INVESTOR TRACK

The DeFi Revolution: An In-Depth Look Into The MakerDAO Protocol

Web3 Maya

Published in

Coinmonks

13 min readFeb 20, 2023

MakerDAO

Introduction

The MakerDAO protocol is one of the most important projects in the DeFi ecosystem. Maker is the name of the organization & DAO stands for Decentralized Autonomous Organization.

It clearly demonstrates the power of blockchain & decentralized finance & can be thought of as a decentralized central bank as it aims to bring stability to the cryptocurrency economy

What problem does MakerDAO solve?

Central Banks have often failed to adequately serve the general public by favoring large corporations, bailing out banks that made risky investments & endless printing of fiat to cover their deficits.

Moreover, In times of crisis, it’s not uncommon for banks around the world to restrict or deny the public to access their own money, creating panic & uncertainty among depositors. This highlights the restrictive nature of traditional finance.

The primary issue with traditional financial systems is that they are governed by a centralized authority, typically composed of a small group of individuals, who are responsible for monetary policies. This concentration of power can result in a lack of transparency, favoritism towards the wealthy and powerful, and insufficient representation of the public interest. To address these issues, there is a growing movement to decentralize monetary policies. This is where the MakerDAO protocol comes in.

What is MakerDAO ?

The MakerDAO ecosystem is a DeFi (decentralized finance) platform built on the Ethereum blockchain that allows users to mint a stablecoin called DAI by locking up digital assets as collateral in a smart contract called a Maker Vault.

The ecosystem is managed by a DAO (decentralized autonomous organization), which is governed by MKR holders & operates with a highly transparent & decentralized governance model.

Overview Of MakerDAO Ecosystem

The Maker Protocol employs a Two-Token system.

DAI: A stablecoin is a decentralized, unbiased, collateral-backed cryptocurrency soft-pegged to the US Dollar.

MKR: a governance token that is used by stakeholders to maintain the system and manage Dai.

Lets understand the Key Components of the MakerDAO Ecosystem.

Maker Protocol

The Maker Protocol is a set of smart contracts that govern the creation and management of Maker Vaults and the issuance of the DAI stablecoin

Its the core of the MakerDAO ecosystem, & is designed to be highly transparent and decentralized,

It’s maintained and governed by a decentralized autonomous organization (DAO) called MakerDAO, which is controlled by MKR token holders and provides a platform for community-driven decision-making and innovation.

Users

Vault Owners

Dai is generated, backed, and kept stable through collateral assets that are deposited into Maker Vaults on the Maker Protocol.

Collateral Asset: A digital asset that MKR holders have voted to accept into the Protocol. Some of them are Ethereum (ETH), Wrapped Bitcoin(WBTC), Basic Attention Token (BAT), Chainlink (Link) & Uniswap (UNI)
Maker Vault: A smart contract on Ethereum blockchain that holds user’s collateral assets & mints new DAI tokens in return.

DAI Holders

Other ways to obtain DAI is, by buying it from exchanges (like Binance, Coinbase & Kraken), or simply by receiving it as a means of payment.

Maintainers

Oracles

Oracles are specialized third-party services that provide accurate and reliable data feeds in real-time to the MakerDAO system & are used to determine the price of collateral assets.

Like most other components of Makerdao, the oracle is also decentralized as a network of multiple independent oracles is used with each relying on a variety of sources, such as financial data providers, cryptocurrency exchanges, and other data aggregators for data collection.

Complex algorithms are used to filter out unreliable data and produce a reliable price feed that is used by the MakerDAO system.

Keepers

Keepers are incentivized with rewards & profit opportunities to participate and help maintain the stability of the DAI stablecoin by performing certain functions such as liquidations .

When a Vault in the MakerDAO system becomes undercollateralized due to a drop in the value of its collateral, Keepers have the opportunity to liquidate the Vault by buying the collateral and paying off the outstanding debt in DAI.

Keepers also participate and bid in collateral auctions, which are held in the event of a system-wide liquidation event.

Note: If you don’t know some of these terms, don’t worry & continue reading. We’ll cover all of these concepts in this article.

Developers

They are individuals or teams who work on a variety of projects, including creating new smart contracts, building new features for the platform, or improving the overall performance and security of the system.

Governors

Risk Teams

Risk teams are groups of individuals or organizations that play a critical role in maintaining the stability and security of the platform

They are responsible for monitoring market trends, evaluating the risk associated with different collateral assets and proposing changes to the collateralization ratio or other aspects of the Maker Protocol subject to market change & other risk factors.

MKR Holders

MKR token holders are the decision-makers of the Maker Protocol, supported by the larger public community and various other external parties.

This means that MKR holders have the ability to vote on proposals that can impact the platform’s protocol, risk management strategies, collateral types, stability fees, and other important aspects of the system.

If the value of the collateral backing DAI falls below a certain threshold, MKR holders are required to participate in an auction to buy back and burn MKR tokens in order to restore the peg of DAI to the US dollar.

Mechanism

What does decentralized stablecoin really mean?

