MakerDAO is a blockchain protocol running on Ethereum that aims to incentivize a distributed network of computers to maintain DAI, a cryptocurrency designed to track the price of the U.S. dollar.
One of a number of emerging decentralized finance (DeFi) cryptocurrencies, MakerDAO is itself part of a larger system called the Maker protocol, which uses a combination of crypto assets to operate and maintain DAI without the need for any bank or government.
Specifically, the Maker Protocol requires two types of tokens to work: DAI and MKR.
DAI is created when a user locks another cryptocurrency, such as ETH, in the Maker platform to take out a loan in DAI. Users can return the DAI borrowed to claim this cryptocurrency, but they must be careful its value doesn’t fall below a certain level or it could be automatically sold.
(For more on how DAI operates, read our ‘What is DAI?’ guide.)
But while DAI is best thought of as the service provided by the Maker Protocol, MKR, is the crypto asset that governs how changes to the protocol that keeps DAI running are made.
In short, MKR tokens allow users to vote on proposals that affect how DAI can be used.
For example, MKR token holders can vote on which cryptocurrencies can be locked in the protocol or the price at which these assets would be sold in liquidation.
As of 2020, the Maker Protocol accepts eight cryptocurrencies including ETH, MANA and BAT that can be used to generate DAI.
Who created MakerDAO?
The Maker Protocol was created in 2015 by a group of developers led by Rune Christensen. The group was formalized later into the Maker Foundation, a Cayman Islands company.
In 2017, the Maker team raised $12 million by selling MKR tokens to noted venture capital firm Andreessen Horowitz and others. These included the cryptocurrency fund Polychain Capital and other venture firms like 1Confirmation.
In 2018, a further $15 million worth of MKR tokens were sold to Andreessen Horowitz. The firm said at the time that it intended to participate in MakerDAO by helping to govern the DAI system.
Maker raised an additional $27.5 million in 2019 from venture firms Paradigm and Dragonfly Capital Partners for expansion to Asia.
How does MakerDAO work?
At launch, 1 million MKR tokens were created to govern the Maker protocol.
Anyone who owns these MKR tokens can cast a vote on key decisions using a process known as Executive Voting. If an Executive Vote is passed, then the code in the Maker Protocol is changed to reflect the winning proposal.
However, before an Executive Vote can be carried out, another form of voting must first take place. This is called Proposal Polling, and it’s a way for MKR holders to gauge sentiment on a proposal before committing any changes to the protocol.
A third type of vote can be cast by non-MKR holders using threads in the MakerDAO forum.
But while anyone may make proposals to MakerDAO, only MKR holders can vote on them. A vote is then measured by the amount of MKR tokens committed to a proposal.
For example, if 10 holders with 1,000 MKR vote for Proposal A, while 5 holders with 5,000 MKR vote for Proposal B, Proposal B wins because more MKR tokens support it.
Only the number of tokens, not the number of token holders, influences the vote’s outcome.
DAI Savings Rate
Importantly, MKR holders can decide how much DAI holders earn if they save DAI on the platform. The amount DAI holders earn for doing this is known as the DAI Savings Rate.
The DAI Savings Rate has been as high as 8.75% per annum, and as low as 0%. In fact, the current savings rate is set at zero due to a market crash in March that caused DAI to trade significantly above $1.
In the aftermath of the crash, MKR holders voted to set the DAI Savings Rate to 0% to encourage the sale of DAI, which would bring the price of DAI closer to $1.
In this case, MKR holders voted in-line with expectations.
When the price of DAI rises above $1, MKR holders are expected to vote to decrease the savings rate to reduce demand, causing the price to fall.
If the price of DAI is under a dollar, then MKR holders should vote to raise the savings rate to increase demand to hold DAI, thus causing the price to rise.
What Makes MakerDAO Unique?
MakerDAO, with six years of operation under its belt, has not only endured multiple crypto market downturns but has also distinguished itself through its unique protocol design.
One key factor setting MakerDAO apart is its DAI token, which contrasts other stablecoins like USDT and USDC.
