MakerDAO is a decentralized financial application (Dapp) built on the Ethereum blockchain. Maker, as it's known, was the first DeFi application, and it's still the most popular DeFi protocol on Ethereum.
Maker is important because it produces the DAI decentralized stablecoin, which is commonly used in the DeFi ecosystem. Before we get into how DAI is made, let's take a look at the two types of stablecoins that are currently available.
Stablecoins
Stablecoins that run on top of Ethereum can be divided into two categories.
Centralized stablecoins
A centralized stablecoin is issued by a corporation like Circle or Paxos. Since these stablecoins are backed by dollars in a bank account, they have value. A stablecoin holder can exchange their stablecoin for dollars at any time.
The most widely used centralized stablecoin is Tether (USDT), which is followed by USDC.
Decentralized stablecoins
Decentralized stablecoins are backed up by cryptocurrency collateral rather than dollars in a bank account. In other words, users lock up Ether in MakerDAO, and the value of Ether supports the value of DAI.
The most widely used decentralized stablecoin is DAI, which is followed by SUSD.
MakerDAO's Work
MakerDAO is a relatively easy project to grasp. The protocol operates as follows.
MakerDAO accepts collateral from traders. Maker accepts a variety of collateral, including WBTC and BAT coins. However, since Ethereum is the most common type of collateral in Maker, we'll focus solely on it in this article.
The trader will produce a certain amount of DAI once the collateral has been deposited in Maker. The more collateral a trader puts up, the more DAI he or she will earn.
There is a minimum collateralization ratio of 150 percent when locking Ethereum. This means that for every $1 of DAI generated, at least $1.50 in ETH must be used as collateral. Given how volatile cryptocurrency prices are, most traders maintain a 300 to 400 percent collateralization ratio. The trader's collateral would be liquidated to pay off their loan if the collateralization ratio falls below 150 percent.
The DAI loan accrues interest for the duration of its life. The trader must deposit DAI with MakerDAO to complete the loan. The duration of a loan is unrestricted.
A collateralized Maker DAI loan is comparable to a mortgage or a car loan in the real world. The collateral (house/car) backs up the loan in all of these situations. The bank has the right to seize the collateral in the event of nonpayment.
MakerDAO's Advantages
MakerDAO can mint DAI, but it has no power over what people do with it. This is not the same as how centralized stablecoins function. We've seen Tether and USDC freeze accounts, block transactions, and so on. These centralized corporations have complete control over the use of their stablecoins.
DAI transactions, unlike USDC, cannot be censored or stopped. A MakerDAO loan can be initiated by anyone in the world, and new DAI can be printed. There are no KYC requirements or territorial limits that prevent users from coming from those countries.
Furthermore, relative to other types of leverage, taking out a loan on MakerDAO is currently very affordable. The interest rate on a Maker loan is currently 0.5 percent, which is significantly lower than what traders would pay on a centralized platform.
The MKR Token
In the MakerDAO protocol, the MKR token serves two purposes.
MakerDAO's governance reforms can be voted on by MKR token holders. On MakerDAO, token holders, for example, may vote to adjust the savings rate or lift the debt ceiling.
DAI is a lender of last resort since each loan is backed by collateral. MakerDAO will mint MKR and sell it on the open market if this collateral cannot be liquidated to pay off a loan or if the collateral is not worth enough to pay off the loan. The money raised from the sale can be used to repay the DAI loan.
Traders who borrow money from MakerDAO must pay interest. MakerDAO collects the interest payments and uses them to purchase MKR. These MKR coins are then "destroyed," reducing the token supply. As a result, demand for MKR is stable, and supply is gradually reduced.
Since interest payments are used to buy and kill MKR, the price of the token should increase. This is particularly true as more traders turn to MakerDAO for funding. The danger is that MKR will be printed and sold on the open market if the company goes bankrupt. As a result, selling pressure will build, and the price of MKR will most likely fall.
What Is the Problem with MakerDAO?
MakerDAO is a game-changing product that serves as the foundation for a modern decentralized financial system. Maker is still a young project, so there are still a lot of bugs to iron out. As an example...
The DAI peg does not always remain constant at $1. The peg is sometimes broken in a major way, as it was in September 2020 when DAI was selling for $1.04. Occasionally, there is a slight difference in the peg. DAI, for example, trades for $0.995 or $1.005 on occasion. That might not seem like a big deal, but when you're dealing with millions of dollars, even a slight deviation from the $1 peg may add up quickly.
A imbalance between supply and demand is the cause of the peg's deviation. The issue with DAI is that, in comparison to other stablecoins, it is not very versatile. If there is a high demand for USDC, for example, it is simple for someone to deposit dollars and create more USDC.
DAI generation is more difficult. Protocol risk exists, as well as the risk associated with the volatile price of the ETH used to secure the loans.
Maker is a relatively new software protocol, so there's always the possibility that something could go wrong. In March of 2020, we saw a painful example of this when Ether's value plummeted by nearly 50% in a single day.
Hundreds of loans fell below the 150 percent collateralization threshold as a result of the ETH price drop. Normally, when this occurs, the loans are liquidated, and traders receive roughly 80% of their collateral back. A flaw in the protocol, however, allowed someone to demand the collateral, resulting in those who had their loan liquidated losing 100% of their collateral instead of just 20%.
The primary risk associated with MakerDAO is black swan incidents like this. Making it easier for users to raise their collateralization rate in a competitive market, the Maker team has implemented an improved liquidation process and a number of secure coins as agreed collateral in maker vaults. It has also introduced ‘multi-collateral DAI,' which allows users to deposit a variety of other Ethereum-based assets at a 175 percent collateralization discount, including Basic Attention Token, Kyber Network, and 0x.
MakerDAO: the Future
MakerDAO is an innovative project that has exploded in popularity over the last year. What we really need is time for MakerDAO to achieve global adoption. More code audits and a longer track record are needed to demonstrate that the platform is as stable as it should be.
There is a lot of potential upside for MakerDAO if it can prove that it is safe. It's not hard to picture a day when MakerDAO has $100 billion in its wallet.
MakerDAO is at the forefront in providing decentralized financial services to citizens all over the planet, as a decentralized lending network is a huge technical achievement.