Popular Stablecoins like USDT & USDC are centralized. This means they are hard-pegged to an asset or a fiat currency, in this case, the US dollar. They are held as reserves with banks

Hard pegged : A stablecoin whose value is strictly pegged to an asset or a currency, always maintaining a 1:1 ratio, i.e. number of stablecoin in circulation is equal to the reserves of asset or currency held by a regulated financial institution like a bank or a trust company.

Tether was the first & by far the largest stablecoin. Currently, its the third largest cryptocurrency after Bitcoin & Ethereum, with a Market Cap of $66 Billion. USDC is the fourth largest with a Market Cap of $54 Billion.
But recently, a lot of people have shown concern about the lack of transparency of stablecoins & their Proof of Reserves.

The need for a decentralized & transparent stablecoin was apparent but it was nearly impossible to achieve decentralization with physical fiat currency as collateral. However, makerdao came up with a solution by using crypto assets as collateral & DAI was created as a stablecoin that could be borrowed against this collateral.

Users would own & lock up their collateral in Vaults (a type of smart contract) & as a result, there would be no single point of failure. With no physical Vaults or regular audits required, DAI became the first decentralized stablecoin. Anyone on the network can view & verify the collateralization in real time, making it transparent.

With no fiat currency to back it how is DAI always equal to $1 ?

Using a soft peg mechanism, DAI is able to maintain its value at around $1. This is achieved through a system of smart contracts and economic incentives that are designed to maintain the supply and demand of Dai in response to market conditions, while still maintaining its overall stability.

Understanding DAI’s Soft Peg To The US Dollar

The ultimate goal of MakerDAO is to ensure that DAI remains as close to its intended peg of $1 as possible.

As DAI is given out as loans, like any other loan, a borrower has to pay interest on DAI loans too. This interest is known as Stability Fee.

Value of DAI is less than $1

If the price of DAI is trading below $1, it signals that there is more supply than demand.
The stability fee is increased, making the loans more expensive & encourage DAI holders to pay back their loans quickly.
Repayment of DAI loans reduces the supply of DAI.
The price of DAI rises until it intended peg of $1 is restored.
DAI that is repaid, is burned.

Token Burning: a technique used to remove a digital asset from circulation permanently to reduce its supply, resulting in its price increase

Value of DAI is more than $1

If the price of DAI is trading above $1, it signals that there is lesser supply than demand.
The stability fee is decreased, making the loans more affordable which incentivizes more people to take out DAI loans.
More DAI is minted for lending out & supply of DAI increases.
The price of DAI falls until it intended peg of $1 is restored.

Challenges That Come With A Highly Volatile Collateral

Ideally, Collateral is supposed to be stable in value or else the price of the stablecoin would fluctuate & it won’t be stable anymore.

But here, our collateral is Cryptocurrency & as we know, cryptos are highly volatile with price fluctuations of 10% — 20% in a day, So how does DAI remain stable?

DAI’s stability is maintained through a system of over-collateralization and smart contracts.

Like centralized stablecoins with a 1:1 collateralization ratio or 100% collateralization, if DAI too kept its collateralization at 100%, even a little fluctuation in the value of the collateral assets could easily affect its value.

This is why DAI uses over-collateralization which is currently set at 1: 1.5 or 150%.

Over-Collateralization: for every $1 worth of Dai borrowed, the user must put up at least $1.50 worth of cryptocurrency as collateral.

This way overcollateralization maintains stability by providing a buffer against high market volatility. If the value of the collateral drops, the system has enough excess collateral to cover any losses and maintain the peg to the US dollar.

Let’s understand Over-collateralization with an example

Let’s say you have 5 ETH and the market price of each ETH is $200. This means your 5 ETH are worth $1000 in total. Now you want some liquidity but don’t want to sell your ETH as you believe its value will appreciate in future. So, you decide to get some DAI, which behaves similarly to cash. You use MakerDao & deposit your ETH in a Maker Vault.

With a collateralization of 150%, how many DAI can you mint?

Loan Amount = Total value/collateralization ratio

DAI Loan = $1000/ 1.5

DAI Loan = 667 DAI (rounded off)

If you mint all of those 667 DAI (which is the max limit ) with fluctuation in ETH price, you would be under-collateralized & get liquidated immediately. So to be on the safer side, you decide to mint a little less than 667 DAI to create an additional buffer.

You finally decide to mint 500 DAI. So, now we have an over-collateralization of 333 DAI, an additional buffer of 167 DAI (667 DAI max limit — 500 DAI minted) & a loan of 500 DAI stablecoins.

Now lets look at two scenarios where the value of the collateral asset (ETH in our example) fluctuates :

SCENARIO 1

ETH appreciates in value

Lets say ETH appreciates by 50%. So each of your ETH is worth $300 & the total value of your collateral ETH in the Maker Vault is $1500.

DAI Loan = $1500/ 1.5

This increases the limit of your DAI loan & lets you mint up to 1000 DAI (this was 667 DAI earlier).

