What Is MakerDAO (DAI)?

Introduction

Stablecoins are highly popular in the cryptocurrency world, serving as a bridge between traditional finance and digital assets. These blockchain-based tokens provide stability akin to fiat currencies while retaining the operational characteristics of cryptocurrencies, making them particularly attractive for "locking in" profits and losses.

Currently, high-market-cap stablecoins are typically pegged to fiat currencies and backed by reserves. However, stablecoins backed by cryptocurrencies as collateral have also garnered significant attention. This article will explore a notable example—MakerDAO—and analyze how it maintains a 1:1 peg to the US dollar while using more volatile currencies as collateral.

What is MakerDAO?

MakerDAO is an Ethereum (ETH) project launched by Rune Christensen in December 2017, focusing on creating DAI, a stablecoin pegged to the US dollar and backed by cryptocurrencies. MakerDAO is not managed by a group of developers or a single organization; instead, it operates through governance tokens known as MKR, which facilitate proposals and decision-making. This governance model is referred to as a Decentralized Autonomous Organization (DAO).

Users can access MakerDAO through the Oasis DApp, where they can apply for collateralized loans, participate in governance, and manage existing Maker profit pools. These interactions rely on smart contracts and game theory to maintain a relatively stable value for DAI, providing similar advantages to fiat-backed stablecoins.

What is DAI?

DAI is MakerDAO's stablecoin, pegged to the US dollar, and is one of the largest stablecoins by market capitalization. As long as users continue to provide collateral to generate more DAI, the supply of this ERC-20 token is unlimited.

MakerDAO uses cryptocurrencies as collateral to maintain its peg rather than fiat reserves. This might seem confusing—how can volatile cryptocurrencies support a stablecoin? In simple terms, the value of the cryptocurrency deposited by users is significantly higher than the stablecoins they receive, providing a buffer against price declines in the collateral.

Like other stablecoins, DAI has several key advantages:

Better suited for stable expenditure needs: Retailers and consumers are often unwilling to transact with highly volatile cryptocurrencies.

Benefits from blockchain advantages: Stablecoins can be transferred globally without the need for bank accounts, provided they are stored securely.

Can lock in profits and hedge risks: DAI helps reduce the overall risk of a portfolio, allowing users to enter and exit positions without needing off-chain operations.

How Does Cryptocurrency Collateral Work?

Collateral is a common concept in traditional finance. When borrowing, you typically need to provide something of value as collateral. If you fail to repay on time, the collateral is used to repay the loan.

Physical Collateral vs. Fiat Collateral

For example, you could pawn jewelry to obtain a cash loan. After repaying the loan, you can redeem the collateral or allow the pawnbroker to keep it to cover their losses. The collateral acts as a safety net, a concept that also applies to mortgages and auto financing. In these cases, assets like properties or vehicles serve as collateral.

Cryptocurrency Collateral

Unlike fiat, stablecoins like DAI accept cryptocurrencies as collateral. Smart contracts manage these funds according to predefined rules: for instance, depositing a certain amount of Ethereum (Y amount) allows you to issue a corresponding amount of stablecoin tokens (X amount). When you repay X amount of stablecoins, the equivalent amount of Ethereum (Z amount) is returned. The required collateral amount depends on the issuing token project, primarily relying on the volatility and risk of the collateral assets.

What is Over-Collateralization?

Low-risk assets such as fiat currencies, precious metals, and real estate are typically used as collateral. Using cryptocurrencies as collateral carries higher risks due to their price volatility. For example, a project might require $400 worth of Ethereum as collateral to issue $400 worth of dollar-pegged tokens.

If the price of Ethereum suddenly drops, the borrower’s collateral may not suffice to repay the loan. Over-collateralization addresses this issue: when a lender issues $400 worth of stablecoin tokens, they require the borrower to provide $600 worth of Ethereum as collateral.

What is a Collateralized Debt Position (CDP)?

MakerDAO has employed over-collateralization for years to maintain a reasonable peg ratio. Since the DAI generation process is controlled by smart contracts, operations are efficient and minimize human interference. When borrowing DAI, your cryptocurrency is locked in a CDP smart contract. The CDP sets a mandatory liquidation ratio—for example, 1.5x, meaning you need to provide $150 worth of Ethereum to receive $100 worth of DAI. Users can choose to add more collateral to reduce risk. If the value of the collateral falls below 150% (1.5x), they face penalties. If users fail to repay DAI on time, they risk liquidation.

