MakerDAO (MKR) is an innovative open financial system that mints Dai stablecoins backed by crypto collateral.
Today, Dai decentralized stablecoins are utilized across DeFi platforms like Aave, Compound, and Uniswap. To understand Dai stablecoins and how MakerDAO works, let's start with a quick look at the differences between centralized and decentralized stablecoins.
Difference Between Centralized vs. Decentralized Stablecoins
Stablecoins are basically digital dollars — they possess a relatively stable value that doesn't keep you guessing from day to day.
The reason crypto investors love stablecoins is unlike volatile cryptocurrencies, stables are a safe place to park your cash at a 1:1 value. So, if we take USD, you can usually trade $1,000 for 1,000 dollar-pegged stablecoins.
For crypto investors and traders, there's tons of utility in the stablecoin system.
You never have to leave the crypto ecosystem to get cash-like stability.
It's easy, fast, and cheap to send stablecoins between exchanges.
Stablecoins earn high interest on DeFi protocols like Compound and Curve.
Borrow stablecoins or crypto with stablecoin collateral on Aave.
The list of ways to use stablecoins goes on. Now, here's where things get exciting and why Maker's Dai stablecoin is so impressive.
Earlier, we called stablecoins digital dollars for a good reason. The vast majority of stablecoins like USDT, USDC, GUSD, and PAX are not only pegged to USD but are actually backed by dollars held in reserve. Yes, that means there's a vault somewhere housing physical dollars and assets to collateralize every minted USDT, USDC, GUSD, and so on.
You can think of these types of stablecoins as the AOL of digital currency. All they're really doing is taking dollars and making them digital. But we all know dollars are centralized currency, right? So are dollar-backed stablecoins.
Behind USDT, USDC, and the other major dollar-backed stablecoins are centralized entities printing them like central banks. An enormous amount of third-party oversight goes into auditing, accounting, and regulating stablecoins like Tether.
If you care about decentralization, then clearly, these digital dollar stablecoins are not what you want. So what do you want?
A decentralized stablecoinsystem, of course! And that's exactly what MakerDAO has built.
What is MakerDAO?
MakerDAO is a decentralized bank of the future issuing stablecoins backed by other cryptocurrencies. The entire system runs on the Ethereum blockchain, is decentralized, and is taken care of by smart contracts.
Take note of this key difference: whereas other stablecoins are dollar-backed, Maker-issued Dai stablecoins are dollar-pegged. Pegged means the Maker protocol uses an oracle to track and peg the value of DAI to USD in real-time.
To wrap your head around the whole dollar-peg thing, here's the TLDR version of how Maker works.
You deposit supported cryptocurrencies to the Maker protocol.
You can withdraw Dai determined by your collateral amount.
To get your crypto collateral back, repay withdrawn Dai.
Simple enough, right? The reason this whole system works is Maker utilizes overcollateralized lending. Basically, you're depositing more than the loan amount to lessen the risk to Maker dramatically.
So, if you want to borrow 500 Dai, you deposit 1.5x that amount in ETH or another cryptocurrency. The collateral amount needs to be high because cryptocurrencies are volatile and often lose large value percentages overnight. Overcollateralizing your Vault protects the loan from dramatic price swings and saves your position from liquidation.
Maker's proper secret sauce is found in its Vault system. In a nutshell, a Maker Vault is where Dai is created against your deposited collateral. Everything happens on the Ethereum blockchain, so transactions are decentralized and fully auditable by anyone.
When you deposit collateral in Maker, you simultaneously open a Vault position. This in turn gives you the option to withdraw Dai stablecoins against your collateral. Once you withdraw, the Dai tokens are minted and brought into the overall circulating supply. When you repay your Vault position, the Dai amount attached to the position is destroyed and removed from the supply.
Because Maker Vaults create and destroy Dai tokens, the supply is said to be elastic. In the same way a rubber band expands and contracts, so too does the Dai token supply. The reason for this elasticity is to maintain the token's dollar peg, but more on that in the next section.
Maker Vaults require you to overcollateralize your position by at least 150% to protect itself and you. Let's say you have ETH for collateral and that right now, ETH is trading at $2,000. To take out a 3,000 Dai stablecoin loan, you need to deposit 2.25 ETH.
The point of overcollateralizing like this is to stave off the risk of liquidation. When the value of your collateral is in danger of dipping below the loan’s value, lenders liquidate your collateral to repay themselves. However, because Maker uses volatile cryptocurrencies as collateral, it needs plenty of cushion to keep Dai solvent.
After creating a Maker Vault position, you can use your Dai stable currency just like regular cash. Dai is conveniently one of the most accepted stablecoins across cryptocurrency exchanges, making it easy to buy more crypto with your existing liquidity.
How Dai Stablecoin Keeps It's Value
We've talked a lot about how the MakerDAO protocol works, but the entire system is for nothing if Dai stablecoins don't hold value. But after years of operation, Dai has maintained value at or around $1 without issues.
So how does Dai stay pegged to the dollar without being physically backed by them? There are a few ways Dai accomplishes stability.
Collateral in Maker Vaults is worth more than the global Dai debt.
When Dai is <$1, traders repay their Vaults, reducing Dai supply.
When Dai is >$1, traders open Vaults, increasing Dai supply.
The opening and closing of Vault positions by arbitrage traders directly affects Dai token supply elasticity. If more traders repay vaults than open them, Dai is removed from supply to push the price per Dai back up to its $1 peg. When the opposite happens, newly minted Dai floods the supply to drive prices down to $1.
Maker Oasis App
If you want to use Maker to borrow Dai, the path forward is confusing since there isn't a clear explanation on the Maker homepage. But not to worry, we have you covered.
To use Maker, you need to access Oasis, the app for creating a Maker Vault and generating Dai. Oasis is pretty slick and easy to use. Like any other DeFi platform, you should have a MetaMask wallet on hand because you can't enter the app without one.
Once inside, you're met with a long list of different cryptocurrencies Maker officially accepts as collateral. To the side of each one are metrics detailing the minimum collateralization ratio along with a one-click open vault button.
However, one thing to note is that if you want Dai but don't want to open a Vault or collateralize your crypto, you can easily buy Dai on Coinbase, Binance, or Uniswap.
Maker Token (MKR) Explained
The Maker token, or MKR, is a governance token used to vote in MakerDAO governance matters. Anyone holding MKR tokens is a co-equal stakeholder in the MakerDAO system — but you should also know what a DAO is.
Short for Decentralized Autonomous Organization, a DAO enables democratic governance between stakeholders without intermediaries, centralized authorities, or owners.
Some important issues at stake for MKR holders are the security of the Maker protocol, governing well to maintain the Dai peg, and enacting an Emergency Shutdown in the event of a hack.
About The Author:
The Shrimpy Team
The Shrimpy Team is comprised of highly experienced content writers who analyze and research the latest market trends, delivering content suitable for both beginner and veteran crypto investors.