MakerDAO aims to build a homeostatic (self-balancing) stablecoin on Ethereum. What’s a stablecoin? A crypto asset that maintains a price peg with a real world asset. In the case of MakerDAO,their DAI asset is pegged to the US dollar.
The most intuitive way to implement a blockchain-based stablecoin is to have an institution hold a large reserve of a real world asset and then issue an equivalent amount of tokens on the blockchain. Users can deposit real assets with the institution to get a highly liquid token equivalent on the blockchain, or redeem the tokens to get their real assets back. However, regulatory roadblocks make this a very difficult system to build in a legal way.
MakerDAO introduces stablecoins to Ethereum while circumventing regulatory issues by creating a homeostatic system that uses minimal external input with cleverly designed internal forces to keep the DAI pegged to the dollar. This is certainly not an easy feat, primarily because there is a huge number of different stress scenarios that could break the peg, thus breaking the system, and there is no good way to prove that the system can withstand each stress scenario until it actually happens. In fact, many believe that self-balancing stablecoins that are economically sound are too good to be true.
One of the most compelling applications of blockchain technology
A homeostatic stablecoin is one of the most compelling applications of public blockchains; the success of one such system directly translates to the success of public blockchains. Many people like to position public blockchains as a technology that will revolutionize payments. A payment network that is cheap, open to anyone, and uncensorable is highly compelling. However, the only problem is that assets on public blockchains are not centrally managed and often have an inelastic and capped supply. This means that these assets are always highly volatile and deflationary which discourage payment velocity.
Stablecoins introduce two highly valuable properties, predictability and stability, to blockchain costs. For example, if a decentralized exchange denoted exchange fees with an inelastic supply asset like ZRX or ETH, then the exchange can become prohibitively expensive to use in a bull market as the assets increase in price. This problem doesn't exist if the exchange was able to charge fees with a stablecoin. Here's another example: if I paid for a coffee with ETH, it would be disappointing if, in 5 minutes, the price of ETH soared and I've basically overpaid for the coffee. This is one of many reasons why predictability and stability are so valuable.
How does MakerDAO work?
The MakerDAO system consists of a series of complex smart contracts on Ethereum. The system has two native assets, Maker (MKR) and Dai (DAI). DAI is the asset that's supposed to be pegged to the US dollar. MKR is more akin to "traditional" cryptocurrency assets in that its supply is inelastic and deflationary. Holders of MKR have a say in system governance and the asset is also needed by borrowers to pay a "Stability Fee" (more on this later).
The primary mechanisms that keep the MakerDAO system sound are: a group of oracles voted in by MKR holders that provide real-time price data and the over-collateralization of every DAI in existence with blockchain assets. An oracle is a system that feeds external data into the blockchain. Over-collateralization means every $1 in DAI is backed by more than $1 in collateral asset. Over-collateralization is needed in order to defend against the highly volatile price of blockchain assets. We never want a situation where, for example, ETH's price tanks and the system is left with more outstanding DAI than there is ETH backing it.
These two mechanisms are not sufficient in keeping the DAI's value stable and pegged. There are a series of supporting systems and mechanisms that cover, theoretically, all the edge cases that could break the system.
First, let's go over the most fundamental activity on MakerDAO: creating DAI. Any user can create DAI. To create DAI, a user deposits ETH into a MakerDAO smart contract to form what's known as a Collateralized Debt Position (CDP). The user can specify any amount of DAI in return as long as the resulting collateralization ratio is above the "Liquidation Ratio". The collateralization ratio is the total value of the collateral compared to the total value of the debt, AKA the amount of DAI created by the CDP. The Liquidation Ratio is the collateralization ratio at which the CDP is deemed too risky and is automatically liquidated by the system.
To put it in simpler terms, a user can create as much DAI as s/he wants from the CDP, as long as s/he put enough collateral in it such that it's not at or below the Liquidation Ratio.
MKR paid as Stability Fees are burned by the system. This reduces the total supply of MKR and increases the value of each MKR token. This is essentially a creative way of paying dividends to MKR holders without paying dividends. If the MKR token paid a dividend, it'd be classified as a security in many jurisdictions including the United States which would make the MKR token incredibly inaccessible.
