MakerDao has blossomed from a small project on a tiny new blockchain in 2015 into one of the more successful and used projects on the now massive Ethereum blockchain.
MakerDao is a decentralized lending facility built on the Ethereum blockchain. The Maker platform leverages Ethereum smart contracts to automate the functions of a lending platform, as well as its associated stable coin in a decentralized manner. Users of the platform can post collateral (Ether) and receive the platform’s native stablecoin, Dai, which is designed to mirror the value of the US Dollar.
The difference between MakerDao and other projects that lend or manage stablecoins is how they operate and how they are governed. Lending projects usually have a company that handles the lending process from start to finish and stablecoin projects often have a central entity working to keep the stablecoin’s peg against a fiat currency. MakerDao has a governance system and automation system that leverages Ethereum smart contracts to perform the functions of lending and stabilization without a central party.
The Maker token (MKR) is a governance token that derives its value from its role in governance in the MakerDao platform as well as interest payments, called stability fees, which are paid by borrowers that create Dai.
MKR holders can vote on proposals submitted by any Ethereum account interested in submitting a proposal to the MakerDao system. Proposals are smart contracts submitted to the Maker platform which seek to modify the internal governance and operational variables of the Maker Platform. MKR voters evaluate these proposals on an ongoing basis. The proposal or smart contract with the highest amount of approval votes is elected as the “Active Proposal” in the MakerDAO system. This specific smart contract or “Active Proposal” can only be approved by MKR voters/holders to modify some part of the MakerDao platform.
The MKR token can also be used to pay interest payments known on Maker as “stability fees” on the Collateralized Debt Positions users have created.
The Dai Stablecoin(Dai)
The MakerDAO platform’s own stablecoin, Dai, is a hybrid stablecoin that relies on a complex mix of underlying assets, automated mechanisms, and external actors to achieve price stability.
Each Dai is backed by Ether held in MakerDAO smart contracts. These contracts are called Collateralized Debt Positions (CDP). Anyone can lock up Ether in CDPs and new Dai will be released to the user in exchange for locking up the necessary collateral. CDPs need to be over-funded or over-collateralized, meaning the CDP’s value will be greater than the value of the released Dai.
For example, if a user locks up $200 worth of Ether, the contract will release less than $200 worth of Dai. The amount of Dai released depends on the CDP’s collateral-to-debt ratio. CDP contracts also have a liquidation ratio which triggers an auction of the CDP’s assets if the value of the underlying Ether falls beneath the collateral-to-debt ratio. The Dai system wants to make sure there is more than enough collateral to back all the Dai circulating in the market.
When a user wants to retrieve their collateral, they have to pay down the debt in the CDP, plus the Stability Fees that continuously accrue on the debt over time. The Stability Fee can only be paid in MKR (or DAI if using the CDP Portal UI). Once the user sends the requisite Dai and MKR to the CDP, paying down the debt and Stability Fee, the CDP becomes debt free.
With the Debt and Stability Fee paid down, the CDP user can freely retrieve all or some of their collateral back to their wallet by sending a transaction to Maker.
Automated Stability Mechanism
Currently, the target price of Dai is a 1:1 USD soft peg. This can change over time, but as of this writing, this is the current Dai peg. When there is extreme market volatility challenging the price stability of Dai, the Dai system automatically engages something called the Target Rate Feedback Mechanism (TRFM). This mechanism operates similarly to how central banks use the interest rate to maintain their own currency’s price stability. According to Maker’s white paper:
“When the TRFM is engaged, both the Target Rate and the 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.”
When the market price for Dai is below the target price of one USD, the TRFM turns positive, which breaks the old targeted peg, creating a higher price target, in turn making the creation of Dai more expensive (decreased supply) and incentivizes the holding of Dai (increased demand).
In the opposite case, when the market price for Dai is above the target price of one USD, the TRFM turns negative, breaking the old targeted peg, creating a lower price target, making the creation of Dai less expensive (increased supply), which disincentivizes the holding of Dai (decreased demand).
The Dai system also relies on external actors voted on by Maker (MKR) token holders who are a part of the MakerDAO governing system. These external actors are called keepers, oracles, or global settlers.
Keepers participate in debt and collateral auctions when CDPs are liquidated, and also trade Dai looking for arbitrage opportunities. Oracles are trusted nodes that feed the platform with accurate pricing data. Global settlers are external actors selected by MKR voters who are in charge of handling the complete and orderly liquidation of the Dai system in 6the event of an existential threat.
Dai has been live since December 2017 and has maintained a very tight trading range around its price target of one USD. It’s still very early in the project’s history, but it has shown the ability to handle massive market volatility around its Ether based collateral. However, in 2019, Dai has struggled to keep that tight trading range as successfully as it did in 2018. In response, the MKR holders have approved proposals to modify the stability fee and other mechanisms to counter the broken peg. As of this writing, Dai seems to be trading pretty close to its goal of 1:1 pricing with the USD.
Risks & Concerns
MakerDao is a unique, exotic, and complex project. Although it’s been relatively stable and operating as intended, it’s a project operating at the edges of technological and financial innovation with a lot of moving parts.
The platform is heavily dependent on smart contracts, as well as external actors, for its successful operation. Smart contracts have been exploited before and can lead to catastrophic events like the infamous DAO hack. Malicious actors will try everything possible to disrupt and steal from MakerDAO smart contracts. As long as Maker has any significant value stored in its smart contracts they will be attacked.
External actors are also essential and are potential security holes. Keepers are expected to perform arbitraging functions to aid in the stability of Dai. If they are unable to complete arbitrage cycles quickly enough, Dai users could see more price instability than desired. In addition, trusted oracles are needed to feed the platform accurate pricing data on the assets locked up as collateral in CDPs in order to know when to trigger the appropriate liquidations. If a malicious actor gains control over a majority of the oracles they could disrupt the functioning of the entire platform. It would be up to the Maker community to handle this threat swiftly.
The platform has also been dealing with internal conflicts amongst the community, developers, and the leader of the project. Recently, the former CTO of the project quit and wrote a tome on the problems and disputes happening within the community. This is to be expected in any large organization, project, or community, but it’s unknown whether these tensions will lead to creative solutions or hold the platform back from reaching its full potential.
MakerDao is a fascinating project and we look forward to supporting its continued development and any users that wish to take advantage of its capabilities.