Lending protocols represent an important part of the crypto ecosystem. One protocol that shines above all others is MakerDAO. With its focus on decentralization, governance, and peer-to-peer lending, MakerDAO succeeds in managing over $7 billion in TVL. By facilitating borrowing and lending with a truly stable DAI token, it has a long-term future in DeFi.
In this article, I’ll guide you through the MakerDAO lending protocol and explain everything you need to know about its tokenomics. But before you understand how MKR and DAI work, I’ll first give you a summary of MakerDAO itself.
MakerDAO is a peer-to-peer decentralized protocol based on the Ethereum network that facilitates borrowing, lending, and savings. The protocol allows you to borrow funds denominated in DAI. You need Ethereum and a MetaMask wallet to do this.
All you have to do is lock your ETH for a limited time and you'll receive the DAI stablecoin. ETH represents the collateral you’re providing to receive a loan. Once you want to unlock your ETH, you simply need to pay back your loan along with some fees.
Decentralize lending works on the premise of liquidations. The protocol will liquidate your assets if you become unable to pay your loan back. What does liquidation mean in this context? Essentially, MakerDAO will take your locked ETH away from you.
Remember, there’s an opposing side to each transaction. The liquidity you’re taking from MakerDAO is supplied by someone else. To ensure that this someone can get his assets back, the protocol has to enforce a liquidation mechanism. Think of it as having your house seized by a bank once you’re no longer able to pay your mortgage.
Another great thing about liquidations is that they prevent investors from borrowing too much money. If everyone were to borrow DAI they’d create an artificial currency that isn’t fully backed - which would happen if ETH’s price fell down.
MakerDAO uses three tokens to support its ecosystem: MKR, DAI, and ETH.
Previously, I've explained that the protocol takes ETH as collateral whenever you borrow DAI. But how do the other two tokens work?
Maker (MKR) is a token that is created and sold off to pay back DAI loans whenever ETH's price crashes. Remember, you provide collateral in the form of a volatile cryptocurrency. To pay back the loan you must give the exact ETH dollar-value you gave when you originally locked up your tokens. You're giving back less than you initially did if the price crashed.
MKR is also used to pay off loan fees. And the liquidation penalties that borrowers pay are used to buy MKR - which the protocol burns in order to decrease the supply. MKR is essentially an ERC-20 token that MakerDAO creates or burns to keep the DAI stablecoin in check. More MKR is produced when the DAI is off the peg (greater or smaller than $1). The protocol burns MKR when DAI is stable.
MKR also represents the protocol's governance token. As a MKR holder, you want your holdings to increase in value. Governance incentivizes you to act in your best interest and support proposals that are beneficial to the protocol. Such proposals include changing lending fees and introducing new forms of collateral.
MKR also represents the protocol's governance token. As a MKR holder, you want your holdings to increase in value. Governance incentivizes you to act in your best interest and support proposals that are beneficial to the protocol. Such proposals include changing lending fees and introducing new forms of collateral.
At the time of writing, MKR has a market cap of $573 million and costs $638 per token. The token has a circulating supply of 901,310 tokens. You can explore MKR’s blockchain activity on the following etherscan page.
MakerDAO launched the token by minting 1,000,000 MKR and distributing it over the course of three private funding rounds. The funding rounds were joined by notable crypto investing firms such as Polychain Capital, Andreessen Horowitz, a16z, Paradigm, and Dragonfly Capital -- collectively raising $54.5 million.
DAI is MakerDAO's stablecoin pegged to the US dollar. The fluctuation of DAI and MKR depends on DAI's peg. You can use DAI to interact with DeFi dApps and invest in other cryptocurrencies on the Ethereum blockchain. The token represents MakerDAO's de facto stablecoin for facilitating lending and providing funds to those depositing ETH.
A lot of crypto investors believe that DAI is the only truly trustless and decentralized stablecoin. Although other stablecoins such as USDT and USDC exist, they come with their shortcomings.
Some believe that Tether's reserves do not cover all USDT tokens in the market. On the other hand, USDC is too centralized and the entity operating it (Circle) can freeze tokens and wallets at its own discretion -- usually to counteract criminal activity.
New DAI is minted whenever you take out a loan and destroyed whenever you pay it back. The DAI created represents a stable version of ETH that you can use across Ethereum's DeFi ecosystem.
The price stability of DAI is ensured by burning or creating MKR. The smart contacts written by MakerDAO automatically ensure that DAI's price stability is kept balanced. DAI has successfully held onto its peg for the last four years with only minor fluctuations.
There are a total of 6.4 billion DAI tokens in circulation at the time of writing.
MakerDAO is a decentralized peer-to-peer protocol on Ethereum that facilitates lending, borrowing, and savings using a complex set of self-executable smart contracts. The tokenomics behind the protocol ensure that all three tokens (ETH, MKR, and DAI) keep each other in check, thus preserving the balance.
Whenever DAI fluctuates from its dollar peg, MKR tokens are burned or minted. And whenever new DAI is minted, someone has to provide collateral in the form of ETH. The newly minted DAI is burned by the protocol once a loan is paid off.
MakerDAO has managed $17.5 billion worth of assets in TVL at the peak of DeFi’s bull run. Although the protocol now manages only $7 billion, it still represents the number one protocol in all of DeFi - and not just among lending platforms. And given that no other stablecoin surprasses the level of decentraliation that DAI offers, the crypto community is more than certain that MakerDAO has a bright future ahead.
If you want to learn more about lending protocols and stablecoins, I recommend reading the following articles:
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