In this article, we will delve into the MakerDAO project and explain how the system works, what are the risks and what can we expect from it in the future.
- What is MakerDAO
- How MakerDAO Works
- Vault liquidation
- Stability Commission
- Rewards for DAI holders
- TRFM as a way to stabilize the price of DAI
- Applications for DAI
- What is MKR for?
- MakerDAO risks and regulation
- Growth of MakerDAO and further development
What is MakerDAO
MakerDAO is an Ethereum-based DeFi protocol that allows users to generate a DAI stablecoin when they deposit collateral. In fact, this is a crypto-credit platform where you can borrow money, regardless of where the person is, who he is and under what circumstances he needs money.
The MakerDAO platform includes 2 tokens: DAI and MKR.
- DAI is a stablecoin.
- MKR is a control token.
The goal of the Maker protocol is to create stability in the decentralized world. DAI token aims to provide this very stability. It is soft-pegged to the US dollar (USD) at a ratio of 1:1. In addition, the token is compatible with ERC-20, ranks 13th in the cryptocurrency rating and is used in many popular Ethereum wallets lile MetaMask, MEW and others.
Since MDAO is also a DAO, MKR control token holders have voting rights in the project. By voting, they decide many issues related to risk parameters, which we will discuss below.
How MakerDAO Works
Although both tokens can be bought on crypto exchanges, DAI is generated when a user locks a cryptocurrency in the Maker vault.
Maker Vault, or Maker Vault, is a tool that allows the user to deposit cryptocurrency and generate DAI.
You can create your own vault using the Oasis Borrow portal or user interfaces that have been developed by the MakerDAO community, such as Instadapp. Next, you need to deposit collateral and conduct a transaction during which the deposited collateral is blocked in the vault, and the user receives the generated DAI.
If the user wants to return the deposit, then it is necessary to pay through the smart contract the amount of DAI that was issued for him. The scheme is very simple and really works. MakerDAO is considered as one of the most developed products, however, there are some difficulties here.
In the MakerDAO system, there is such a thing as the liquidation ratio.
The liquidation ratio is the minimum level of vault provisioning. Due to the volatility of cryptocurrencies, it happens that the collateral is not enough to pay off the debt. In other words, the liquidation ratio does not match the market value of the collateral.
When this happens, the Oracle Security Module (OSM) informs the Maker protocol that the liquidation price has been reached, and the vault is liquidated.
Liquidation of a vault is the sale of a pledged asset at auction in order to cover an outstanding debt.
At the auction, the collateral is redeemed by the liquidators, after which the received DAI is burned. This is done in order to reduce the emission, as well as to ensure that the stablecoin is tied to the USD.
In general, the liquidation ratio plays a big role in deciding whether to sell collateral at auction. Calculate it when assessing the risk profile of the collateral and the commission for stability. The formula looks like this:
Liquidation Rate = (Collateral * Collateral Value) ÷ DAI Issued * 100
Each vault differs in collateral type, stability fee, and liquidation rate.
Let's say you created a vault with a liquidation rate of 150%. There will be at least $1.50 of collateral value per $1 of DAI issued. If the price of the collateral has dropped even by a cent, liquidation begins. And the owner is subject to a liquidation penalty, a payment charged for the liquidation of the vault. The fine is not set by the system itself, but by the people who own MKR by voting.
Essentially, DAI is a user's debt to the platform, backed by a collateral that is always slightly higher than the amount of the loan itself. MakerDAO earns commissions when returning funds in the form of DAI or MKR, as well as through the liquidation of the user's vault if the value of the collateral falls below the liquidation ratio.
The Stability Fee is an additional payment on top of the amount of DAI that was issued by the user when depositing collateral in the vault.
In simple terms, this is the annual interest on the loan. They are subject to change if MRK owners vote for it. The decision to change is made based on the recommendations of Risk Teams. Analysts from Risk Teams help assess the risk of collateral locked in a smart contract. They can also change the stability fee if the underlying asset or the entire system changes dramatically.
The stability fee is accumulated on the internal balance of the Maker protocol. Once the maximum liquidation balance is reached, DAI is sent to an auction where holders buy back the stablecoin in MKR at a higher price. The highest bidder receives the stablecoin, and the MKR they paid with is burned.
Part of the fee is spent on maintaining the Maker protocol. This also includes the cost of running DSRs, Risk Teams, and other MakerDAO options.
