MakerDAO: What Is It And How It Works
MakerDAO is a protocol behind the DAI stablecoin which is a cryptocurrency that maintains a 1:1 peg to the USD. This means that 1 DAI is equal to $1. What makes it special is that each DAI is backed by Ether instead of another third party that claims to have the required collateral. Since Ether is extremely volatile, this poses great challenges to maintain the peg.
The project was initially launched in 2015 without even conducting an ICO. Instead, the project chose to privately sell the MKR tokens to fund the development over time. Maker’s DAI stablecoin was launched at the beginning of 2018 and has gained popularity ever since.
Why Does The Market Need DAI?
Dealing with the high volatility of cryptocurrencies is a huge problem. As far as the traders in the blockchain space now, the DAI is not the first stablecoin in the space. We can name some of the predecessors including TrueUSD, Tether, and a few others. However, the risk that hovers around all of these projects is that the custodial party that holds the real US dollars will refuse the redemption of the stablecoin for regulatory reasons. This also goes far beyond the ethos of one crypto being permissionless. Also, we do have to believe that the custodial solution has the correct amount of US dollars and not creating artificial inflation.
Who Is Using MakerDAO?
DAI is one of the most successful projects that was built on the Ethereum blockchain over the years. Currently, it holds about 2 percent of all Ether inside the smart contracts and has issued more than $77 MM in DAI in its system. Further, Maker continues to see a growing 20 percent monthly increase in terms of the DAI issued with 71 percent of the users spending their DAI as soon as they get it. This shows that there is a massive shift of usage rather than speculation.
How Does It Work?
The basics of the system are pretty simple. All you need to do is a deposit or send Ether to Maker’s smart contract which creates a Collateralized Debt Position CDP. This means that if you deposit 1TH which is worth about $100, you can later take up to 40 DAI assuming a 150% rate against the $100. However, if the price of the Ether drops below $100, the CDP will also be forcefully closed. To stop this from happening, you will have to put more Ether or take out less DAI in the first place. This will make sure that there is always enough capital locked against the amount of money that gets taken out.
Who Is Responsible For The System?
Inside the MakerDAO ecosystem, the MKR token allows for the token holders to influence some of the aspects of the protocol such as the stability fees, the collateralization ration, and the emergency shut down the question in case of a flash crash of the price of Ether. One very important information is that when the stability fee is paid, the dollar equivalent amount of MKR is purchased off the market to pay the stability fee. This means that the MKR token is a deflationary currency.
At the core of the token, MakerDAO is working like a credit facility that issues loans with a certain interest rate. If the interest rate or the stability fee is low, the people are encouraged further to borrow more but if the interest rate is high, the cost of capital is high making it much less attractive to borrow. The DAI has been consistently trading on exchanges below $1 and a big reason for that is because there is a huge amount of pressure from the DAI holders to sell. DAI can only be generated via the opening of CDPs. To bring the peg back to the correct target price, MKR holders decided to increase the stability fee from 1 percent to 3.5. By doing this, they hoped that a reduction of the incentive to open CDP will happen and will also increase the buying pressure. In the future, the MAKER team aims to introduce the DAI Savings Rate which will allow the DAI holders to lock up their DAI and earn interest. The interest is paid to the holders which are financed from the stability fee that goes to buy and burn MKR. In the case when the MakerDAO system has less collateral that it is supposed to, more MKR will be issued and sold on the market to buy back ETH and DAI holders.
Multi-Collateral DAI Explained
So far, the MakerDAO experiment seems to be working among the community and is growing every month. However, there is a huge limitation because you can only use Ether tocollateralise your CDPs. By introducing the multi-collateral DAI, you could use any ERC20 token in order to collateralize your CRP so this means that you could actually use your Bitcoins to do so. While it all sounds good, there are two implications which the users and holders should be aware of:
- By using the custodial assets such as the wrapped bitcoins, it could result in undersollateralised CDPs if the issuers have to freeze their assets.
- Since Ethereum is not the only asset inside the collateral it means that any positive feedback that loops from the ETH price can’t be realized as there is less ETH to contribute.
A positive ETH feedback loop and the Dai Savings Rate could pour some more life into the cryptocurrency because we have never seen a collaboration of this scale. Coupled with all of the other open finance projects, the experiment will be exciting to see how it thrives and succeeds. Maker is the third most successful experiment after Bitcoin and Ethereum at least according to many analysts because the team has managed to stay true to the values of crypto and launched a project that is meaningful to the entire crypto space.
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