MakerDAO: The Pioneering Force in Decentralized Finance

What is MakerDAO?

• MakerDAO is an Ethereum-based smart contract platform that allows for the issuance of Dai stablecoin against cryptocurrencies and real assets. The name of the platform comes from the term market maker.
• MakerDAO is on the first place among the DeFi protocols of the Ethereum ecosystem in terms of blocked liquidity. Dai is among the top five largest stablecoins.
• The project operates and develops on a fully decentralized basis using DAO. MakerDAO has Maker (MKR) as its management token.

Who created MakerDAO

The creator of the MakerDAO platform is Danish-born Rune Christensen. He studied biochemistry and international trade before co-founding the international recruiting company Try China. 

In 2014, Christensen founded and led the Maker Foundation organization headquartered in Santa Cruz, California.

In March 2015, Christensen, former Amazon software engineer Andy Milenius, and several other developers began working on a decentralized platform that allows users to borrow cryptocurrency-backed stablecoins.

On March 26, 2015, Christensen published an article in which he presented the concept of eDollar, a stablecoin on the Ethereum blockchain.

Christensen proposed incentivizing market makers, later called holders (Keepers), by rewarding them with utilitarian Maker tokens (MKR) for providing liquidity.

The first version of MakerDAO launched in December 2017. The centerpiece of the protocol then was the Single Collateral Dai (SCD, monolateral Dai), launched in December 2017. The only asset used as collateral for loans was Ethereum.

How DAI stablecoin works and what it is backed by

The developers of MakerDAO managed to create a unique steblecoin called Dai. Unlike centralized projects, it is entirely based on Ethereum smart contracts.

Dai stablecoins are issued by the users of the protocol themselves. To do this, they must lock in a special smart contract called Vault a certain amount of cryptocurrency as collateral. In return, they receive some amount of Dai in a certain ratio to the blocked cryptocurrencies. 

Due to the volatility of cryptocurrency prices, MakerDAO has an overcollateralization principle, meaning that the amount of collateral must be higher than the amount of Dai stablecoins being issued.

In the first version of MakerDAO, only ETH could be pledged as collateral, and the collateralization rate was 150%. This means that $150 worth of ether coins could be pledged against $100 worth of Dai.

In addition, certain pool tokens (LPs) in Uniswap and Curve can also be used as collateral. Also in July 2022, MakerDAO became the first DeFi protocol to start accepting public company stock as collateral. 

According to Daistats data as of the end of September 2022, about 40% of all pledges in MakerDAO are USDC-denominated. ETH is next in popularity. The total amount of pledges is over $8.67 billion. In terms of blocked liquidity, MakerDAO ranks first among all projects in the Ethereum ecosystem.

What is collateral liquidation in MakerDAO and why you need it

Liquidation is the process of selling a Vault to cover the DAI funds that users generate from their Vaults. The liquidation price is the price at which a Vault is subject to liquidation. Users can lower the liquidation price by posting additional collateral or returning DAI to Vault.

System viability is maintained through Vault liquidations when the collateral value of debt positions falls below the Liquidation Ratio.

The Liquidation Ratio is the minimum collateral level for each type of Vault. In fact, this is the collateralization rate, which differs depending on the cryptocurrency used in the collateral. If it is not achieved, the user's Vault is considered unsecured and is subject to liquidation.

Maker Protocol oracles provide a system with pricing data used to track Vaults' non-compliance with the liquidation ratio. The latter is set based on the collateral's risk profile and stabilization fee. 

If the value of the collateral falls below the required collateral rate, it is liquidated to cover the generated DAI. In addition, a so-called liquidation penalty is imposed. 

DAI tokens actually represent a collateralized debt to MakerDAO. The collateral always exceeds the value of the loan;

If the value of the collateral falls below a certain value of the loan, an auction is started in which network participants, called liquidators, buy back the collateral for DAI. The system then burns the resulting stablecoins, reducing the issuance. This mechanism is designed to ensure a peg to the dollar.

Generating passive income from Dai deposits

In addition to Vault, MakerDAO also runs a smart contract called the DAI Savings Rate (DSR), which is a variable accrual rate from DAI tokens locked into the DSR smart contract. 

