. According to him, the best real-life working example of the smart contract is a vending machine. 

When you want something from a vending machine, you just deposit a certain amount of cash into it, and the vending machine gives you the product that you want. You make a secure transaction without any involvement from a third party. As long as you deposit your money and choose your product, the vending machine will give you your product. This reduces the chance of malicious third parties interfering with your transaction. 

Suppose you want to give Ethereum to Bob once he finishes some tasks.The smart contract "locks up" the Ethereum so that they are inaccessible until Bob finishes his task, at which point the Ethereum is given to Bob.

Generating DAI with CDP

Users lock up their Ethereum in the form of Pooled Ethereum(PETH). The CDP then generates DAI while calculating the interest over the pooled Ethereum over time. If a user wants to withdraw their ETH from the CDP then they will have to payback the equivalent amount of DAI. Therefore the PETH really isn't meant to be withdrawn. DAI uses cryptocurrency collateralization, which removes the centralised fiat currencies from the equation. DAI also uses a strategy that ensures price stability.

So, if you want $100 worth of stablecoins then you will need to deposit $200 worth of Ethereum. It is not a straightforward 1:1 ratio.

This is true with CDPs as well; they are always over-collateralized.

Interacting with the CDP

There is a four-step process to the interaction with the CDP.

Creating the CDP and depositing Ethereum collateral: The user sends a transaction to MakerDAO to create the CDP, then sends Ethereum collateral to MakerDAO. At this point the CDP is considered collateralized. 

Generating DAI: The CDP user then requests to retrieve DAI from the CDP, and in return the CDP accrues an equivalent amount of debt, locking them out of access to the collateral until the outstanding debt is paid.

Paying the debt and stability fee: When the user wants to retrieve their collateral, they have to pay down the debt in the CDP, plus the Stability fee that continuously accrue on the debt over time. The Stability Fee can only be paid in MKR. Once the user sends the requisite Dai and MKR to the CDP, paying down the debt and Stability Fee, the CDP becomes debt free.

Withdrawing collateral and closing the CDP: With the debt and fees paid, the user can retrieve all or some of their collateral by sending a transaction to MakerDAO. 

Risk management of CDPs

CDPS have a risk management system that manages how they can be used. 

-Debt Ceiling: Debt Ceiling is the maximum amount of debt that can be created by a single type of CDP. Once the ceiling has been reached by a CDP, it becomes impossible to create more unless existing CDPs are closed.

-Liquidation Ratio: Liquidation Ratio is simply the ration between collateral and debt, at which the CDP becomes vulnerable to Liquidation. Low Liquidation Ratio means low volatility and vice-versa.

-Stability Fee: Once a CDP is made, a stability fee is accrued over time. It is an annual percentage yield and needs to be paid by the CDP user. This can only be paid by MKR and the MKR is immediately burnt after it has been paid off.

-Penalty Ratio: If the liquidation mechanism is not efficient enough, the Penalty Ratio comes into play. It is used to determine the max amount of DAI raised from a Liquidation Auction. 

Let’s assume that Ethereum is worth $100. As mentioned before, CDP is always over-collateralized to make up for the cryptocurrency peg’s volatility. For this example, let’s assume that the collateralization ratio is 150%, meaning for $100 worth of ether you will get 66 DAI.

So, the ether that you have put up as collateral stays locked until you pay back the 66 DAI. When you pay back the DAI, the DAI tokens get burnt.

How does the price of DAI remain stable?

There are two things which can move DAI's price away from $1:

-The value of Ethereum goes down

-DAI doesn't trade for the $1 target price

#1. The value of Ethereum goes down

If the price of Ethereum suddenly goes down, then the Ethereum will be worth less than the DAI which is supposed to be backed by it. In this scenario, MakerDAO auctions off the locked up Ethereum before the CDP percentage falls below 100%. 

For example, if the normal CDP percentage is 150%, and the CDP percentage drops to 125%, MakerDAO will auction off the Ethereum to ensure that the DAO is not worth more than the Ethereum it's supposed to be backed by. Remember that over-collateralization prevents the backed currency from being worth more that the backing currency unless the price swings are massive. 

#2. DAI doesn't trade for the $1 target price 

The value of Dai goes >$1 when there is more demand for Dai and not enough supply. Conversely, its value goes <$1 when there is not enough demand and too much supply. Supply and demand is basic economics. In situations where the supply and demand fluctuate, MakerDAO combats by utilizing Target Rate Feedback Mechanism.

What is Target Rate Feedback Mechanism(TRFM)?

TRFM is a mechanism which adjusts the Target Rate in order to cause market forces to maintain the stability of the DAI price. During periods of severe instability, the TRFM kicks in. When that happens, the fixed peg of DAI breaks but it still maintains the same denomination.

The Target Rate determines the change of the Target price over time, in other words, during normal times when TRFM is not engaged, the target rate is fixed at 0%.