What is the Maker Profit Pool?

The Maker Profit Pool is where users deposit collateral and generate DAI. Users can use various cryptocurrencies as collateral simultaneously. The process is as follows:

Deposit supported cryptocurrencies into the Maker protocol.

The deposit creates a position in the Maker Profit Pool.

Users can withdraw DAI based on the amount of collateral and must pay stability fees.

To redeem collateral, users must repay the DAI they withdrew.

Users can generate or return DAI at any time and add or redeem collateral, but they must maintain the mandatory liquidation ratio displayed in the profit pool. If it falls below this ratio, the profit pool will liquidate the user’s collateral.

How is DAI's Value Maintained?

The CDP mechanism not only reduces MakerDAO’s risk as a lender but also helps maintain DAI's peg to the US dollar. Additionally, MakerDAO can vote to adjust the stability fee and DAI savings rate (the interest paid to stakers) to control DAI’s supply and demand. Together, these three factors help maintain the 1:1 peg of DAI to the US dollar. Specifically:

When DAI falls below the peg ratio, the system incentivizes users to repay debts, reclaim collateral, and destroy DAI, which can be achieved by increasing the stability fee.

Conversely, when DAI is above the peg ratio, lowering the stability fee stimulates the generation of DAI, increasing the total supply and thereby reducing the price.

Use Cases for DAI

As mentioned earlier, the uses of DAI are similar to those of other stablecoins, and its advantages are largely the same. You don't even need to generate DAI yourself; you can purchase it directly in the cryptocurrency market, such as on Binance. DAI also has several unique use cases:

Leverage: Suppose you have $1,000 worth of Ethereum and anticipate its price will rise, but you currently lack additional funds to buy more Ethereum. You can use Ethereum as collateral to generate DAI and then use that DAI to buy more Ethereum. If the price of Ethereum rises, you can sell some of your Ethereum for DAI and redeem your collateral.

DAI Savings Rate: Depositing DAI into the DAI Savings Rate smart contract allows you to earn interest. This interest rate fluctuates with the DAO’s control over DAI’s price.

How to Participate in MakerDAO's Governance System?

To have voting rights and a voice in MakerDAO, you need to hold the project’s governance token, MKR. Approximately 40% of this token is allocated to the team and early investors, while the remaining portion is held by the DAO for future sales.

MKR holders can vote to adjust the platform's stability fee, DAI savings rate, liquidation ratios, and more. Voting power is proportional to the amount of DAI held. You can visit MakerDAO’s governance portal to participate in current votes.

Governance Polls

Governance polls allow users to propose non-technical proposals for other MKR holders to vote on, such as adjusting governance models or budgets. These polls use an instant runoff mechanism, allowing users to rank multiple options.

Executive Votes

Executive votes involve technical changes to smart contracts and use a continuous approval voting system that allows for the introduction of competing new proposals. Executive votes will lead to changes in the smart contract code, such as adjusting fees or collateral levels, which must occur after the governance poll passes.

Conclusion

As a leading cryptocurrency-collateralized stablecoin, the success of DAI is evident. This system has successfully mitigated the volatility of cryptocurrencies without the need for fiat collateral, marking a remarkable achievement. Additionally, it has played a significant role in the development of DAOs, becoming one of the longest-operating and largest DAOs, laying the groundwork for the growth of other DAOs. If you decide to experiment with DAI, remember that it also carries the risks faced by other stablecoins.

Risk Warning

While the cryptocurrency market offers significant growth potential and innovation opportunities, it also carries a high level of market risk and price volatility. The value of crypto assets can fluctuate dramatically in a short period, potentially leading to substantial financial losses for investors. Additionally, the cryptocurrency market faces multiple risk factors, including technical risks, legal and regulatory uncertainties, cybersecurity threats, and market manipulation. We strongly advise users to conduct thorough research and due diligence before making any investment decisions and to consult professional financial advisors. All investment decisions are made at the user’s own risk. Thank you for your trust and support of Venkate!

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