First look at MakerDAO.
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TLDR below. This is not financial advice.
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, that make MakerDAO better.
What is MakerDAO?
MakerDAO is an important factor in the DeFi ecosystem. It uses $ETH as collaterals to create $DAI, a currency soft-pegged to USD.
MakerDAO is a 2-token ecosystem built on Ethereum Blockchain.
$DAI, stable coin soft-pegged to USD
$MKR, governance token to govern how DAI is managed.
$MKR is an ERC-20 token in the MakerDAO ecosystem. It is used to pay the Stability Fee and other fees play an important role in the governance of this system.
In MakerDAO's ecosystem, $MKR functions as a Governance Token.
What Are Tokens Used For?
$DAI is a Stablecoin created inside the MakerDAO ecosystem. Serves as a stable currency.
When users deposit their collateral inside the MakerDAO system and receive the corresponding $DAI, the user can use $DAI for whatever purpose they want.
Utility Token function: $MKR Token is used as a Stability Fee when users pay their debts in the system. Stability Fee of about 1%.
Governance Token function: $MKR function is used for voting in a governance mechanism. The $MKR Holders can vote for the Proposal they want. Then, the system will select the Proposal with the highest number of votes - called Active Proposal. These Active Proposals are directly related to Risk Management and Business Logic.
With Recapitalisation resource: $MKR can autonomously be minted by the Flopper auction house and sold for $DAI, which is used to recap the Maker Protocol in times of insolvency.
How does it work?
MakerDAO is using smart contracts which are called CDP (collateralised debt positions) or Vault.
Imagine you have a car. You give the car to the bank and receive USD. The "bank" is Maker's technology protocol. The car is ETH or other assets they approve of. Instead of USD, you get $DAI, which is soft-pegged to USD.
This Maker's technology protocol relies on smart contracts through Maker governance. It will adhere to the rules set by the governance team.
Simply, Vaults will hold the collateral of the users, then return $DAI to them. Users pay back the loan they borrowed, plus the fee and receive back collateral.
What Is Interesting In MakerDAO?
What makes MakerDAO interesting is the mechanism that generates $DAI by mortgaging an underlying asset, a real asset. This is similar when banks relied on gold to print money in the past. Obviously, the gold standard adherence has brought economic stability for many years. Hence in DeFi, this same thing should be there and therefore MakerDAO comes in.
Other hand, users come to MakerDAO because sometimes they don't want to sell assets. By mortgaging their existing assets, they immediately have the capital to do something else.
As a protocol that provides stablecoins, the token policy is always the most important issue. A good policy will promote the stability of the stablecoin and get more people involved in the protocol.
The $MKR Token’s Role
Those holding between $MKR will have voting rights on all protocol operations, including parameters, $DAI savings rate, etc. And the mechanism to freeze (Emergency Shutdown) when problems seriously affect the protocol.
In addition to its role in Maker Governance, the $MKR token has a complementary role as the recapitalisation resource of the Maker Protocol. If the system debt exceeds the surplus, the $MKR token supply may increase through a Debt Auction (see above) to recapitalise the system. This risk inclines $MKR holders to align and responsibly govern the Maker ecosystem to avoid excessive risk-taking.
Decentralised monetary system
Building on Ethereum network, MakerDAO uses $ETH as collaterals to produce $DAI. For this to happen, the system overcollateralises $ETH to allow $DAI to maintain the US$1 peg.
Stablecoin is needed especially for mainstream adoption of cryptocurrencies. If you think about more traditional finance like trading, financing, buying and selling or saving, we rely on the stability of money value.
$DAI Stablecoin System
To describe the stable coin system, as many are probably familiar we have what previous called CDP, now called vault.
Vaults are basically the minting smart contracts that you have your cryptocurrency as collateral to mint it.
To describe in traditional finance, it is using your house as collateral to borrow money. Instead of your house, you are now using $ETH in DeFi.
What happens when $DAI not peg $1?
Vault creators/Speculators are incentivised to buy $DAI and repay their debts, thus reducing $DAI supply and putting upward pressure on prices. Similarly, when $DAI is trading at a premium, it becomes more attractive for Vault creators/Speculators to pledge additional collateral and mint more supply.
When the market price of $DAI deviates from the Target Price due to changing market dynamics, $MKR holders can mitigate the price instability by voting to modify The Stability Fee and The $DAI Savings Rate accordingly:
If the market price of $DAI is above 1 USD, $MKR holders can choose to gradually decrease The DAI Savings Rate and increase the Stability Fee, which will reduce demand and should reduce the market price of $DAI toward the 1 USD Target Price
If the market price of $DAI is below 1 USD, $MKR holders can choose to gradually increase the DSR and decrease the Stability Fee, which will stimulate demand and should increase the market price of $DAI toward the 1 USD Target Price.
Last but not least, each $DAI is backed by more than $1 of collateral. The confidence of market participants in this fact is essential to maintaining the peg. So The Emergency Shutdown can be invoked by $MKR holders if deemed necessary. When this happens, $DAI holders are entitled to redeem one unit of $DAI for $1 USD of collateral.
This could happen as a long-term stability policy for the exchange rate, as $MKR holders could call this at any time if the protocol is facing an attack or if any critical malfunctions are detected.
It is important to note that, however, if The Emergency Shutdown is activated while the system is under-collateralised, $DAI holders will not be able to receive full value for their $DAI. In this scenario, $DAI will most likely trade below the peg unless $MKR holders agree to backstop the losses.
In theory, this could be a strong policy, but it could harm the protocol’s longevity. As such, it has never been used.
MakerDao is an alternative source of leverage. Because it is an alternative way to gain access to leverage for those who do not wish to custody assets with a centralised exchange. Borrowing from Maker could also be cheaper when stability fees are low.
Any losses incurred by $DAI holders are backstopped implicitly by $MKR holders, who will be diluted in case the system as a whole becomes under-collateralised. This is a major advantage that Maker has versus other lending platforms on the market, where any losses are borne by the lender.
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