Now you can borrow more DAI if you want.

SCENARIO 2

ETH depreciates by 25% & now the value of your ETH falls from $200 to $150.

The total value of your collateral in the Maker Vault is $750, which is exactly 150% of $1000 (the initial value of the collateral you borrowed DAI against).

This is a very risky situation if ETH falls even 1% the contract will be closed out.

There are a few things you could do to get out of this situation:

Add More Collateral: You could add some more ETH to your Maker Vault, which will increase your borrow limit & you’d be well above the 1.5 ratio mark.
Pay Back Full Loan: You could return your loan of 500 DAI & Retrieve the 5 ETH you put in originally.
Pay Back Loan Partially: If you don’t have all of your borrowed DAI with you, you could repay some of it & you’d be good to go.

If neither of the above measures is taken & ETH falls further & gets below the required collateralization ratio, the Maker Vault (smart contract) will automatically liquidate the collateral to pay off the debt and maintain the stability of the Dai token.

All of this happens very quickly within minutes with the help of algorithms.

Now let’s understand the Liquidation process in detail.

Liquidation / Collateralized Debt Position

The liquidation process is designed to ensure that the outstanding debt is paid off by selling the collateral at a discount so that the system remains solvent and stable.

The liquidation process in MakerDAO is a Two-Stage process:

Stage 1: Triggering Liquidation

When a loan in MakerDAO falls below the required collateralization ratio the Vault holding the collateral enters the liquidation phase. As the Maker Vault is undercollateralized, the value of the collateral is not enough to cover the outstanding debt.

So the MakerDAO system automatically starts the liquidation process by placing the under-collateralized Maker Vault into a collateral auction. This auction is designed to sell this Vault’s collateral for DAI to pay off the outstanding debt.

Stage 2: Liquidation Auction

This is where Keepers can bid on the undercollateralized Vault’s collateral to purchase it at a discount.

The auction starts at a discount of 3% off the prevailing price of the collateral and then increases by 0.5% until a Keeper is willing to accept the auction terms. The Keeper who wins the auction pays DAI for the collateral.

If the collateral is not sold during the liquidation auction, then the Vault is considered “bitten” and is no longer eligible for liquidation. In this case, the system will still attempt to recover as much of the outstanding debt as possible by using a penalty mechanism that charges a 13% penalty on the outstanding debt.

This penalty is paid by the Vault’s owner, who is then able to retrieve the remaining collateral.

How Is The Risk Management System of MakerDao?

Overall, MakerDAO employs a multi-layered approach to risk management to ensure the stability of the platform & the safety of user funds.

But, what happens when something catastrophic happens & you exhaust all the previous levels? The final level is called Global Settlement.

Let’s say we’ve got a situation where we need to pay back the debt. We don’t have enough collateral nor do we have enough stability funds. We need to come up with some more funds.

And this is done is with the MKR tokens.

The MKR tokens are inflated by minting new maker tokens. And these new tokens are used to pay off the debt. This is almost like bankruptcy. Where MakerDAO offers new equity to different equity holders, to get started again.

So, the maker token is diluted & this is known as the Global Settlement.

Now let’s dive a little deeper into MKR tokens & the governance process of MakerDAO.

Governance

As we have discussed earlier, Governance in MakerDAO is a decentralized and community-driven process that involves MKR token holders and various risk teams.

MKR is the governance token of the MakerDAO system, and MKR token holders have the right to propose and vote on changes to the protocol.

The governance process in MakerDAO can be divided into Two Main stages:

The Proposal Stage:

Proposal: Any MKR holders can propose a new governance action or change to the MakerDAO system. Proposals can cover a variety topics, from changing stability fee, to adding or removing collateral types & modifying the liquidation process.
Discussion: Once a proposal is submitted, the MakerDAO community can discuss and debate it in various forums, such as the MakerDAO subreddit, MakerDAO’s official forum, or in MakerDAO’s official chat channels.
Submission: After a proposal has been discussed and refined, it is submitted to the MakerDAO governance portal for formal consideration.
Risk Analysis: The MakerDAO Risk Team then evaluates the proposal and performs a risk analysis to determine the potential impact on the system.

The Voting Stage:

Voting Portal: Once a proposal has been submitted and evaluated, it is placed on the voting portal where MKR token holders can vote on it. Each MKR token represents one vote, and token holders can vote either in favor, against, or abstain.
Voting Process: The voting process typically lasts for seven days, during which time MKR token holders can change their votes.
Approved: If a proposal receives a quorum of at least 4% of the total outstanding MKR tokens, and a majority of the votes are in favor of the proposal, then the proposal is considered to be accepted and becomes part of the MakerDAO system.

Conclusion

In this article, we have explored the key components, mechanisms, liquidation process, and governance of MakerDAO.

I hope you have learned something new & gained a better understanding of how MakerDAO operates and the significance it holds in the DeFi world.

Thanks for reading! I hope you learned something new & gained a better understanding of how MakerDAO operates and the significance it holds in the DeFi world.