MakerDAO For Dummies — 2021 Edition
This article is an update on the original article written by Gregory DiPrisco in 2017 on MakerDAO’s explanation. A lot has changed since then, and a dummy would benefit from reading the original article and coming here to catch up on the leftovers.
Ethereum opened the door to a host of new applications on top of Blockchain. These Decentralized Applications, or DApps, are replicating the traditional financial system on Blockchain and innovating upon them at the same time. One of the most basic functions of Banks is to act as an intermediary for borrowing and lending, and MakerDAO is the first blockchain alternative to this specific function of Banking.
Rune Christensen came up with the idea of MakerDAO in 2015. The problem with traditional cyptocurrencies at that time was their volatility, and he wanted to create a Decentralized Autonomous Organization (DAO) which could create and regulate a stable cryptocurrency pegged to a Dollar.
MakerDAO is a series of smart contracts running on Ethereum. It is one of the first Decentralized Autonomous Organizations to gain widespread adoption. MakerDAO runs on two cryptocurrencies — the DAI stablecoin, and the MKR (maker) governance token. It relies on a decentralized oracle infrastructure for price tracking of various cryptocurrencies.
Vaults
Anyone was free to Deposit Ethereum in the Vaults in the era of Single-collateral DAI (SAI). Now, everyone is free to deposit other select ERC-20 cryptocurrencies in the era of Multi collateral DAI (DAI). In the era of Single Collateral DAI, the Vault was called the CDP (Collateralized Debt Position). Now, the Vault is simply called the Vault.
The amount of DAI minted relative to the collateral is set through a collateralization ratio. If the value of the collateral rises, then users can unlock more DAI relative to their collateral, upto the collateral ratio.
You deposit your Ethereum-based cryptocurrencies, and DAI are minted in a specific proportion according to the collateral ratio (for example, if 1 Eth = 100 Dai, then depositing 1 Eth will mint 66 DAI). You have to pay back the DAI you have minted to gain access to your deposited collateral . The DAI will be burned, to maintain the $1 soft peg. The DAI you have paid back have to be paid back with Interest, and the interest has to be paid back in DAI as well in the Multi-collateral DAI.
Liquidations
If, however, the value of the collateral falls below the collateralization ratio, Maker has set some mechanisms to maintain the integrity of the protocol.
The first line of defense is over-collateralization. Essentially, this means that a lot more crypto is required than users can unlock in DAI.
This essentially means that more DAI It is recommended to deposit a much larger amount of collateral than the minimum collateral ratio to avoid liquidation.
If however, the value falls to the liquidation ratio, the maker system will trigger an auto-liquidation. In an event of auto-liquidation, a collateral auction is held. In this event, the collateral of a vault is auctioned. The penalties in such an event are as follows:
- Debt: The accrued debt is auctioned off to keepers at a small (3% discount).
- Liquidation Penalty: a liquidation penalty (13%, set by MKR voters for each collateral) is deducted from the collateral, and the proceeds are transferred to Surplus Auctions, resulting in burning of MKR.
- Remaining collateral: The remainder of above deductions is sent to the original owner of the liquidated vault.
If the debt is not sold in the auto-liquidation, the debt is covered through the surplus from the stability fees. If the surplus from stability fees is not enough to cover the collateral, a debt auction is initiated, whereby the outstanding debt is auctioned off to Keepers, who pay for the debt in DAI and receive newly minted MKR tokens in exchange.
Liquidations 2.0
In April 2021, A set of improvements were passed for the liquidation system in Maker. In short, the improvements include the ability to make partial bids, support for flash loans, DEX and Aggregator integration, and a new auction model.
How DAI maintains its stable price
The DAI uses a clever combination of Game Theory and Arbitrage Opportunities to maintain the supply and demand.
If the Value of Collateral Rises
Since DAI is backed by an ERC-20 Collateral, the price of DAI shall fluctuate in accordance with the value of the underlying asset. If the value of the collateral rises, users are incentivized to collateralize more of their assets through arbitrage opportunities, minting more DAI, and bringing the price to more stability. Target Rate Feedback mechanism.
If the Value of Collateral Falls
If the value of the collateral falls, The price of DAI is also expected to fall. Since the loan re-payback is calculated in terms of DAI, it is cheaper to pay back the loan, so the DAI would be exchanged back for the collateral, and since returning DAI results in burning of DAI, the supply of DAI would be reduced and the price would be stabilized.
Governance
Through a system which they refer to as ‘scientific governance’, MakerDAO is managed by a group of pseudonymous and independent people. All holders of Maker (MKR) token are eligible to vote on matters of governance, and anyone, regardless of their MKR holdings, can propose new changes. This distinction allows them to be labelled as a Decentralized Autonomous Organization.
Future Outlook
Since a lot of assets are convertible on Blockchain and the NFT revolution gives us the hope of converting our tangible items such as Property and Land into immutable NFTs, the future for MakerDAO is bright with the possible inclusion of such items as collateral. Either way, MakerDAO is all set to disrupt the financial sector.