However, when TRFM is engaged, the Target Rate can determine the Target Price over time to either:

-Make it appealing enough to make users hold DAI

-Make the users want to borrow more DAI

According to the DAI whitepaper, 

The Target Rate and Target Price:

" change dynamically to balance the supply and demand of Dai by automatically adjusting user incentives for generating and holding Dai. The feedback mechanism pushes the market price of Dai towards the variable Target Price, dampening its volatility and providing real-time liquidity during demand shocks. “

So this means that when DAI is below the target price, the Target Rate increases, causing the Target Price to rise at a higher rate.This causes DAI generation via CDP to become more expensive. The increased target rate causes an increase in DAI demand.The combination of reduced supply and increased demand causes a rise in DAI’s prices pushing it towards the Target Price.

When DAI is above the target price, the mechanism works in reverse.

-The Target Rate decreases.

-The Target Price decreases.

-Dai generation via CDP becomes cheap.

-Decreased rate causes decrease in Dai demand.

-The increased supply and reduced demand pushes the value down towards Target Price.

What determines the magnitude of this Target Rate change is called the "Sensitivity Parameter". 

If all else fails, there is a big red virtual button that can be pushed.

The Global Settlement(the virtual red button)

This basically shuts down and unwinds the MakerDAO platform while making sure that everyone ends up with the appropriate amount of funds. The process is decentralised and only MKR holders can use it to avoid exploitation. There are 3 steps:

#1. Global settlement is activated

If Global Settlement is activated, then CDP creation and manipulation is stopped and freezes the Price Feed at a fixed value that is then used to process proportional claims for all users.

#2. After Global Settlement has been activated, a period of time is needed to allow keepers to process the proportional claims of all DAI and CDP holders based on the fixed feed value. After this processing is done, all DAI holders and CDP holders will be able to claim a fixed amount of ETH with their DAI and CDPs.

#3. Dai and CDP holders can exchange DAI and CDPs directly for Ethereum, based on the price of DAI and Ethereum. There is no time limit for when the final claim can be made.

What is MKR? 

Maker is not a stablecoin like DAI. There are a total of 1 billion Maker. Maker is both a utility token and a governance token. 

MKR as a utility token-MKR is needed to pay the stability fees that are accrued on the CDPs that have been used to generate DAI. These fees can only be paid by MKR and as soon as the payment is done, the MKR paid is burnt completely removing it from supply.

This means that if the demand for DAI and CDPs increase, then the demand for MKR will increase as well. Plus, since MKR is burnt the moment it is used, it decreases the overall supply of MKR as well.

MKR as a governance token

MKR holders can also vote in the MakerDAO platform. The voting process for the governance is done through continuous approval voting. In simple terms, any MKR holder can vote for any number of proposals with the MKR that they they hold. They can also submit a new proposal or cast or withdraw their vote any time they want. The proposal with the maximum votes from MKR holders becomes the top proposal and can be activated to implemented any changes in the MakerDAO platform.

In an ideal scenario, the CDPS will remain over-collateralized. 

However, to make the system trustless, a few measures need to be put into place. It may be possible that parts of the collateral portfolio become under-collateralized.

When that happens, the MKR tokens trigger an “automatic recapitalization” through forced MKR dilution. What does that mean?

This means that the MakerDAO system automatically creates new MKR tokens and sells them on the market. This serves two purposes: 

-It brings in some much-needed liquidity

-It punishes the MKR holders for bad governance(the more tokens there are the more the price goes down)

External roles in the MakerDAO ecosystem

#1. Keepers

Keepers are incentivized by profit/profit opportunities to contribute to decentralised systems. 

#2. Oracles

Oracles give the market realtime information such as the current price of DAI and MKR.

Real-time information about the market prices of assets to be used as collateral in CDPs is needed because it lets the platform know when to trigger liquidations.

Plus, the MakerDAO Platform needs info about the market price of Dai and its deviation from the Target Price in order to adjust the Target Rate IF TRFM needs to be triggered.

#3. Global settlers

Global settlers play the smallest role. Their only job is to trigger Global Settling when it is needed. Other than that, they have no role. 

Risks with MakerDAO

Hacking: Since MakerDAO is based on smart contracts without manual regulation, it will be susceptible to hacking.

Irrational Market actions: If the market doesn't follow basic economic principles then the whole MakerDAO system falls apart

Human error: People aren't perfect. So voters aren't perfect either.

Complexity: As you may have guessed by now. The Maker platform is not really straightforward. New users may get overwhelmed and move on to something like Tether which is pretty straightforward to use even though it has numerous flaws.

The plain old price crash: If Ethereum experiences a big crash, then MakerDAO will fail to work

 

However these factors are unlikely and a well-created stablecoin could be the one thing that pushes cryptocurrency into mainstream adoption.

 

Thanks for reading this article! If you liked it, please don't forget to tip and leave a like.

 

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