What is MakerDAO (DAI)

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29 Jan 2024

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MakerDAO is a Decentralized Finance (DeFi) project offering DAI, a stablecoin collateralized by crypto and pegged to USD. The project's community governs the coin through a Decentralized Autonomous Organization (DAO). Users can create DAI by locking their cryptocurrencies in the Maker Vault at a certain Liquidation Rate. For example, a 125% Liquidation Rate requires $1.25 worth of crypto for every $1 of DAI.

The stablecoin is over-collateralized to stabilize the volatile prices of the crypto and a Stability Fee is also charged. If your collateral falls below a certain Liquidation Rate, your cryptos will be liquidated and used to cover losses.

DAI remains stable thanks to its DAO controlling the Stability Fee and DAI Savings Rate. The Stabilization Fee affects the supply of DAI by changing the cost of mining DAI. The DAI Savings Rate affects the demand for the coin by changing the earnings investors receive from staking DAI. When DAI's index gets corrupted, DAO restores the index using these two mechanisms.

DAI offers similar advantages to other stablecoins and crypto assets. It can be easily transferred around the world, used to make payments or lock in losses and damages. It is also possible to use DAI to invest in the DAI Savings Rate contract and earn profits.

To participate in Governance Surveys and Executive Polls, users purchase MKR tokens that give them voting power. These tokens are used for changes to the Stability Fee, DAI Savings Rate, team, smart contracts, and more.

What is MakerDAO?

MakerDAO is a decentralized organization built on the Ethereum blockchain to allow lending and borrowing of cryptocurrencies without the need for any intermediary. MakerDAO , part of the DeFi movement , describes itself as a decentralized organization dedicated to bringing stability to the cryptocurrency economy.

Maker Protocol uses a two-token system. First; DAI, a collateral-backed stablecoin that offers stability, is the second; MKR, a governance token used by stakeholders to maintain the system and manage DAI. Since DAI's launch in 2017, user adoption appears to have increased significantly . Moreover, DAI is known to have become a building block for decentralized applications that help expand the DeFi movement.

Users can create a certain amount of DAI by locking ETHs in MakerDAO's smart contracts. The more ETH locked on the contract, the more DAI can be created. The amount of ETH locked on MakerDao, one of the most widely used projects in the DeFi ecosystem, is increasing day by day.

Who is the Founder of MakerDAO?

MakerDAO was developed in 2015 by Rune Christensen , a Danish entrepreneur . Christensen graduated from the University of Copenhagen with a degree in Biochemistry and also studied international business at Copenhagen Business School. Prior to MakerDAO, Christensen also co-founded international recruiting company Try China.

What is DAI?

DAI is MakerDAO's USD-pegged stablecoin and is one of the largest stablecoins and cryptocurrencies by market cap. This ERC-20 token has an unlimited supply as long as users continue to submit collateral to generate more DAI.

MakerDAO uses crypto collateralization instead of a fiat vault to maintain its index. It can be confusing how crypto, which is known for its volatility, can be used to back a stablecoin. Simply put, the value of the crypto a user deposits to create DAI is much higher than the value of the stablecoin they receive. This provides extra room for a downward price movement in the crypto collateral.

Similar to any other stablecoin, there are several advantages to using DAI:

It is more suitable for expenses that require stability:Sellers and buyers may not always be willing to accept payments in cryptocurrencies, the value of which can change overnight.
DAI takes full advantage of blockchain:It is possible to transfer stablecoins anywhere in the world without a bank account. They are extremely safe if stored correctly.
You can use DAI to lock in profits or losses and hedge risk:DAI will reduce the overall risk of your portfolio and provides a convenient way to exit or enter positions without leaving the chain.

MakerDAO Working System

As it is known, when the collateral of a loan falls below a certain point (when the ETH price falls well below the amount of DAI borrowed), that loan is liquidated.

In other words, the ETH used as collateral is sold to repay the borrowed DAI, penalties and fees. Such a liquidation system keeps the system stable by preventing people from getting too much debt.

When the ETH price drops and too many loans are liquidated at the same time, MKR is created and sold to repay the loans.

At the same time, fees must be paid on MKR, and liquidation penalties are used to recover burned or destroyed MKR.

