DeFi 101. MakerDAO Stablecoin EcoSystem

MakerDao’s Dai has made the concept of decentralized finance a reality. The Dai stablecoin system allows users to take out asset-backed loans without the assistance of a financial intermediary like a bank. It also allows Dai’s value to stay equivalent to the US dollar. To keep this decentralized, community-governed, financial service up and running, smart contracts maintain the creation and destruction of Dai tokens. They also adjust the economic variables within the MakerDAO ecosystem so that Dai stays equal to $1 at nearly all times. Let’s take a closer look at MakerDAO and its decentralized financial service, the Dai stablecoin system.

What is MakerDAO’s Dai?

Dai is a collateral-backed stablecoin created by MakerDao. The Dai stablecoin system is MakerDao’s main product; the Dai project is community-governed and decentralized. Each DAI is created, destroyed, and loaned out through smart contracts called Collateralized Debt Positions (CDP). Dai is mainly used to take out collateral-backed loans and to trade cryptocurrency with leverage, but Dai can also be used as a payment rail.

How Does a MakerDAO CDP Work?

Dai is created, loaned out, and destroyed through Collateralized Debt Positions. CDPs are Ethereum-based smart contracts that mint new Dai when users lock up at least 150% of collateral in Ethereum relative to the value of Dai they would like to create. Afterward, users are free to use their Dai however they would like for as long as they would like. However, if the amount of collateral backing a CDP ever falls below 150%, then the CDP is auto-liquidated with a 13% forced-liquidation fee in addition to the interest rate (stability fee) on the loan.

The CDP holds a user’s collateral in escrow and returns the collateral when a user repays their Dai loan (in Dai), and it’s stability fee (in Dai or MKR). The stability fee can be thought of as the annual interest rate for taking out a loan in Dai. The current stability fee is 20.5% per year. This means that if you take out a loan of 100 Dai, then you will need to pay the equivalent of 120.5 Dai to close-out your CDP. When the stability fee is paid in MKR, the MKR that is paid to cover the fee is burned (removed from circulation). This makes MKR a deflationary currency and puts economic pressure on MKR to increase in value when a CDP is closed — but not auto-liquidated. This is because auto-liquidation requires inflating the MKR supply (adding to the money supply), and using the new MKR to buy and burn Dai to keep the economy stable (fully-backed). Let’s take a closer look.

How a CDP Enforces 1:1 Backing: Auto-liquidation

Auto-liquidation is an economic stabilization feature built into CDPs. Anytime a user’s CDP collateral falls below 150% in value relative to the amount of Dai they have borrowed their CDP is auto-liquidated. That is why it is recommended that CDP holders keep an amount of collateral significantly greater than the 150% minimum.

When a CDP is auto-liquidated, the smart-contract takes a CDP holder’s locked collateral, takes a 13% forced-liquidation fee as well as the stability fee from it, and then sells the collateral for an amount of MKR equal to the CDP holder’s outstanding Dai debt. The CDP then uses that MKR to purchase an amount of Dai equivalent to the CDP holder’s outstanding debt. Afterward, the Dai they have purchased is burned. This removes an amount of Dai from circulation that is equivalent to the value of Dai the CDP holder has taken out in their loan. In other words, the CDP closes your position for you; when it is all said and done, the CDP returns your remaining collateral.

Popular Use Cases

There are two popular-use cases for DAI. According to the MakerDAO whitepaper, one of them is using Dai to invest in Ethereum (or any crypto-asset) with leverage; the other is taking out a collateral-backed loan for non-volatile liquidity.

Let’s take a closer look at these popular use-cases:

1. Some traders lock up their Ethereum to receive Dai so that they can use that Dai to buy more Ethereum. CDP holder’s use the Ethereum bought with leverage to add collateral to their position, or to take a long position. Because CDPs let holders retain ownership of their Ethereum and issue them newly minted Dai, in essence, the holder has increased purchasing power. The increased purchasing power comes from the fact that the CDP holder keeps their collateral (which has retrievable value), and can invest in other crypto-assets despite their wealth (collateral) being locked away. If a trader has a belief that the price of crypto is going to rise in the future, they might open a CDP to trade with leverage. Afterward, they could use their profits from the price appreciation in the crypto they bought on leverage to pay off their debt, or add collateral to their position.
2. Another reason traders open a CDP is for increased liquidity. There may come a time when traders need a liquid, non-volatile asset, however, they are stuck with an asset like Ethereum — but Dai provides the solution to this problem. The Dai stablecoin system allows Ethereum holders to retain ownership of their ETH while issuing them a liquid stablecoin — Dai. If an individual believes that the price of Ethereum is going to rise in the future, but they need liquidity ASAP, then they might find opening a CDP beneficial given their situation and beliefs. Opening a CDP will give them access to the funds they need today while letting them keep their volatile asset for the future. If the price of Ethereum rises during the term of their loan, then the CDP holder will find out their collateral has appreciated in value when they pay off their debt and receive their collateral back.

How is Dai Governed:

DAI is governed by a decentralized autonomous organization (DAO); an entity that is not controlled by a central government. Instead, participants in the Dai ecosystem can vote on the governance of the project through vote.makerdao.org — a website that allows the MKR community to vote on proposals that will affect the Dai stablecoin system. Any account can upload a valid proposal for the MKR/Dai community to vote on. However, if a proposal is elected, there is a 24-hour delay from the time a proposal is elected to the time it is implemented. This is so the community has time to protect itself in case the elected proposal encourages malicious activity within the ecosystem.

What Sets Dai Apart from Other Stablecoins?

Dai is unique because it is one of the first decentralized financial (DeFi) products. The Dai stablecoin system is not governed by a centralized entity, and it does not have centralized reserves. This means that Dai users who are looking to take out a loan can do so without it being facilitated by a financial intermediary. Dai allows financial services to be obtained in a decentralized manner through user-activated smart-contracts. These smart contracts give users full control over financial services like receiving a loan and trading with leverage — services that typically require an individual to apply and then have their application reviewed by a financial intermediary before they are approved.

Because CDPs occur on-chain, users have 100% transparency into the reserves backing the Dai system — this differs drastically from many existing stable coin models. With Dai, CDP holders can take a look at the on-chain metrics for the Dai ecosystem to see what the total amount of collateral backing the total outstanding debt is.

MakerDAO’s Dai is one of the first projects within the blockchain and cryptocurrency space that grants its users decentralized, censorship-resistant financial inclusion — an unprecedented innovation in the world of banking and finance. That being said, and considering Dai’s success, we expect more decentralized financial products to come to fruition in the coming years.

For more information on digital assets, feel free to reach out to WhitePark Capital at vs@whitepark.capital, and be sure to check out our website www.whitepark.capital

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