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MakerDAO case study
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TLDR below. This is not financial advice.
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MakerDAO is a DAO based platform that contains $MKR and $DAI. $MKR and $DAI are two types of tokens in the ecosystem, where $MKR is the governance token and $DAI is the currency token. $MKR (and its holders) govern $DAI and its stability.
$DAI is soft pegged to the USD. 1 $DAI is about 1 $USD. This value is maintained by the collaterals and $MKR token holders.
A DAO is a decentralised autonomous organisation where no central entity owns the ecosystem, nor governs it. It is governed in a decentralised way, both with the machine (automation) and humans (non-automation).
MakerDAO beyond Stable Coin Protocol
MakerDao is an alternative source of leverage; 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.
Besides, 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.
However, MakerDao has some disadvantages. The governance process can take some time before changes can happen. The Stability Fee and The DSR occur through voting instead of being algorithmically determined like in Compound. $DAI can trade away from the peg for sustained periods if governance does not react quickly enough.
There are risks in collateral prices falling too quickly for the system to liquidate in time. In these cases, the system can become under-collateralised, leading to losses for $MKR or $DAI holders (depending on whether $MKR holders are willing to assume losses). During periods when the price of collateral is falling rapidly, vault creators tend to rush to buy $DAI to close out their vault positions, leading to high $DAI prices relative to the peg. This also leads to a relatively weak peg, as I mentioned.
How Maker Works
To understand the mechanism design behind MakerDAO, let’s first understand how the system works.
The smart contract uses crypto assets (e.g. $ETH) through collateralised debt positions (CDP), to create $DAI tokens. These $DAI tokens are thus backed by these on-chain collaterals ($ETH, $BAT). In MakerDAO, the ecosystem is always over-collateralised, so the value of the collateral is always greater than the debt.
What is a CDP? A digital asset that is added into the MakerDAO ecosystem. It holds collateral assets deposited by the user and permits the user to generate $DAI. Generating $DAI accrues debt. This debt can be paid anytime or when the owner wants to withdraw their collateral (CDP).
MakerDAO, the system, enables anyone to leverage digital assets (e.g. $ETH) to generate $DAI, the output. Then, like any other currencies, $DAI can be freely spent.
Another way to look at it is that new $DAI tokens are minted when a user stakes their digital assets ($ETH, $LINK, $USDC, $YFI) with MakerDAO’s smart contract. By staking digital assets, they can create $DAI.
Tokens in Maker
MakerDAO uses a 2-token model in its ecosystem. This is because each token has a specific objective and function.
$DAI is the token with a money function, and it acts as a form of currency. It is a form of payment (via DeFi), store of value (1 $DAI = 1 USD) and unit of account (1 $DAI = 1 USD).
$DAI is also known as a “stable coin” because it is soft pegged to 1 USD. The value is backed by collaterals on-chain via CDP. It is completely decentralised; anyone who wants to own $DAI can buy it on the exchange or stake $ETH for $DAI.
$MKR is a token with a utility function, and it acts as a form of governance in the MakerDAO ecosystem. $MKR holders are part of the decentralised governance for $DAI. They are responsible for the decision-making process. They can vote and have a say on issues and proposals in the ecosystem. $MKR tokens are created or destroyed in accordance with price fluctuations of the $DAI coin in order to keep it as close to $1 USD as possible. $MKR has a value, and the value is determined by market forces, e.g. demand and supply of $MKR tokens.
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In conclusion, 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 are continually making improvements to the protocol, so it is very likely that the risks we have outlined could largely be mitigated in the future.
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