What Is MakerDAO?

Maker, a Santa Cruz, California-based developer of a decentralized autonomous organization, called MakerDAO, has helped create the largest Ethereum-based lending ecosystem. As an integral part of the decentralized finance (DeFi) market, Maker, a blockchain-based lending protocol, aims to minimize the price volatility of a stablecoin, known as Dai - which is used to manage the issuance of loans.

As the world’s first decentralized stablecoin, Dai is backed by Ether (ETH), the native token of the Ethereum blockchain - instead of the USD or other major fiat currencies (like other stablecoins such as the USDT or USDC).

Third-Parties Not Needed to Manage Dai’s Reserves

According to its developers, Dai may be a more reliable stablecoin investment as it does rely on third-parties to maintain its reserves. The management of Dai’s issuance process also does not require independent auditing firms to verify whether there are enough funds held in reserves to adequately back the number of stablecoins in circulation.

As explained by Kerman Kohli, the Founder of the stablecoin-based 8x protocol, the MakerDAO protocol manages the circulation of Dai. Notably, it is more challenging for Dai to maintain a 1-to-1 peg with the USD because it’s backed by Ether, which is a highly volatile cryptoasset.

Creating a Permissionless System for Stablecoin-based Lending

Founded in 2014, the Maker company did not conduct an initial coin offering (ICO) to raise funds for the MakerDAO project. The firm’s founders acquired capital for the initiative through a private sale of MKR coins, and launched the Dai cryptocurrency in early 2018.

Due to the highly volatile nature of cryptocurrencies, the developers of Dai aim to create a permissionless system which would allow the stablecoin’s holders to redeem their cryptocurrency holdings for the equivalent in fiat currency or other assets. Other stablecoins such as Tether’s USDT might not be able to maintain adequate reserves to allow users to always redeem their crypto for other assets.

Over $77 Million Worth of Loans Issued In Dai 

As one of the most notable crypto lending platforms developed on Ethereum, the DAI ecosystem holds approximately 2% of all ETH (as of March 2019) in circulation - which is maintained through the issuance of a smart contract

The smart contract-based lending system has issued more than $77 million in debt (using Dai). Due to the increased use of the lending protocol, Maker has reportedly experienced a “month-to-month” growth of around 20%. The usage of the P2P lending platform has increased because the majority, or 71%, of Dai borrowers spend the stablecoin immediately after acquiring it.

Smart Contracts Issue Dai In “Exchange for Collateral”

In order to use the decentralized lending system, users must first deposit Ether to Maker’s smart contract. By sending ETH to the contract, users are able to enter a collateralized debt position (CDP).

As explained, MakerDAO’s CDP is managed via an Ethereum blockchain-based smart contract, which creates Dai in “exchange for collateral.” This, according to MakerDAO’s website, which notes that the collateral is held in escrow until the borrowers pay back their loan in Dai.

The outstanding or circulating supply of Dai is altered through CDPs, in order to issue more Dai when “new assets are leveraged”, according to MakerDAO’s documentation. CDPs also alter the Dai supply by destroying a certain amount of the stablecoin when it’s “repaid to the position.” 

As noted by its developers, the total supply of Dai is managed through a smart contract which controls the cycle of creating and burning the stablecoin - based on when loans are issued and paid back. 

The value of collateral held in a CDP is “always” considerably greater than the debt issued (in Dai), which ensures that, at all times, 1 Dai is approximately equal to 1 USD worth of “underlying” assets. 

Collateralized Loans Managed By Strict Conditions Specified In Smart Contracts

For example, depositing 1 Ether (appr. $300 at current prices) will allow borrowers to obtain a loan of up to 40 Dai. The loan amount is based on a 150% collateralization rate ($300/1.50), issued against $300 in ETH.  

If the Ether price falls below the $300 mark, then a borrower’s CDP will have to be closed. In order to prevent this, users must either deposit additional funds in ETH or they should have not borrowed as much Dai (when they first took out a loan). Notably, the smart contracts which manage the Dai issuance process have been created to ensure that there are always adequate funds locked against the amount of Dai loans that have been issued.

Borrowed Funds Must Be Returned to Get Back ETH Deposit

Borrowers must pay back the amount they’ve taken out as a loan and also pay a small service fee, in order to get back their Ether that is being held as collateral.

For instance, a user may take out a Dai loan by depositing 1 ETH, which is currently valued at around $300. If the user borrows 50 Dai, then their CDP will be collateralized 600%. In this case, a borrower’s position should stay safe - provided that the Ether price does not fall below the $150 mark (50 x 300%). 

After a one-year period, a borrower could pay back the 50 Dai loan, and then get back the ETH locked in their contract. Once the user’s position has been closed, they will be charged a Dai stability fee - which is currently set to 16.5% by MakerDAO’s community members (through a voting system).

MKR Coins Purchased to Pay Stability Fee

Through the use of MKR coins, users may vote on matters related to MakerDAO’s management, which includes casting votes for setting the annual Dai borrowing fee, commonly referred to as the stability fee. MKR coin holders may also participate in decisions involving the collateralization ratio - which determines the amount of collateral that will be used to back CDPs.

Notably, each time users have to pay the stability fee, an equivalent (in dollar amount) of MKR coins are acquired from the market. These funds are then used to cover the stability fee. This type of payment process ensures that MKR remains a deflationary cryptoasset. 

An Ethereum-based Credit Facility

In a manner that’s similar to a traditional credit facility, MakerDAO’s lending system allows users to take out loans and set interest rates (charged as a stability fee). Lower interest rates, or stability fee, might motivate users to deposit more ETH as collateral, in order to take out loans in Dai.

Higher interest rates would mean that the cost of acquiring capital would also be high, which could discourage users looking to borrow money. According to DeFiPulse, there is currently $445.4 million locked in Maker’s contracts.  

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