MakerDAO: The Maker Protocol With the Best Decentralized Stablecoin

MakerDAO: The Maker Protocol With the Best Decentralized Stablecoin

Lookout for a stablecoin that's actually stable? Look no further than the Maker Protocol's DAI

MakerDAO: The Maker Protocol With the Best Decentralized Stablecoin
Guy Ovadia

Published May 23, 2022Updated Jun 22, 2022

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Decentralized finance (DeFi) would be nothing without stablecoins. The stability they bring to the cryptosphere can help investors, traders, and financial service providers alike hedge against volatility without sacrificing efficiency and decentralization—at least in theory.

If you think stablecoins are a guaranteed safe bet, think again. Stablecoins—regardless of whether they are collateralized or algorithmic—are only as good as the people behind them. If you put too much trust in a centralized company or a team of blockchain developers, you could be left holding the bag. That's where the Maker Protocol, an accessible DeFi solution for minting stablecoins, comes in. Here's how it works and how it produced Dai (DAI), one of the best stablecoins.

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What is the Maker Protocol?

The Maker Protocol is a decentralized mechanism for minting a stablecoin called Multi-Collateral Dai (DAI). Unlike other stablecoins like USDC and USDT that are backed by cash or fiat-equivalents, DAI is issued against collateralized debt positions composed of cryptos like ETH and other ERC-20 tokens such as liquid staking derivatives. This means that anyone can deposit crypto into the protocol to mint DAI stablecoins, which in turn can be used on other DeFi platforms like Curve Finance.

Maker Vaults

The mechanisms that make up the Maker Protocol are very effective at striking a balance between the economic interests of all parties involved and maintaining DAI's peg to the dollar.

DAI tokens are issued when someone deposits their crypto into a Maker Vault. DAI is issued as debt against cryptos locked into the vault, and in order to withdraw those cryptos, you have to repay the DAI loan plus interest. Maker Vaults make the DAI stablecoin accessible to most crypto investors, but the caveat is that depositing your cryptos implicates them in the protocol's mechanisms that maintain DAI's peg to the US dollar.

Liquidation ratio

Firstly, each DAI vault has a liquidation ratio based on how risky the assets in the vault are. The minimum liquidation ratio for most vaults is 150%, which means the value of your collateral must be 50% greater than your debt. So, if the value of your collateral drops below the liquidation ratio, then the liquidation mechanism kicks in.

Collateral auction

Vaulted crypto assets that fall below the liquidation ratio are put on auction. The collateral auction mechanism only sells enough assets from the vault to cover the value of DAI that had been borrowed against it as well as a liquidation penalty. Any assets that are leftover in the vault after the collateral auction are returned to the vault's owner. 

Stability fee

Withdrawing collateral from a Maker Vault requires paying back any outstanding DAI plus a stability fee. Stability fees are calculated exactly like an annual interest rate, and they must be paid in DAI tokens. Stability fees along with liquidation fees are deposited into a protocol debt fund called the Maker Buffer.

Dai Savings Rate (DSR)

The Dai Savings Rate is the yield awarded to anyone with DAI tokens deposited into the DSR smart contract. The DSR is determined by the MakerDAO as a way of mitigating DAI's price instability if its value deviates from the dollar. This means the DSR is constantly being adjusted lower or higher according to whether DAI's price is deviating above or below its target, so it may not be the best way to earn yield on stablecoins.

MakerDAO

MakerDAO is the decentralized autonomous organization (DAO) that governs the Maker Protocol. The MakerDAO votes to determine the parameters of mechanisms such as the stability fee, liquidation fee, DSR, debt ceiling, and more. MakerDAO members also collectively approve assets for Maker Vault deposits and the liquidation ratio of new assets.

Maker Buffer

The MakerDAO is also responsible for deciding when to liquidate the surplus protocol debt. All of the Maker Protocol's surplus DAI collected from fees is rounded up and deposited into the Maker Buffer. When the amount of DAI in the Maker Buffer reaches a certain level, those funds are placed in a mechanism called a surplus auction. This mechanism takes the Maker Protocol's revenue and uses it to buy MKR tokens and burn them—making the MakerDAO governance token more scarce by removing supply from circulation.

MKR token

The MKR token is the governance token used to vote on adjustments to the Maker Protocol. MakerDAO is composed of MKR token holders who participate in Maker Governance by voting or submitting proposals. This means that those with the largest MKR balances have more influence over the Maker Protocol.

The MKR token also serves as a recapitalization resource for the Maker Protocol. If a collateral auction fails to cover the DAI borrowed against its respective vault, this deficit becomes the protocol's debt and usually gets covered by the Maker Buffer fund. In the case that the Maker Cover fails to cover the protocol's debt, MKR tokens are minted and sold for DAI via a debt auction. This mechanism is a counterbalance to the buy-and-burn mechanism of the Maker Buffer.

Oasis DeFi app

The Oasis app is the Maker Protocol's platform for interfacing with the Maker DeFi ecosystem. This user-friendly app makes borrowing DAI, earning DAI, and swapping cryptos more accessible than ever. Oasis is also implementing new features, such as the ability to enter leveraged positions on certain assets.

Trade 

Traders can swap cryptos within the Oasis app using the 'Trade' feature. This feature integrates the Uniswap to enable Oasis users to access liquidity pools to conduct trades directly from the app. Oasis trade doesn't function as a standalone decentralized exchange, but nonetheless offers convenience for Oasis users.

Save 

Oasis also makes it easier to access yield from the DSR through the 'Save' function in the app. This is the simplest way for DAI holders to deposit their tokens and earn yield. In the future, this function will also integrate peer-to-peer crypto lending protocols like Aave to give Oasis users access to the highest interest rate on their DAI.

Borrow

Finally, the Oasis 'Borrow' function is what could take the Maker Protocol into the mainstream. This feature makes opening vaults, depositing collateral, and borrowing DAI super intuitive. Additionally, the new 'Multiply' feature uses the same function except it adds an extra step of using the borrowed DAI to market buy more of the collateralized asset—investors can use this function to increase their exposure by leveraging existing assets.

Is DAI a good stablecoin?

 

In terms of track record, DAI is the most successful decentralized stablecoin. It is also the only stablecoin that's able to maintain its peg to the dollar effectively without the backing of actual dollars. The two main factors that attribute to DAI's strength are economic incentives and over-collateralization.

Firstly, the mechanisms that make up the Maker Protocol are very effective at striking a balance between the economic interests of all parties involved and maintaining DAI's peg to the dollar. They provide economic incentives for both holders of MKR tokens to keep the system sustainable and for vault holders to seek arbitrage opportunities that help maintain the peg. While the entire Maker Protocol can be reduced to just two parties, the infrastructure supporting DAI is complex and very well-designed. 

One valid criticism of the Maker Protocol is the high liquidation ratio because it imposes poor capital efficiency on collateralized assets deposited into vaults. While it's true that other DeFi protocols utilize crypto assets more efficiently than Maker does, over-collateralization is arguably the strongest mechanism for maintaining DAI's incredibly close peg to the dollar. This is largely what makes it one of the safest stablecoins.

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