Destroying DAI - Manually closing CDPs
Once a CDP is created, the user cannot retrieve their deposited collateral until they close the CDP by paying back the created DAI plus a "Stability Fee". This fee accrues over time as the CDP is open. Once the DAI and the Stability Fee are paid, the user gains access to their collateral again. The Stability Fee can only be paid in MKR. This MKR is burned by the system, effectively reducing the total supply of MKR tokens and increasing the value of each outstanding MKR token. This is a creative way of paying dividends to MKR holders without actually paying dividends (if the MKR token paid a dividend, it'd be classified as a security in many jurisdictions such as the United States).
Another way to think about opening and closing CDPs is that this is essentially going margin long on the collateral asset in a decentralized way. For example, if a user believed that ETH will appreciate in value over the next few days, s/he could open a CDP for 500 DAI collateralized with 2 ETH at $500 per ETH (so $1000 worth of ETH). The user then immediately takes the 500 DAI to buy one more ETH. The user now has 1 ETH that they own and 2 ETH locked in their CDP. If the price of ETH rose to $1000 per ETH, then the user only needs to sell 0.5 ETH for $500 to reclaim their CDP, leaving the user with 2.5 ETH, which is not only 0.5 more ETH than they originally had (2 ETH), each ETH is worth substantially more than before.
Destroying DAI - Liquidating CDPs
When the price of ETH drops (remember, the system knows what the price of ETH is through the oracles), then any CDPs collateralized with ETH will have its collateral value drop. If this collateral value drops low enough such that the CDP's collateralization ratio is lower than the Liquidation Ratio, the system will automaically liquidate the CDP.
Liquidation is a process where the system automatically sells off the CDPs collateral for DAI to cover and close the CDP. Automated liquidations are needed in order to mitigate the risk of undercollateralized CDPs. If there is insufficient collateral to back the system's outstanding DAI, the confidence in DAI's value can quickly erode.
There are two possible outcomes in a liquidation. If selling off a portion of the collateral yields enough DAI to cover the DAI created by the CDP, then the remaining collateral is returned to the CDP creator, minus a fee known as the "Liquidation Penalty". Things get interesting when there is not enough collateral to sell to cover the created DAI.
This case will only occur when the collateral's price collapsed so fast that even over-collateralization was not enough to secure the CDP. In this event, the system will start creating and selling MKR tokens for more DAI until the liquidating CDP is fully covered. This increases the total supply of MKR tokens which dilutes the value of each token. As a sidenote, this MKR creation mechanism is currently still in development and is substituted with what's known as pooled ETH (PETH). Learn more about PETH here.
Post-liquidation, the CDP creator is left with whatever collateral the system did not automatically sell, minus the Liquidation Penalty, plus the DAI that they created in the first place.
Global Settlement - Final line of defense
Over-collateralization is one line of defense for the system from price volatility. To doubly secure the system, the team added another line of defense with a mechanism known as Global Settlement.
Global Settlement is the process in which the system freezes (no CDPs can be created, closed, nor liquidated) and begins a process of returning all collateral back to users based on a frozen Target Price of DAI and a frozen price for each type of collateral asset. I discuss the Target Price in more details below but it's not necessarily set at $1.
For example, if the Target Price of DAI was $1.20 and the last reported price of ETH was $1000, then, when Global Settlement is triggered and you had a CDP with a 1000 ETH collateral and 500,000 DAI, the system will take 600 ETH ($500,000 / $1.20 * $1000) to cover the created DAI, leaving you with 400 ETH to withdraw. At the same time, all users will also be able claim ETH with DAI at a constant rate from the system until all outstanding DAI is absorbed by the system ($1.20/$200 = 0.006 ETH for each DAI).
A Global Settlement event is significant and can only be triggered by a set of "global settlers" chosen by MKR holders. Global Settlement should only be triggered if: there is a successful malicious attack on the system, a "black swan" event (unpredictable events with extreme consequences) threatens to bring down the system, or the community decides to upgrade the system.
Target Price and Target Rate - Keeping DAI at $1
Over-collateralization and Global Settlement are mechanisms that primarily protect the system from black swan events that challenge the integrity of the entire system. MakerDAO also has a separate mechanism that aims to keep DAI's value as close to $1 as possible. This is done through the Target Price and Target Rate.