In theory, there should always be sufficient value in MKR to support liquidated loans.

DAI, ETH and MKR operate as an automatic system of checks and balances, each working to neutralize the other and keep the system stable.

At this point, the working order of DAI and MKR works as follows:

DAI is an ERC20 token pegged to the US dollar on the Ethereum blockchain. It is also a key player in the MakerDAO credit system. Because DAI is created when a loan is received through MakerDAO. This is the currency that users borrow and repay.
The Maker (MKR) token was created by MakerDAO and its primary purpose is to support the stability of DAI and provide governance for the DAI Credit System. In addition, MKR holders can make important decisions about the operation and future of the system.

How does crypto collateral work?

The concept of collateral , which you've probably encountered before , is quite common in the world of traditional finance. When taking out a loan, you need to offer something of value as collateral. This collateral is used to cover the loan in case you are unable to repay it.

Physical and fiat collateral

Getting a loan from the bank is a good example of this. You can offer a valuable physical object (collateral) such as your own jewelery in exchange for a cash loan. Then, to get your collateral back, you either pay the debt and an additional fee or leave the collateral to the bank so that it can compensate for its loss. Collateral acts as a security measure, and the same concept applies to mortgages and auto loans. In these examples, the goods (property or automobile) serve as collateral.

Fiat-backed stablecoins such as BUSD are collateralized by fiat currencies. The user gives his cash (collateral) and receives tokens in return. The user can return the tokens if he wishes, but if he does not, the money he paid remains with the unit that issued the token. This mechanism allows arbitrage , which allows the stablecoin to maintain its index . Learn more about this topic in What is a Stable Coin? You can find it in our article.

Crypto collateral

Crypto-collateralized stablecoins like DAI accept crypto rather than fiat as collateral. A smart contract manages these funds, applying specific rules like this: For Y ETH deposited, X stablecoin tokens are issued. Give back Z amount of ETH when X stablecoins are returned. Exactly how much collateral is required depends on the project issuing the token. At its most basic, the ratio is based on the volatility and risk of the collateral asset.

What is DAI overcollateralization?

Stable and low-risk assets such as fiat, precious metals, and properties are generally most preferred for collateral. As we mentioned before, using crypto as collateral is more risky for those who issue the token as large changes in prices can occur. Let's say a project wants 400 USD worth of ETH for 400 USD-pegged tokens.

If the price of ETH suddenly drops, the collateral held by the unit that issued the token will no longer cover the value of the tokens it issued. The solution here is overcollateralization: token issuers demand 600 USD worth of ETH in exchange for 400 tokens of their USD stablecoin.

What are collateralized debt positions (CDP)?

MakerDAO has used overcollateralization to maintain a highly reliable index for years. DAI operates efficiently and without human intervention, thanks to the creation processes being controlled by smart contracts. When you want to create the DAI stablecoin, you lock your cryptos in the CDP smart contract. This CDP determines a Liquidation Rate , for example 1.5x . In other words, for 100 USD of DAI you must provide 150 USD of ETH. The user can reduce his risk by adding more collateral if he wishes. If the deposit amount falls below 150% (1.5x), you will have to pay a penalty fee. As a result, the user risks liquidation if they cannot repay their DAI and the interest rate attached ( Stability Fee ).

What are Maker Cases?

Maker Vaults are where users deposit their collateral and create DAI. These safes allow you to use different cryptocurrencies as collateral at the same time. DAIs returned by users are also burned by the Maker Vault . The process works like this:

You deposit supported cryptocurrencies into Maker Protocol.
Deposited funds open a Maker Vault position.
You can withdraw an amount of DAI determined according to your collateral amount. You must also pay the Stabilization Fee.
You pay back the DAIs you withdraw to get your crypto collateral back.

You can create or return DAI at any time. Additionally, you can add to your collateral or withdraw your deposited collateral. However, you must maintain the Liquidation Rate determined by the Safe. If you fall below this rate, your collateral will be liquidated by the Safe.

How does the value of DAI maintain its stability?

