Making sense of MakerDAO – The DeFi project people are talking about

The blockchain-related media have had on eye on MakerDAO recently. Nothing like the hype surrounding Bitcoin, but steadily growing attention. Here we look at the concept and how it works.

Cryptocurrencies have been infamous for drastic price fluctuations. As explained in one of our quick reads, stablecoins were developed and to tackle this volatility. MakerDAO has issued such a stablecoin, Dai (other well-known examples include Tether), which is equipped with mechanisms to eliminate volatility in relation to the US dollar. One Dai is exchangeable for one dollar, simple as that. Only that ensuring this parity is anything but simple. Here’s how it works.

The difference between Dai and fiat-backed stablecoins like Tether is that Tether is collateralized by US dollar reserves while Dai is collateralized by reserves of the cryptocurrency Ether.

MakerDAO was founded in 2015 by Rune Christensen and is set up on the Ethereum blockchain. It is a decentralized autonomous organization (DAO), which means it is completely transparent, run on a computer-embedded code (with smart contracts) and not controlled by a centralized party. The project went live in December 2017.

Collateralization

The Dai is backed by collateralized debt positions (CDPs), which use pooled Ether (PETH) as collateral. Users deposit Ether into a smart contract, which gives them the equivalent amount in PETH to use as collateral. The purpose of using PETH was that if the market for Ether were to crash, the debt in a CDP would be worth more than the collateral held. CDPs lock these “collateral assets” and generate Dai for the users in return.

In addition to the stablecoin Dai, MakerDAO issues the utility and governance token MKR. Unlike Dai, its value volatile. All the fees related to CDPs are paid using the MKR tokens. To withdraw the collateral, users must pay the debt and the “Stability Fee” (in MKR) that has accrued over time. Each loan has a 1.5% interest rate, which, when repaid, triggers the purchase and destruction of an equivalent amount of MKR.

The entire mechanism can be summarized in four steps:

  1. Create a CDP and deposit collateral
  2. CDP will generate Dai
  3. Pay the debt and the Stability Fee
  4. Withdraw your collateral

Stabilization

MakerDAO is able to call Dai a stablecoin thanks to its automatic target rate feedback mechanism (TRFM). The target rate, determined by market supply and demand dynamics, identifies changes in the value of Dai needed to take it back to US$ 1. TRFM is triggered if severe market instability occurs and brings large disparities in Dai’s fixed peg. It can be positive and incentivize holding Dai or negative and incentivize borrowing Dai. In the event of a severe emergency, the platform resorts to global settlement, which cryptographically guarantees Dai’s parity to the target price. It will shut down the Maker Platform and ensure that CDP users and Dai holders get the correct amount of assets (in terms of net value).

MakerDAO’s current market cap stands at US$ 532m. According to the DeFi (decentralized finance) platform DeFi Pulse, approximately US$ 300m worth of digital assets are currently locked away in MakerDAO’s ecosystem. As the users in Maker’s platform are increasing, the value of its utility token MKR is also expected to increase. Based on the fact that the entire organization runs with the help of smart contracts, it has introduced a smart and automated system of running a basic financial service like lending. The organization is working to secure the platform, reduce the stability fee and make operations risk-free.

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