Open Finance: A Simple Guide to Using MakerDAO and Compound
MakerDAO and Compound are two emerging cryptonative services that have the potential to become a key infrastructure for the open financial system. MakerDAO system provides a collateralised cryptocurrency, or a “stablecoin”, DAI. Compound is a protocol for algorithmic and efficient money markets. Both systems are open-source and built on top of Ethereum. This post is a practical guide on how to get started with these first applications of the open financial system, or “decentralised finance”. Further, you will learn how these systems benefit from each other and understand how a financially motivated entity could benefit from such services.
A Quick Introduction to MakerDAO and DAI Stablecoin
The DAI stablecoin is a collateralised cryptocurrency that is soft-pegged to be 1:1 with the USD. The difference between DAI and other known stablecoins like Tether and USDC is that DAI is decentralised and built using smart contracts on Ethereum.
Maker is a smart contract platform that stabilises DAI with a system called Collateralised Debt Positions (CDPs). Basically, anyone with Ether can generate DAI and effectively take a low-interest loan with crypto as collateral. In the future, MakerDAO system will feature Multi-Collateral DAI, which means other cryptoassets can be used as collateral in addition to ETH.
This post won’t go too deep into explaining the details behind the MakerDAO system but works as a practical guide for anyone interested in trying it out. For more detailed information, I recommend reading the MakerDAO whitepaper and their Medium-posts.
Let’s move on!
Step 1: The CDP Portal
Let’s head to the CDP Portal at https://cdp.makerdao.com/. Our goal is to generate DAI, move this DAI to Compound’s money markets, and earn interest on our DAI holdings.
Initially, the portal wants you to connect a wallet to the system:
Once you’ve connected a wallet (and purchased and transferred ETH to the wallet), you can proceed. For Metamask, the UI in the CDP Portal will look like this:
Step 2: DAI Generation
Once you have your wallet filled up with ETH, you are able to generate DAI by posting your ETH as collateral. By clicking the “Generate”-button, the portal will initiate the generation process in the back-end (originating DAI requires several smart contract transactions to be completed on the Ethereum blockchain).
When the portal has created the CDP, the view will show the key information regarding your loan:
Let me explain what’s going on with the terms and numbers:
- Liquidation price: Since you have effectively taken a leveraged position using ETH as collateral, there exists a price at which the loan will be force liquidated, or “margin called”.
- Liquidation penalty: In an event of forced liquidation, you will pay a fee of 13% of your existing collateral. This fee is dynamically adjusted based on the Maker system participants’ risk analysis and is likely to decrease in the future as crypto volatility decreases and more stable assets are accepted as collateral.
- Collateralisation ratio is your collateral-to-debt-ratio and tells you how leveraged you are. You are able to dynamically add more collateral to secure your loan in order to maintain a high enough ratio and to not get force-liquidated.
- Minimum ratio is the ratio at which you will be force-liquidated, should your collateralisation ratio fall below this level.
- Stability fee is the fee paid in MKR tokens, which needs to be paid together with the DAI you borrowed to close the loan. In the future, the stability fee can be paid in different tokens by utilising a DEX-protocol (MKR will still be needed in the background).
Congrats, you have just taken a DAI loan out of an open financial protocol using Ethereum smart contracts! Next, let’s be even more rational and find a place for our DAI that yields more than the cost of borrowing it, which is the same as its stability fee, currently at 0.5% APR.
It needs to be highlighted that the Maker platform will include a DAI Savings Rate (DSR) feature after implementing Multi-Collateral DAI. But, in the meantime, let’s find a profitable place to store our DAI right now.
Step 3: Enter Compound — A Protocol for Efficient Money Markets
Compound is a decentralised liquidity pool enabling you to earn interest on your cryptoassets by supplying them to the market.
When you enter https://compound.finance/ and integrate your Ethereum wallet with the platform, your UI will look similar to this:
When you click DAI, you will see the interest rates both for the supply and demand of DAI:
As you can see, the supply interest rate is as high as 2.22% APR (at the time of this writing), which is much higher than the stability fee of 0.5% APR you are paying for borrowing your DAI on the MakerDAO platform. The demand (borrow) interest rate sits at 8.59% APR in Compound.
You might be wondering how this is possible and why isn’t everyone arbitraging this.
The difference of the interest rates is explained by you taking a risk of exposure to both ETH volatility and to the MakerDAO protocol. A person borrowing DAI from Compound’s money markets doesn’t necessarily have to use only (or at all) Ether as their collateral and can thus have a more diversified risk exposure. Moreover, the interest rates can reflect the trust to the protocols as a whole.
There’s no such thing as a risk-free return. The reason this strategy currently generates revenue for any ETH holder is that there are people wanting to borrow DAI, but who are not willing to use ETH as their only collateral.
Here’s a picture of the UI after you’ve earned some interest on your DAI:
The MakerDAO and Compound protocols represent the first practical use cases of what is already referred to as “Open Finance” or “Decentralised Finance”. If you successfully followed this article and ended up to Compound with your DAI, you did something that has never been possible in history before crypto: Take a USD-stable loan out of a protocol without having to trust any central entity to coordinate this process. In order to make a profit, you then lent that DAI to someone else who didn’t want ETH-only exposure but still wanted access to a USD-pegged stablecoin.
This is a strategy for any ETH holder to earn interest (but not risk-free) on their holdings, in a trustless fashion, using protocols built on top of the Ethereum blockchain. In the future, with the implementation of Multi-Collateral DAI, one can earn interest with a more diverse portfolio of cryptoassets by directly utilising the MakerDAO-native DSR.
Expect these protocols to be a raindrop of what is yet to come for decentralised and open finance.
I hope you found this article useful — we are living exciting times.
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