[De-Fi Fundamentals] MakerDAO, the Central Bank of De-Fi

MakerDAO was formed in 2014 by Danish entrepreneur Rune Christensen. MakerDAO is a lending and stablecoin issuance protocol, operating on Ethereum Blockchain. It has a total TVL of $6.0 billion at the time of writing. The basic function of MakerDao is simple: when a user deposits collateral, MakerDAO will mint and lend the user a stablecoin, Dai. When the user returns the borrowed Dai, it will be burnt and MakerDao returns the user his collateral. Taking an analogy in the traditional financial market — think of the central bank of a small country — MakerDao is taking gold (ETH, BTC in this case) reserves and printing notes. This makes MakerDao the central bank of De-Fi, i.e. the source of M1 monetary supply in De-Fi.

(Source: Defillama)

As of today, the market cap of Dai is more than $5 billion with the price stabilized closely around $1.

(Source: Coinmarketcap)

The Dai stablecoin is a collateral-backed cryptocurrency whose value is soft-pegged to the US Dollar. Dai is held in digital wallets and supported on Ethereum and other popular blockchains. All circulating Dai are generated from MakerDao’s vaults and are backed by a surplus of collateral assets. For instance, depositing $150 worth of ETH as collateral allows one to borrow $100 worth of Dai.

Maker allows users to receive loans, collateralized with crypto assets. The loan comes in the form of Dai. The loans have to retain at least 2/3rd of the value of the underlying collateral; these ratios are set depending on the risk assessment of the used underlying asset. If due to price changes, the value of the borrower’s collateral drops below the threshold, some of the collateral is automatically sold, similar to Aave. The proceeds of this auction can then partially pay down the outstanding loan and keep the system in balance in a time of stress.

In MakerDao, Dai holders leaving Dai in the system can earn yield through the Dai Savings Rate (DSR), a protocol-level yield paying feature. But in other protocols like Curve and Aave (and thousands more), Dai is very useful in generating yield — it is money.

In addition to the DSR, which enables Dai users to earn accruals on the Dai they save, here is a non-exhaustive list of things Dai can be used for:

A Vault is a tool that lets the owner deposit collateral and generate Dai. Vault is individual, i.e. each user creates his own vault for his own collateral and borrowing of Dai. Vaults cannot be shared or mingled.

Vaults are categorized by the type of collateral used to generated Dai. Users create Dai by generating it against their collateral and destroy Dai when repaying their generated Dai balance. The process of generating Dai happens entirely on-chain, which enables anyone to audit the amount of circulating Dai and the collateral backing it. A current list of Collateral types and Vault types is shown below.

(source: https://oasis.app/borrow)

Stability Fee

The Stability Fee is a variable-rate fee continuously added to a Vault owner’s generated Dai balance.

Stability Fees are a Risk Parameter designed to address the inherent risk in generating Dai against collateral in Maker Vaults. A portion of the Stability Fee is diverted toward sustaining the operation of the Maker Protocol, which includes the DSR, Risk Teams, and other costs associated with maintaining the protocol. The Stability Fee for each Vault type changes as a result of the decisions of MKR token holders who govern the protocol. These decisions are based on the recommendation of Risk Teams who perform risk assessments on Collateral used in the system. The Risk Teams may update their proposed Stability Fee when something fundamental changes about the underlying asset or the system as a whole.

Liquidation

Vaults are required to be overcollateralized and have a Liquidation Ratio that Vault owners need to uphold to avoid the Liquidation of their positions. The Liquidation Ratio is the minimum required collateralization level for each Vault type before it is considered undercollateralized and subject to liquidation. To make sure that the required surplus of collateral exists at all times, a class of users called Keepers are incentivized to maintain a constant watch for Vaults that become under-collateralized. During the Liquidation process, Keepers can sell enough collateral of a liquidated Vault to cover the Vault’s debt along with a Liquidation Penalty, restoring the Liquidation Ratio above water and leaving the remaining collateral available for withdrawal.

Additionally, a Debt Ceiling is imposed on the Maker Protocol as well as each Vault type. The Debt Ceiling is the maximum amount of Dai that can be generated. The Global Debt Ceiling limits the amount of Dai that can be generated across the entire system, while Vault-specific Debt-Ceilings limit how much Dai each type of Vault can generate.

In summary, MakerDao has made a Credit System that allows users to self-issue Dai-denominated loans against collateral deposited into smart contract-based escrow. At the core is the collateral portfolio, a pool of on-chain digital assets that back the Dai supply. While the collateral presents a source of value, additional heuristics are required to maintain a soft peg of $1.

Arbitrage

In calculating the borrowed amount and liquidation ratio, $1 is always applied to 1 Dai. As Dai price fluctuates in other markets, arbitrageurs can buy and sell Dai to make profits. This arbitrage is supported by monetary policy adjustments that influence the supply and demand for Dai recursively until Dai has returned back to its target price. Market makers have come to rely on these Stability Fee changes, and as a result supply the necessary liquidity to minimize outsized deviations.

Emergency Shutdown

In extreme events, 1 Dai can be redeemed for $1 worth of collateral through a process known as emergency shutdown. Collateral values can sometimes fluctuate dramatically. If they were to suffer a sharp decline in value, the settlement feature enabled by Emergency Shutdown may not allow for full redemption by MakerDao. As a last line of defense against volatile asset prices, a process for auctioning MKR tokens exists as a backstop for undercollateralized Dai.

The MKR token sits at the core of the MakerDAO network and allows users to have a say in the development and direction of the network, mostly by voting on the parameters around loans. For example, the maximum amount of Dai that users can issue themselves depends on the loan parameters set by MKR holders. Having a principal at risk incentivizes borrowers to be responsible for their debts. The cost of a loan within the protocol, called a stability fee, is paid with MKR, which is subsequently destroyed. Accrued fees go to purchasing MKR off the secondary market and burning it. This makes it a deflationary asset from its starting supply of 1,000,000 MKR. The more loans that are created and redeemed, the more MKR’s supply will deflate. This burning mechanism helps create token value similar to how equity buy-back programs can drive share prices in traditional companies.

This mechanism ensures proper incentive alignment between MKR token holders and the governance over the MakerDAO. Good governance decisions mean more MKR burned over time and bad decisions lead to less MKR burned. An important note is to understand that the revenue generated from the fees is not dependent on the price of MKR. If the price of MKR is high, users will burn smaller amounts and vice versa.

MKR Token holders are ultimately the group motivated to ensure the successful operation of the Dai Credit System. MKR token holders coordinate themselves using a decentralized governance process through which they evaluate and select appropriate collateral assets. The success of this endeavor is strongly correlated to a proficient risk evaluation of the collateral set. A failure in due diligence or coordination will result in severe losses for both end users of the protocol (in the form of declining Dai price) as well as MKR token holders (in the form of MKR dilution).

(By YQ, Serenity Team, 29 June 2021, Twitter: https://twitter.com/SerenityFund)

Zero risk and 20% return - risk neutralised cryptocurrency fund.