The DAI stablecoin is about to enter a new phase with multi-collateral contracts — increasing flexibility for issuers and rewards for holders, and likely improving the stability of its peg to the dollar.
MakerDAO (MKR) isn’t the easiest project to understand, but once you get it, you’ll be hooked. It’s a protocol that issues stablecoins (called DAI) backed by crypto collateral. DAI are algorithmically managed to keep them as close as possible to a $1 peg.
Algorithmic stablecoins are nothing new. Early versions included NuBits and BitShares’ BitUSD, among others. These all failed, for one reason or another. Either there were elements of centralisation, undermining trust and presenting single points of failure, or else they simply couldn’t withstand the kind of dramatic and often sustained volatility for which the crypto markets are so well known.
Launched on Ethereum at the end of 2017, MakerDAO addresses the shortcomings of these earlier algorithmic stablecoins with a new model, fully decentralised and enforced by smart contracts. Tested by fire in the bear market of 2018 and parabolic rise and correction of 2019, DAI has fared well. Deviations from the $1 peg have generally been limited in size and brief, indicating the protocol is working as planned.
Collateral portfolios
MakerDAO will shortly enter a new phase. Up to this point, users have been able to lock ETH into a smart contract and issue DAI against it. Effectively, they are lending DAI into existence against that ETH collateral; when the DAI is repaid (plus a fee), the ETH is unlocked and they get it back. From 18 November, it will be possible to use certain Ethereum assets such as BAT as collateral, as well as ETH. This makes the platform more flexible, and allows a wider range of holders to use their crypto assets to free up cash without actually selling them.
It’s simple in theory, but somewhat more complicated in practice. The process by which the MakerDAO ecosystem maintains the $1 peg for DAI is a labyrinth of different technical components and economic actors. Here’s broadly how it works…
MakerDAO collateral contracts
The process starts with a user opening a smart contract called a Collateralised Debt Position (CDP). This is funded with ETH and, from next month, other crypto assets. The CDP owner can now lend DAI into existence from that contract, against the collateral it holds. Think of it as a secured loan, like borrowing against the value of your house.
Of course, it’s important the value of this collateral is never less than the value of DAI issued. One of the factors that prevents that happening — just like in the conventional financial system — is over-collateralisation. Contracts need to hold at least 150% of the value of the DAI issued. That gives some room for the day-to-day ups and downs of the crypto markets. The value held in the contract is checked regularly by a series of Oracles, which read price data from various sources and record it to the blockchain.
DAI can be transferred and traded like any other crypto coin, with the difference that they are designed to maintain their value of $1 each. When a CDP owner wants their collateral back, they simply need to repay the DAI and it unlocks their crypto assets.
Contract liquidation
If the value of the collateral held in a CDP contract falls below the 150% ratio, the MakerDAO ecosystem takes action. That contract is liquidated — a lot like being margin-called on a leveraged trade on a conventional exchange — and the creator forfeits ownership to its contents. The collateral is auctioned to recoup the DAI issued against it. (Any left over at the end goes to the CDP creator, minus fees.)
Maintaining the peg
So what’s to stop DAI from trading at more or less than $1, depending on supply and demand? This is where two sets of fees come in.
The first is the ‘Stability Fee’ (SF) that accrues over time on DAI issued from every CDP. When it’s paid back, the fee also needs to be paid before the collateral is released. MakerDAO has a governance system consisting of Maker holders, and they set the Stability Fee.
If DAI starts trading at significantly more than $1, the fee is decreased. This reduces the cost of having outstanding DAI, incentivising CDP owners to maintain and increase supply. Conversely if DAI is trading below $1, the fee is increased. This incentivises CDP owners to redeem DAI due to the rising cost of keeping it outstanding, reducing supply and hopefully increasing prices on the open market. This is a little like the way that central banks aim to target a given inflation rate by adjusting interest rates.
The other side of it is the demand element. When the new version of the MakerDAO protocol launches, anyone who holds DAI will be able to lock it in a smart contract and earn interest on it. The interest will be paid from the Stability Fee. So again: if DAI is trading below $1, increasing the return on it will make it more attractive to investors, leading to rising demand and therefore rising prices. If DAI is trading above $1, reducing the interest rate on it will prompt holders to free up DAI locked in contracts and sell it for other assets.
Ok, but what if…?
Crypto is notoriously volatile. A collateralisation ratio of 150% might seem plenty, but prices can drop hard and fast. Moreover, what about a ‘Black Swan’ event, where an asset used as collateral suddenly becomes worthless? Perhaps a large number of tokens are dumped after an exchange theft, or a project is destroyed by hackers who exploit a loophole in a smart contract. If that happened, CDPs couldn’t be liquidated fast enough, the contents wouldn’t be worth enough, and DAI would inevitably lose its peg.
The last backstop to maintain the price of DAI is provided by Maker holders themselves. As well as forming the governance body who set the collateralisation ratio, stability fees and returns on DAI, Maker holders are buyers of last resort for DAI. If a set of emergency oracles determines that prices have fallen too far, new MKR is created and sold to fund the shortfall. This dilutes the value of Maker already in existence, reducing the price of each MKR token.
Why would Maker holders sign up for this risk? Because they get paid every time a CDP is closed. Part of the fee levied when DAI is redeemed is used to purchase and burn MKR, incrementally increasing demand and reducing supply. Just like any other investment, this makes holding Maker a risk/return calculus.
Overall, the MakerDAO ecosystem is maintained by a complex but very elegant set of economic incentives, enforced by smart contracts.
All clear?
Article by Moonhub