Vaults users receive accruals automatically while retaining control over the tokens. The DSR smart contract has no withdrawal and deposit limits and no liquidity restrictions. The rate is set and adjusted by MKR token holders through an onchain-based management system. 

DSR is a global parameter that can go down or up, affecting the demand for DAI. An increase in DSR motivates users to hold more DAI, a decrease leads to a decrease in demand for tokens. 

These changes are reflected in the market price of DAI. If the stablecoin is trading below the dollar, the DSR can be raised to increase the demand for DAI, and thus its price. If the DAI is trading above the dollar price, the DSR can be lowered to reduce demand for the Stablecoin and lower its price. As of the end of September 2022, the DSR rate is 0.01%.

Dai stabilization mechanisms

MakerDAO has a special stabilization fee (Stability Fee) that is continuously assessed to DAI holders who use Vaults. A portion of the funds collected is used to maintain the Maker Protocol, including covering the costs of operating DSRs, Risk Teams, and other mechanisms. 

The stabilization fee for Vaults of all types is changed by votes of MKR holders who manage the protocol. Their decisions are based on Risk Teams' recommendations assessing the risk of the collateral used in the system. Risk Teams may update their proposed stabilization fees when the underlying asset or the entire system changes in a fundamental way.

Stability Fees accumulate on the Maker Protocol's internal balance sheet. Once the maximum liquidation balance is reached, the system automatically sends DAIs to the Surplus Auction. During the auction, Keepers offer a higher price in MKR for the DAI. The winner of the auction receives the Stablecoins and the MKRs paid are burned. 

According to the whitepaper of the project, the DAI target value on the Maker platform has two main functions:

• Calculating Vault's collateral-to-debt ratio;
• Determining the value of collateral assets in a global settlement situation.

In case of severe market volatility, future versions of the platform may include the Target Rate Feedback Mechanism (Target Rate Feedback Mechanism, TRFM). It changes the target rate, motivating market participants to maintain the DAI rate at the target value.

When TRFM is turned on, the parameters change dynamically, balancing supply and demand for DAI. The mechanism gradually moves the market price of the stablecoin towards the target price.

With TRFM, the target rate rises if the market price of DAI falls below a certain point. Against the background of the price increase, generating a stablecoin becomes more expensive. This also increases the attractiveness of holding DAI, contributing to an increase in demand for the coin. The combination of reduced supply and increased demand causes the market price of the stablecoin to rise, approaching the target rate.

Conversely, if the market price of DAI exceeds the target price, the target rate decreases, leading to an increase in the attractiveness of generation and a decrease in the demand to hold the stablecoin. As a result, the market price of DAI decreases, approaching the target price.

Ways of using Dai

Maker representatives give an example of four areas that could benefit from the DAI stablecoin:

• Gambling markets. It makes no sense to make long-term bets using volatility-prone cryptocurrencies. This carries not only the risk of reducing the size of the bet, but also the risk of the underlying asset prices falling. Using an asset that is stable in price allows you to limit your risk to the normal probability of losing.
• Financial markets. Stable in price collateral is well suited for smart contract derivatives.
• International trade. The cost of cross-border payments can be quite high. By eliminating intermediaries, DAI reduces costs to an adequate level.
• Transparent accounting systems. With verifiable transactions, DAI enables organizations to improve operational efficiency and reduce the potential for abuse.

Maker (MKR) cryptocurrency and the MakerDAO management system

In addition to the DAI stablecoin, the platform uses Maker (MKR), a native MakerDAO token of the ERC-20 standard.

The Maker Foundation first issued MKRs back in 2017. They were distributed to early users and sold out in three rounds of closed sales totaling $64.5 million.

MKR acts as "fuel" to repay commissions for using the system's smart contracts. Once fees are paid, MKR tokens are burned.

MKRs are destroyed when the liquidation balance of the MakerDAO system exceeds a minimum threshold. Excess DAI is auctioned for MKR tokens, which are then burned. Conversely, when the Maker Protocol is in deficit and the system's debt exceeds the maximum threshold, MKR tokens are created and auctioned to recapitalize the system;

The primary responsibility of MKR holders is to ensure the stability of the DAI exchange rate and the health of the system as a whole.

