The original decentralized financial protocol: MakerDAO and DAI
Imagine a currency that matches the value of a regular, physical dollar in the United States but can be accessed through the internet. Citizens in countries with rapid inflation can purchase said currency and avoid losing their buying power day by day. People in areas with high crime rates or limited access to banks need secure alternatives to store money. Now, they can safeguard their assets digitally wherever they are.
MakerDAO, a Decentralized Autonomous Organization (DAO), is a service that brings financial tools to the Ethereum blockchain. In operation since 2017, MakerDAO currently holds over six billion dollars worth of crypto, making it one of the largest protocols in the decentralized finance (DeFi) market. MakerDAO’s services include a stable cryptocurrency and the ability to earn interest on or borrow crypto.
In 2017, there was no way to convert cryptocurrencies into a U.S. dollar equivalent without moving funds off the blockchain. MakerDAO looked to fill gaps in the DeFi space and pair traditional financial services with the benefits of blockchain technology.
Thus, MakerDAO created DAI, a stable cryptocurrency whose value is always worth one U.S. dollar. If someone wanted to hold their assets on-chain without being exposed to the price fluctuations of crypto, they could simply convert their crypto into DAI. Users of MakerDAO can earn interest on their DAI if they deposit it into the protocol savings account. They can also borrow DAI by depositing crypto collateral such as Bitcoin or Ether. At any time, users can withdraw their DAI from the savings account or their collateral from the protocol as long as they repay the DAI they borrowed.
How MakerDAO ensures DAI remains at $1
DAI deviating from a 1:1 ratio with the U.S. dollar renders all of MakerDAO’s services useless. So MakerDAO closely monitors and maintains the ratio using over-collateralization and incentives.
If someone deposited $20K in Bitcoin into the protocol and borrowed $10K in DAI, they have an overcollateralized position. But if the deposited value of Bitcoin later fell to $5K, the position would be undercollateralized, and only $5K worth of crypto would be backing the $10K in DAI lent out, destroying the ratio. The minimum collateralization ratio (Crypto Collateral Value divided by DAI Loan Value) prevents the value of the collateral deposited from being less than the DAI lent out. So, in the previous example, as the position's Bitcoin value decreased, the minimum collateralization ratio would trigger MakerDAO to sell the crypto collateral even before it reached $10K to ensure proper collateral backing.
To further illustrate this idea, imagine a sink. Water runs through the tap and into the drain. If the drain is plugged, water starts to fill. However, the sink will never overflow because of the hole below the sink's rim that drains excess water. In the same sense, the minimum collateralization ratio is the hole that prevents the water from overfilling, the collateral is the size of the sink, and the debt value is the water. The minimum collateralization ratio prevents the debt of DAI from exceeding the value of the collateral backing the DAI.
MakerDAO also uses monetary incentives to control DAI's value. MakerDAO has two proprietary tokens: DAI and MKR. DAI is always worth one dollar, whereas MKR fluctuates in value. Unlike other cryptocurrencies, MKR is a governance token for MakerDAO. DAOs sometimes issue governance tokens just as companies issue shares. And just as shareholders can vote on issues concerning their company, governance token holders can vote on changes to a protocol. If someone suggests adding MakerDAO’s offerings to Arbitrum, another blockchain network, MKR holders can vote for or against that proposal. Introducing the protocol to another blockchain network might increase total revenue, but MKR holders must consider factors like implementation costs and possible security risks.
In general, MKR holders vote to increase or decrease variables that would keep DAI at one dollar since the price of DAI is a function of supply and demand. Less DAI on the open market increases scarcity, pushing the price up. More DAI on the open market increases the quantity, decreasing its price. Changing the borrowing fee or total amount of DAI borrowable are a few ways MKR holders can influence the price of DAI. A higher borrowing fee discourages users from borrowing DAI, decreasing the demand and price. A lower total loanable DAI amount decreases the overall quantity available, thus increasing the price.
Essentially, MakerDAO — including its profitability and stability — is MKR holders' responsibility. Good decisions reward MKR holders with a more valuable token, but bad decisions punish them by diluting the value of their MKR tokens. The goal of MKR holders is to keep DAI at the one dollar target price and keep MakerDAO profitable. If MKR holders vote for changes that create a surplus in the MakerDAO treasury, the protocol will use the surplus to buy MKR tokens off the market and destroy them.
To ground the idea, consider a coveted car manufacturer producing five supercars each worth a considerable amount. If the car manufacturer bought back one supercar and destroyed it, the value of the other four supercars would increase. In this sense, MakerDAO is the manufacturer of MKR and will buy back and destroy MKR tokens using treasury surplus to make other MKR holders’ tokens more valuable. Alternatively, if MKR holders create changes that lower DAI’s value below one dollar, the protocol will mint and sell MKR tokens to buy back and destroy DAI. By creating more MKR tokens, each individual MKR token becomes less valuable. The protocol uses the proceeds from the MKR token sale to purchase DAI. Just as the car manufacturer can buy and destroy their supercars, so too can the protocol buy back and destroy DAI. By destroying DAI, the amount of DAI available decreases, making each individual DAI more valuable. This process is done until DAI regains its one dollar target value.
Benefits of MakerDAO for the user and investor
MakerDAO markets the stable crypto DAI as having three use cases on their website: earn, borrow, and multiply. Earning is done through the DAI savings account and can function as an on-chain version of a bank’s savings account. Borrowing is generating DAI from over-collateralized loans. By borrowing DAI against their crypto, users can take out loans against unrealized gains. In doing so, users can access their money without selling their crypto and triggering the taxable event. The multiply option is similar to borrowing but uses the DAI generated to automatically purchase more collateral. If someone deposited $20K worth of Bitcoin and borrowed $10K DAI, they could convert that DAI into Bitcoin and deposit the new Bitcoin as collateral, making their total collateral $30K worth of Bitcoin. Because each loan amount has to be less than the collateral value, eventually, no more substantial DAI could be created and deposited. Now, a user has $30K exposure to Bitcoin rather than the original $20K, hence the tool’s name, “multiply.” Multiply is a good way to automatically increase the exposure to an asset without having to deposit new money into the protocol or convert borrowed DAI collateral manually.
To provide the savings interest rate and pay developers and contributors, MakerDAO must generate revenue. Users borrowing DAI pay a fee to MakerDAO. Additionally, when a user falls under the minimum collateralization ratio, the protocol takes a percentage of the collateral sold.
One of the most important factors that determine the safety of protocols in DeFi is standing the test of time. MakerDAO is one of the oldest and largest DeFi protocols to exist, and it has survived many market shocks. Large firms such as Andreessen Horowitz, Polychain Capital, Dragonfly Capital, and Paradigm have invested over $50 million cumulatively in MKR tokens and actively participate in MakerDAO’s governance. With such big money in the game, MakerDAO has contracted audits by security organizations in the blockchain space and third-party auditors. In the event of long-term market irrationality, hacks, or security breaches, MKR holders can also vote to trigger an emergency shutdown. The Maker Protocol will stop, and users can withdraw their collateral, and DAI users can redeem DAI for collateral.
Uncertainty plagues the future of all blockchain projects. Cryptocurrency and decentralized financial regulation remain unfinished. And it’s hard to predict what legislation federal agencies will produce. Still, MakerDAO has distinguished itself as a cornerstone in DeFi, offering simple financial tools that function in any market condition.