Flashback Friday: Maker and DAI
We’re throwing back to one of the oldest defi projects - Maker and its stablecoin DAI.
As the fallout from the Terra collapse continues, the worst losses have come from CeFi players using and marketing defi (e.g. Celsius, Voyager, Vauld, Blockfi). DeFi players have largely held up amid this turmoil so today, we’re throwing back to one of the oldest DeFi projects - Maker and its stablecoin DAI.
The Maker protocol was originally started in 2014, it launched DAI (a decentralized stablecoin softly pegged 1:1 to USD) in 2017 and upgraded to be multi-collateral (multiple cryptocurrencies can be collateral) in 2019.
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Why does this exist?
In its whitepaper, they argue while Bitcoin is successful as a cryptocurrency for many reasons, its highly volatile nature makes it a bad medium for exchange (i.e. paying for anything is hard when if the price changes constantly). Thus, DAI was born to be a stablecoin functioning like a digital dollar - being both a store of value and a medium of exchange
Originally, DAI could only be generated by overcollateralizing with ETH (i.e. to receive $1 worth of DAI $1.5 worth of ETH needed to be locked up). Today, MakerDAO has chosen to accept more ERC-20 tokens as collateral including WBTC, USDC, LINK, etc.
How does it work?
To generate DAI, a user puts collateral into a vault (smart contract) and generates DAI in exchange for locking up the collateral. If the value of the collateral drops past a liquidation ratio (i.e. if I generated $1 worth of DAI and had < $1.5 worth of ETH locked up), the vault gets liquidated (it’s a bit more complicated than this but this is more or less right)
How does DAI maintain its peg?
DAI is complex, but to simplify, it largely maintains its peg through two mechanisms:
Changing the Dai Savings Rate (DSR) (this is essentially interest rate in normal monetary policy except instead of central banks deciding the rate, all MKR holders as part of MakerDAO decide the rate):
If 1 DAI is > $1, MKR holders can vote to decrease DSR → less demand for DAI, price should go down, if 1 DAI is < $1, MKR holders can vote to increase DSR → more demand for DAI, price should go up
Free market arbitrage (this is essentially money supply in normal monetary policy):
If DAI is > $1, vault owners are incentivized to mint more DAI and sell at this premium (collateral is exchanged for DAI), this increases the supply of DAI, price should go down, if 1 DAI is < $1, users are incentivized to buy DAI at the discount and pay down down collateral debt in vaults (DAI is exchanged for collateral), this decreases supply of DAI, price should go up
In a very self-aware move, a risk Maker admits to having is that it’s quite complicated and the average user may favor an easier to understand system. Having read this, would you agree?
Interesting bonus mechanism:
Emergency Shutdown: If MKR holders agree it’s all over for DAI, then the Emergency Shutdown process commences. Essentially, all collateral can be redeemed at the rate of 1 DAI equalling $1, and once it’s all gone, it’s gone. This would happen due to a serious emergency such as a horrendous security breach or black swan events like all collateral value going to zero.
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