In addition, MKR performs the function of governance - the token is used in voting for risk management mechanisms and business logic of the platform. The proposal with the highest number of votes automatically receives the status of "important", thus influencing the further development of the entire project.

MKR holders vote on four key Vault risk parameters to ensure the stability of the Maker system:

• Debt Ceiling - the maximum amount of debt that can be created by a single Vault type;
• Liquidation Ratio - the ratio of collateral to debt at which a Vault becomes vulnerable to liquidation;
• Stability Fee - An additional fee calculated as an annual percentage rate over and above the principal of the Vault debt;
• Penalty Factor - a measure of the maximum amount of DAI that can be charged if the debt is liquidated.

In this way, MKR holders are the ultimate authority in the MakerDAO. They manage the system and share in the distribution of profits, but are forced to take losses if decisions are unsuccessful.

What are the risks associated with MakerDAO

MakerDAO's creators describe the platform's biggest risk factors and offer a list of mitigation actions.

• Malicious hacking. If there is any vulnerability in smart contracts, an attacker may try to steal collateral from the Maker platform.
• Competition. Stablecoin's decentralized DAI system is quite complex, so users may prefer simpler centralized stablecoin systems.
• Market irrationality. Prolonged periods of market irrationality can cause users to lose confidence in the stability and liquidity of the system. To address this problem, a large pool of capital needs to be raised. This will improve the rationality and efficiency of markets.
• Regulatory risks. According to the U.S. Securities and Exchange Commission (SEC), some steblecoins may be subject to securities laws. According to the SEC's classification, one steblecoin may be tied to real assets like gold or real estate, another to fiat currency, and a third may use a variety of "financial mechanisms that support price stability." The third category, which includes DAI, could come under the regulator's scrutiny.

How MakerDAO is evolving

MakerDAO was one of the first successful projects in decentralized finance.

By March 2020, the process of putting the management of the project in the hands of the community was completed: the Maker Foundation transferred all MKR management tokens to users, and MKR holders were able to vote on the issuance and destruction of tokens, as well as future changes to the rights set of this contract.

In the second half of 2020, crypto-market and DeFi activity grew significantly, resulting in a more than 20-fold increase in Dai's capitalization. MakerDAO became the first DeFi protocol with a total value of blocked funds (TVL) of $1 billion.

The MakerDAO protocol has found applications in traditional finance as well. In April 2021, real estate revitalization investment company New Silver opened a $5 million line of credit to issue Dai.

In the summer of 2021, MakerDAO creator Rune Christensen announced the end of the protocol's decentralization process. As a result, the developers shut down the Maker Foundation and handed over the right to make all decisions to the DAO.

In the spring of 2022, the MakerDAO community decided to implement an Ethereum Layer 2 protocol called StarkNet, which reduced smart contract fees and increased the speed of the protocol.

The summer of 2022 saw several big shocks to the cryptocurrency market at once. One of them was the bankruptcy of centralized lending platform Celsius Network. 

To solve its financial problems, it attempted to borrow $100 million from Dai, secured by stETH. As a result, MakerDAO disconnected the Aave protocol, which provided a similar service, from its system. In addition, Celsius Network was a large holder of Dai. As a result, the platform redeemed the stablecoins and bailed out of MakerDAO.

The project's community responded to the crisis by deciding to transfer $500 million in reserves into U.S. government and corporate bonds.

Proposal to unpeg Dai from being pegged to the US dollar

In July 2022, US authorities imposed sanctions on Ethereum mixer Tornado Cash and froze the assets of its users for several hundred million dollars. The decision of the authorities was also obeyed by the American company Circle, which issues USDC stablecoin - these coins in the accounts of Tornado Cash were blocked.

In response to this, MakerDAO founder Rune Christensen brought a radical proposal to the community: to make the DAI steiblcoin freely floating, unbound to the U.S. dollar, and to refuse to accept USDC, which serves as the most popular means of collateral in the protocol. In this way, he argued, the project could avoid regulatory risks.

Christensen's proposal was met with criticism. In particular, Ethereum founder Vitalik Buterin called it a "terrible idea". Community members were also skeptical of the proposal - they called it radical, utopian and extremely risky, pointing to the possibility of the collapse of the Dai stablecoin.