[DeFi] Masterclass on Collateralized Debt Protocols, Part 1 : MakerDAO v1
In this article, I will introduce the basic concepts of Collateralized Debt Protocols using the original version of MarkerDAO as a first concrete example.
This article is the first part of a series containing the following articles:
- MakerDAO v1
- MakerDAO v2
- Alchemix
Motivation
CDPs are the backbone of Defi, they enable users to maximize capital efficiencies and allow affordable leverage via their unique money creation capabilities.
However, I am not satisfied with the current designs proposed by existing protocols.
That’s why I started this series — to look into various protocols and eventually suggest ways to enhance them…
MakerDAO v1
Over-collateralized Stablecoin
MakerDAO was originally a simple collateral debt protocol (CDP), introducing the concept of over-collateralized stablecoin.
The protocol enables users to deposit ETH as collateral to borrow DAI, a stablecoin pegged 1-to-1 to USD.
Borrowing & Minting
For instance, a user deposits $1000 worth of ETH, allowing them to borrow 500 DAI, theoretically valued at $500.
DAI is minted ex-nihilo by the protocol and is backed by the user’s collateral.
Consequently, the user possesses 500 DAI, and the protocol retains the ETH as collateral.
Debt & Position
To reclaim the deposited collateral, the user must repay the borrowed debt.
While the position is opened, the user incurs fees based on the borrowed amount, which contribute to MakerDAO’s treasury, bolstering the collateral peg.
The lending rate is fixed by MakerDAO’s DAO, in order to safeguard the peg while optimizing utilization.
Bad Debt & Liquidation
Users are incentivized to repay their debt as long as the value of the collateral is greater than the debt.
If the collateral’s value drops below the borrowed amount, the protocol faces bad debt, resulting in systemic losses.
To prevent this, the protocol must liquidate the collateral and repay the debt, before the collateral value drops under the break-even point.
If the protocol cannot liquidate the collateral in time, the stablecoin issued by the protocol could not be 100% backed anymore and its price would depeg.
Defending the Peg
An analysis of DAI’s price history reveals two distinct periods, one with a lot of of volatility at the beginning, and a second one where the peg has been very stable since then.
Initially, MakerDAO relied on adjusting borrowing rates and leveraging arbitrage to maintain the peg.
However, this approach proved insufficient during events like Black Thursday, when DAI liquidity was needed to close borrowing positions, and DeFi Summer, when stablecoins were in high demand.
Price Stability Module & USDC
In response, MakerDAO introduced the Price Stability Module (PSM), enabling the minting of DAI against USDC at a 1–1 ratio, effectively capping the DAI price at 1 USDC.
This strategy led to a situation where up to 80% of the MakerDAO treasury backing DAI comprised USDC, raising concerns about decentralization and risk management.
Usage
There were 2 primary strategies when opening a MakerDAO’s position:
- leverage: mint DAI, sell DAI, buy more ETH or another altcoin
- lending: mint DAI at 1%, lend it at 5% on platforms like Compound
Conclusion
While the initial version of MakerDAO achieved significant success, the current DeFi landscape presents new challenges.
New factors such as the availability of staked ETH and alternative investment options like T-Bills at 5% APY have reshaped MakerDAO’s role in today’s ecosystem.
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