The Target Price is determined by the Target Rate and the Target Rate is automatically managed by the system. If the DAI's market price is below the Target Price, the system tries to lower its price by reducing its supply through raising the Target Rate. A higher Target Rate makes the Target Price increase at a higher rate. This, in turn, causes DAI creation to be more expensive and CDP closing to be more profitable. As a result, the supply of DAI should decrease and its price should rise.
On the other hand, if DAI's market price is above the Target Price, the system needs to lower its price by increasing its supply through lowering the Target Rate. This makes DAI creation cheaper and the closing of CDPs less profitable. As a result, the supply of DAI should increase and its price should drop.
In the worst case scenario where this feedback mechanism is not capable of pulling the price of DAI back to $1, Global Settlement can be triggered to prevent an uncontrolled collapse of the system.
With key defense mechanisms for the system in place and functional, the team plans to introduce new features to the system. These include a much anticipated multi-collateral system. Currently, the only type of collateral asset that CDPs can hold is ETH or, more specifically, PETH. In future iterations, the system will allow more assets to be used as collateral. MKR token holders will be able to vote for these assets.
MakerDAO is a complex project
Building a stablecoin system is not an easy task- so it goes without saying that MakerDAO is an incredibly complex system. In this overview, I’ve only cherry-picked the most important parts of the system to discuss. To dig deeper into how the system works and understand the nuances that safeguard the system against numerous edge cases, I recommend reading their whitepaper.
The team behind MakerDAO
MakerDAO was in development for 3 years. The team spent significant effort in making sure the system was as economically sound as possible and that their smart contracts were bug-free. The system launched in December 2017 and in that same month, it was revealed $12 million worth of MKR tokens was sold to venture capital firms in an investment round led by Andreessen Horowitz.
MakerDAO is headquartered in Santa Cruz, California. The team is led by Rune Christensen, a Danish entrepreneur who previously co-founded Try China and Matt Richards, who was previously the Marketing Director of Audience Science and Playdom.
The current state of MakerDAO
MakerDAO is currently a fully released and operational system on Ethereum. As mentioned before, the system currently only supports a single collateral type, ETH, but there are plans to introduce a multi-collateral system in the future.
At the moment, DAI markets exist primarily on decentralized exchanges including Paradex and Radar Relay. The MakerDAO team has wisely also built their own decentralized exchange called OasisDEX that contains MKR and DAI trading pairs.
Can DAI be kept at $1?
Many analysts have raised concerns on whether the system's feedback mechanism (Target Price and Target Rate) is sufficient in keeping DAI's price at $1. For example, imagine if there is a sudden surge in demand for DAI, will there also be a sudden surge in demand to create CDPs? Even with the Target Price rising, the incentives for creating CDPs are still quite poor. A user not only has to take on risk and lock up liquidity by over-collateralizing their assets in a volatile market, they also need to pay a stability fee. A well-structured market should reward participants who take on risk and lock up liquidity, not punish them!
Because DAI creation is really another way of taking a leveraged long on the collateral asset, there is a lot of incentive to open a CDP during a bull market, but very little incentive to open one during a bear market. If the price of the collateral asset increases, the user that is leveraged long has amplified winnings. On the other hand, if its price decreases, that user has amplified losses.
With poor incentives to create CDPs, the concern that the system will not be able to keep up with sudden increases in DAI demand is a very valid one.
A reliance on MKR holders voting
The system has a huge reliance on MKR holders voting and making the right decisions. MKR holders are expected to (1) choose the set of global settlers, (2) choose the set of trusted oracles, (3) modify the target rate, and many more. There are already significant doubts around the viability of single-parameter voting in cryptocurrency systems, MakerDAO's multi-parameter voting system is thus even more questionable.
MakerDAO is an incredibly complex system that aims to solve a very hard but rewarding problem. Stablecoins, if successfully deployed, have been dubbed the "holy grail in digital currency". They combine all the advantages of the blockchain with the predictability and safety of centrally managed fiat currencies.
However, this is certainly not an easy problem to solve and as many safeguards as MakerDAO has built into the system to keep the DAI pegged to the dollar, there are still very valid concerns on whether they are enough. For these kinds of systems, only time will tell how robust the system actually is.