EP 53: Basic Primer to Token Design of DAI (MakerDAO) | The OG Stablecoin
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TLDR below. This is not financial advice.
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MakerDAO is one of the core project on DeFi. The foundation of the project is built on the Ethereum blockchain. The two main components are $DAI (stablecoin) and $MKR (governance). The protocol creates $DAI that is backed by $ETH using a vault mechanism.
This system is able to regulate and stabilise the price of $DAI stablecoin. This protocol is also the first successful onchain reserve stablecoin.
The mechanisms of stablecoins have changed since 2017 and we're going to start classifying stablecoins into four different categories:
Check the previous newsletter if you want more clarity.
In MakerDAO’s ecosystem, $DAI is the stablecoin and uses a dual token and reserve mechanism. It is soft pegged to one dollar and uses over-collateralisation to get that one dollar. It uses different kinds of on-chain crypto assets like $ETH, stablecoins, and non-stablecoins.
Dual Token Mechanism
In the dual token model, as the name suggests, there are two tokens in the system. The primary token is stablecoin $DAI which is soft pegged to the US dollar. The secondary token is $MKR. The main function of the secondary token is to absorb volatility in the system. Think of $DAI as your output which is stable and has low volatility, but because there will always be volatility within the system or outside of the system. The volatility needs to go somewhere, so it goes to the other token, $MKR.
Functions of the MKR Token
This is a utility token and functions as a governance token for voting. It can be used to pay off interest accrued in the system, and during insolvency. During crashes or different kinds of liquidation $MKR can be minted and sold for $DAI in the ecosystem. $MKR is a crucial aspect of governing the entire system of $DAI. $DAI is the facilitator that allows people to exchange goods and services. A few months ago MakerDAO moved more of its funds towards the DAO which means that it is no longer mainly controlled by the founders and is now controlled by the community.
This means that the stablecoin or the $DAI is backed by reserves and you can use the $DAI to redeem the underlying collateral. You can redeem $DAI for the underlying crypto assets that you deposited to get $DAI initially.
Creating $DAI: How it Works
You can create $DAI in three simple steps:
You have to own the asset.
You deposit that asset into a vault.
Based on the amount of value in the vault you can mint some $DAI out and then can use it in some other system.
The only thing that you have to be careful about is the minimum collateralisation ratio. If I have $150 worth of $ETH and I put it in my vault then I can take out a maximum of 100 $DAI from this vault and spend it somewhere else. My $150 worth of $ETH sits in the vault. I cannot touch it until I repay the amount that I borrowed, which is 100 $DAI.
What happens when your $ETH falls in value?
I put $150 worth of $ETH in the vault but if the value falls to $100 then my collateralisation ratio is 100% which is less than the ideal amount of 150%. Now I will have to either repay the loan (instead of borrowing 100 $DAI I must repay 33 $DAI) or I will have to add $50 worth of $ETH into the collateral so that the minimum collateralisation ratio or the c-ratio is balanced.
What Else Did You Miss?
When $DAI > $1
When $DAI < $1
Crashes and Liquidations
Maker VS Lending/Borrowing
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MakerDAO is a novel and innovative protocol that allows for on-chain collateralised borrowing, while also creating a reasonably effective stablecoin. This gives the crypto community an alternative to fiat-backed stablecoins like $USDT. Furthermore, $MKR holders continue to make continual improvements to the protocol, so it is very likely that the risks we have outlined could largely be mitigated in the future.