DAI’s value is not tethered to cash reserves; rather, the MakerDAO protocol uses various mechanisms to consistently support and uphold the value of the DAI token, including over-collateralization, stability fees, automatic liquidation, and MKR dilution.
Below, we provide a brief overview of each of these distinctive mechanisms:
- Stability Fees: These are charges levied for creating new DAI tokens from MakerDAO’s vaults. These fees are paid using the MKR tokens and are often adjusted based on the prevalent needs of the protocol at particular periods. Hence, the stability fee can either be increased or decreased. For instance, if the DAI value rises above the $1 peg, the stability fee is increased to reduce CDPs. The reverse happens when the stability fee is reduced.
- Overcollateralization: This distinctive approach is a trust-building measure, ensuring that crypto users deposit excess collateral compared to the DAI they aim to create within MakerDAO. The minimum collateralization ratio is fixed at 150%.
- Automatic Liquidation: This occurs when a user’s collateral ratio drops below the 150% minimum ratio. In the event this happens, the MakerDAO smart contracts automatically begin to sell the deposited collateral to cover up for the debt. This feature incentivizes users to always maintain the recommended collateral ratio.
- MKR Dilution: When a substantial number of liquidations occur, MakerDAO responds by minting MKR tokens and offering them on the open market to cover the collateral losses. This process reduces the quantity of MKR tokens in circulation and impacts the holdings of token holders.
New Update: Multi Collateral Dai (MCD)
While MakerDAO boasts of some of the most robust stop-gap mechanisms to maintain its lending services, the dApp has successfully brought credit systems into the DeFi landscape.
One key advantage is its inclusive nature, allowing individuals worldwide, regardless of their demographics or location, to access capital if they meet the specified deposit requirements. This vastly opens up a new funding channel for both businesses and individuals to tap into.
In addition, the protocol launched the Multi Collateral Dai (MCD) upgrade on 18 November 2019.
This upgrade comes with a number of new features, including:
- Support for all Ethereum-based tokens approved by MKR token holders.
- The introduction of a Dai Saving Rate (DSR) enables users to earn yields on their savings by locking their Dai stablecoins into DSR smart contracts.
- Payment of stability fees for every new block, as against periods of repayments.
- Launch of Oasis Trade, now Summer.fi.
MakerDAO Tokens (DAI & MKR)
The DeFi lending protocol operates through a combination of DAI and MKR tokens.
The DAI stablecoin is fiat-backed and tracks the value of the US dollar on a 1:1 basis. The stablecoin is soft pegged to the US dollar and backed by the collateral locked in Maker Vaults.
Here are some of the benefits of using the DAI stablecoin:
- Users can take out loans against unrealized gains without triggering a taxable event.
- The DAI stablecoin is more stable.
- Yields of up to 8% via the Dai Savings Rate smart contract.
The MKR token serves as a major backstop to the DAI. MKR is used in voting on network proposals and the general direction the DeFi protocol is headed.
DAI primarily serves as the lending asset, while the MKR token plays a distinct role as:
- A support system to ensure the value of DAI is pegged to $1.
- A stakable asset to secure the network.
- A governance mechanism where others determine the direction the crypto lending platform heads towards.
The concept of over-collateralization is pivotal to MakerDAO’s operation. Overcollateralization entails users locking up a significant amount of collateral that exceeds the loan’s value.
As of October 2023, the minimum collateralization ratio for Vault on MakerDAO is 150%. Vaults are smart contracts that receive collateral from investors and, in exchange, generate the DAI stablecoin.
Here is an example:
- A user would need to lock up $150,000 worth of cryptocurrency (such as ETH) as collateral in order to access a $100,000 loan in DAI stablecoin.
- Once the loan expires, the user must repay the DAI and a stability fee to access their collateral. In many ways, the stability fee is comparable to the interest paid to a bank for a loan.
- However, it is recommended that users deposit more than 150% of the collateral ratio to prevent automatic liquidation.
Automatic liquidation is when a user’s collateral is used to settlle their debt if they cannot pay the loan on time or the deposited asset’s value crashes significantly.
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