At Crypto Explained, we are on the mission of making crypto easy for everyone.
If you benefit from this, and value the effort, make sure to subscribe to receive our weekly Newsletter directly in your email!
Crypto has grown big enough that it’s no longer about an alternative financial system no more. The rise of NFTs, metaverse, DAOs, to name a few, have been drawing a lot of attention to this space.
However, every crypto project is ultimately still created around the concept of building an economy, so crypto at its core is still about building and offering an option that is better than today’s outdated financial institutions. That’s why Bitcoin was created in the first place, and the subsequent DeFi space that came along, empowered by Ethereum, and more recently by other blockchain platforms as well.
Within this context, stablecoins play a significant role.
Last week, we covered the historic collapse of algorithmic stablecoin UST (read more here). As Luna Foundation Guard is still trying to figure out which is the least nasty way to start over (and hopefully compensate some of the affected holders), it is pretty clear that UST as a stablecoin has failed, and is being abandoned.
Staying in theme, but providing some contrast at the same time, today I’m covering the OG algorithmic stablecoin and its maker that have been standing strong throughout the years.
So let’s start with the origin story
MakerDAO is a decentralized finance application created on the Ethereum blockchain.
It was built in 2014 by Rune Christensen, and it is fair to say that it’s the first DeFi application to earn significant adoption.
As its name suggests, it is a DAO (Decentralized Autonomous Organization), which means it is a community-run organization with no central authority: all governance decisions are proposed and voted by members of the community.
MakerDAO created 2 tokens (both ERC20):
MKR, a governance token: essentially this is the token you need to hold in order to be able to be part of the MakerDAO community and vote on key decisions.
DAI, their algorithmic stablecoin that was developed and launched in 2017.
In a nutshell, MakerDAO is a lending platform that enables users to create currency, aka DAI. The whole mechanism of how this process works is governed by the Maker community, who are holders of MKR tokens.
A quick recap of what a stablecoin is and why it matters…
If you are already quite savvy at this, please jump directly to the next section.
Stablecoins are cryptocurrencies that are stable in price.
Typically, the mechanism to maintain the price at 1:1 with the USD is through pegging its value to a different asset: the most common case is to peg it to real world currency like the US Dollar itself. This is the case for USDT, USDC, BUSD, etc.
But this is not the only way. There are also algorithmic stablecoins that seek to maintain a soft peg to the USD by the use of algorithms. This is the case of DAI, as well as the recently collapsed UST.
Thanks to its stable price, stablecoins play a key function in this space because it bridges crypto with the traditional financial systems, offering properties of money as we know it today. This is why it’s been adopted as a medium of exchange and store of value.
Read more about Stablecoin here
So what makes DAI so special?
Well, the fact that it’s an algorithmic stablecoin.
Or rather, what being an algorithmic entails. For this, you have to understand the concept of decentralization.
Bear with me…
The existing financial system is centralized: this means that decision-making power is concentrated in a few people at the top of the food chain, and these institutions and banks have full access and control over our assets…
So stablecoins like USDT, USDC, etc that maintain their 1:1 peg to the dollar by holding fiat currency, end up ultimately depending on the current financial system after all.
Considering that the whole point of the crypto space, to begin with, is to provide an alternative where we are not so helplessly dependent on institutions and decision-makers that do not hold our best interest into consideration, the question is, what’s the point of maintaining the price by holding fiat?
Ergo, DAI is relevant because it doesn’t rely on fiat money to maintain its peg, therefore has no dependency on it: it is not issued or administered by any centralized actor, or trusted intermediary, or counterparty.
So what do you need to know about the mechanisms behind DAI?
First, how to get your hands on DAI:
Users can borrow DAI by locking up ETH (or other pre-approved Ethereum token) in the Maker Vault.
The amount of DAI that can be created and therefore borrowed is up to 2/3 of the locked-up value.
This is how Dai enters into circulation and how users gain access to liquidity.
Of course, if you want to just hold DAI, you can buy from exchanges.
This is attractive to the users because you can get liquidity without having to sell your ETH, and without having to go through all the typical requirements and documentation that a bank or similar institution will require.
In order to withdraw the collateral leveraged and locked inside a Vault, users will have to repay the borrowed DAI, as well as pay a Stability Fee which is basically an interest rate.
The paid-back DAI will be burnt, as there is no longer debt to represent, and collateral is released, so supply-demand can go back to balance.
Understanding the Maker Vault
You can visualize the Vault like a normal physical vault, as it pretty much does the same job.
However, the Maker Vault is a smart contract, which is a protocol that would self execute once certain pre-established criteria are met, removing the need for intermediaries.
Vaults are inherently non-custodial.
This means each user has complete and independent control over their deposited collateral as long the value of that collateral doesn’t fall below the required minimum level (more on this later).
Again, decentralization.
The complicated balance of economic incentive and game theory.
Let me try to summarize the most relevant pieces you should know regarding mechanisms of how Maker protocol maintains DAI’s 1:1 peg, manages collaterals and other kinds of incentivized behaviors.
1. Arbitrage opportunities
Every time there is a slight deviation from the 1:1 peg, an arbitrage opportunity presents itself, which essentially means that traders can simultaneously purchase and sell the same asset in different markets in order to profit from tiny differences in the asset's listed price.
In the DAI ecosystem, these independent (usually automated) actors are called Keepers
, and they sell Dai when the market price is above the Target Price, and buy Dai when the market price is below the Target Price.
As a result, they help maintain the 1:1 peg.
2. Overcollateralization.
DAI is overcollateralized.
It holds a minimum amount of collaterals that is 1.5 times the supply of DAI. This means, that in order to borrow 100 DAI, you need to lock up $150 worth of ETH.
Therefore, every Dai in circulation is directly backed by excess collateral, meaning that the value of the collateral is higher than the value of the Dai debt.
3. Automatic Liquidation
If the collateral value of a vault falls too low, the protocol will perform an automatic liquidation during which part of the collateral is auctioned to cover the outstanding debt and penalty fee.
What determines when liquidation happens?
Well, there is this Liquidation Ratio
that represents the collateral-to-debt ratio at which a Vault becomes vulnerable to Liquidation. 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.
4. Liquidation Penalty
Should you be liquidated, there is a double-digit % of penalty fee you need to pay as the vault owner, and whatever collateral is left in the vault will be returned to you.
The purpose of this is to disincentivize users to get liquidated, and therefore make sure that there is enough collateral locked in the vault, which in turn helps maintain the security and strength of the larger protocol.
……………………………
Now, all of the above can be considered the first layer of protection.
Without going further into technical details, a high-level note:
In the case of an outstanding debt that is not able to be covered by the liquidation auction, then there are additional mechanisms put into place, such as the Maker Buffer and Debt Auction, with the purpose to recapitalize the system.
There are also price stability mechanisms put into place in case of emergencies.
These are beyond the reach of this article, but if you are interested, here is the link to the Maker Protocol’s whitepaper.
To close off…
Overall, it is fair to say that MakerDAO built an ecosystem that not only has mechanisms set in place to penalize users that might threaten the system, but it’s also overcollateralized, and will go out of its way to maintain it this way.
And it’s been working well so far. As the OG in this space, it has survived the ups and downs of the market throughout the years, and still standing strong.
So even though the overall market is bearish right now, and the sentiment towards crypto and particularly algorithmic stablecoins is understandably low given the recent historic collapse of UST, the intention of today’s article is to remind ourselves that fundamentals are essential, and more so when we are building the core of a nascent space like crypto.
Thanks for making it this far! Make sure to like, subscribe and share, so more people can find us!