Apart from reducing risk for MakerDAO as the issuer of the token, the CDP mechanism also helps DAI maintain its index to the USD. MakerDAO may also vote to change the Stability Fee and the DAI Savings Rate (the fee paid to those staking in the DAI Savings Rate smart contract) to change the supply and demand for DAI. These three mechanisms work together to ensure that DAI maintains its $1 index. Let's examine exactly how this works:

When DAI falls below the index, the system makes it more attractive for users to repay their debts, reclaim their collateral, and burn their DAI. This can be done by increasing the Stability Fee, thus making it more expensive to issue tokens. By increasing the DAI Savings Rate, the DAO may also increase the demand for investing in the token.
When it rises above the DAI index, the opposite happens. DAO creates incentives to create DAI by lowering the Stability Fee. This causes new DAIs to be created and total supply to increase, lowering the price. MakerDAO could also reduce demand by lowering the DAI Savings Rate, meaning investors will look elsewhere for profits.

Areas of use of DAI

As we mentioned before, DAI can be used similarly to any other stablecoin and offers the same benefits. It is not necessary to create the tokens yourself. It is possible to purchase DAI from crypto markets such as Binance. DAI also has several unique uses:

Extra Advantage:Let's say you have 1000 USD worth of ETH and you think the price will rise. But you do not have extra funds to buy ETH. You can use ETH as collateral, create DAI and buy more ETH with these DAI. If the price of ETH rises and you want to cash out, you can sell some of your coins in exchange for DAI tokens and get your collateral back.
DAI Savings Rate:You can earn profits by investing your DAIs in the DAI Savings Rate smart contract. The DAO may make changes to this rate in order to control the price of DAI.

How can I participate in MakerDAO's governance system?

In order to have a say and vote in MakerDAO, you must hold MKR, the project's governance token. This token has a maximum supply of 1,005,577 MKR, of which approximately 40% was distributed to the team and early investors during the launch phase. The DAO has kept the remaining tokens for future sales.

MKR holders can vote for changes to the platform's Stability Fee, DAI Savings Rate, Liquidation Rate and other issues. Their votes are proportional to the amount of MKR they hold. You can visit MakerDAO's governance portal and participate in current voting.

MKR Token

Maker (MKR) is the governance token of MakerDAO, a decentralized organization based on the Ethereum blockchain, and Maker Protocol, a software platform that allows users to mine and manage DAI.

So, the creation of a new MKR depends on the determination of DAI. If DAI remains constant, more MKR will be burned, reducing its total supply. If DAI moves away from the dollar price to which it is pegged, it creates more MKR, increasing the total supply.

Maker (MKR) Differences

As of September 2021, DAI is one of the most popular stablecoins. DAI, the 31st largest cryptocurrency with a total market value of approximately $6.5 billion, is among the biggest competitors of USDT, the largest stablecoin in the market.

Since MKR holders benefit financially from a stable MakerDAO system, they are incentivized to act in the best interests of the MakerDAO protocol.

As a result, MKR holders are able to vote on governance decisions, such as how high fees are set and what types of collateral can be accepted as collateral by the protocol.

In the MakerDAO system, one MKR token equals one vote, so individuals or organizations holding large amounts of MKR can have a large influence on the voting results. We can list a few aspects of the protocol that users can vote on as follows:

Adding new types of collateral assets to the protocol, allowing users to submit new cryptocurrencies to generate more DAI.
Changing the risk parameters of existing collateral asset types,
Changing the DAI Savings Rate,
Future updates to the platform.

Governance Surveys

Governance Poll allows users to create non-technical proposals for other MKR holders to vote on. For example, this recommendation could be for a change in governance, goals, team or budgets. The Governance Survey uses a Quick Decision mechanism, meaning you can rank your preference from multiple options.

Administrator Ratings

Admin Votes are for technical smart contract changes. Suggestions use a Continuous Approval Voting system, meaning it's always possible to put forward new, competing suggestions. An Administrator Vote results in significant changes to smart contracts, such as changing fees or collateral levels. Executive Votes are required to implement some changes voted on in Governance Surveys.

DAI, the most dominant crypto-collateralized stablecoin, has proven its success. The system manages to avoid the volatility of crypto without collateralizing it with fiat money, which is quite an achievement. Its importance in the history of DAOs should also not be forgotten. As one of the longest-running and largest DAOs, MakerDAO has paved the way for many other projects. However, if you decide to try DAI, you should still consider that it carries similar risks to other stablecoins.