Rewards for DAI holders
MDAO users can not only take out loans and borrowings, but also receive rewards for owning a stablecoin using DSR, or the interest rate on savings.
DSR is a global parameter that determines the reward for depositors in DAI.
An increase in DSR encourages users to hold as much DAI as possible, while a decrease leads to a decrease in demand for a stablecoin. All this is reflected in the market price of DSR. Its course is being followed by MKR holders. So, if the price of DAI exceeds $1, then MKR holders can reduce DSR to reduce demand, as well as bring the stablecoin back to its target price. Conversely, if DAI is below $1, DSR will rise to increase demand and bring the stablecoin back to its target price.
All stablecoin holders are rewarded by default when they block DAI under the DSR smart contract. In such a contract, there is no minimum deposit amount, as well as no liquidity restrictions. You can withdraw DAI from a DSR smart contract at any time.
TRFM as a way to stabilize the price of DAI
Basically, the DAI target price determines the value of the pledged assets and the calculation of the collateral-to-loan ratio. However, if there are serious changes in the market, then the Target Rate Feedback Mechanism (TRFM) will work instead of the target price —a feedback mechanism with a target rate. TRFM changes the target rate, thereby incentivizing users to maintain DAI at the target price level, while the mechanism does not have a fixed DAI peg to USD.
Key parameters begin to change dynamically, balancing supply and demand for a stablecoin. For example, if the market price of a coin falls, the target rate increases with the help of TRFM – at the same time, the issue of a stablecoin rises in price, DAI becomes interesting for storage, and demand grows. This is what allows DAI to rise, reaching the target price.
The mechanism also works in the opposite direction: when the market price rises, the target rate decreases - at this time, the attractiveness of issuing DAI increases, but the demand for storage decreases. So the market price is reduced to the target.
Applications for DAI
MakerDAO identifies four areas where DAI can be useful.
Сross-border payments. With the help of DAI, you can reduce transaction costs for transfers outside the country due to the absence of intermediaries.
Game industry market. In blockchain games, the introduction of DAI may mean the creation of a new economic model, the development of game scenarios based on the DeFi system. The use of fiat-pegged DAI allows you to reduce the risk to the usual probability of losing in gambling.
Financial markets. Stable Collateral can be used for derivatives based on smart contracts.
Transparent reporting. All transactions are verifiable, easy to track and can be used for accounting purposes. This allows you to take the work to a higher level, reducing the risk of abuse.
What is MKR for?
MKR is the control token for the Maker protocol. The protocol itself is a combination of smart contracts that allow you to generate DAI.
Back in 2017, the Maker fund held a three-round private sale for $64.5 million, issuing $1,000,000 MKR.
One of the tasks of the token is to pay off the commission for using MDAO smart contracts. As in most cases, after payment, the tokens are burned.
In addition, MKR acts as a source for the recapitalization of the entire system. Recapitalization needed if the Maker protocol is in deficit and the system debt is above the maximum. To do this, you can increase the supply of MKR through an auction. Conversely, if the liquidation balance exceeds the minimum value, the excess DAI is sold at auction for MKR. At the end of the auction, the collected MKRs are automatically burned.
One of the tasks that control token holders face is to ensure the stability of DAI, as well as to organize the transparent and efficient operation of the system. This is done with the help of the same MKR. It gives owners the right to vote: you can vote and offer your ideas to improve the system.
One MKR equals one vote. The proposal that receives the majority of votes affects the further development of the project. The decision made directly affects not only the system, but also the profit of the holders.
So, for example, holders of control tokens affect the following vault risk parameters:
- Debt ceiling. The maximum amount of debt for one type of vault.
- Liquidation ratio. The ratio of collateral to debt at which the vault can be liquidated.
- Stability Commission. The annual interest rate for the borrower.
- Penalty factor. Payment imposed in the event of liquidation due to unpaid debt.
Thanks to the Decentralized Autonomous Organization (DAO), MKR holders can independently make important decisions about improving the platform, raising or lowering the interest rate, distributing profits, and so on. Because of this, storing the token looks attractive to users.
MakerDAO risks and their regulation
Like any platform, MakerDAO may face certain risks. The platform openly shares problems and also proposes measures to help mitigate them.
Attack on the security system. Hacker attacks do not leave anyone alone, especially if a vulnerability is found in a smart contract. Malicious participants can use a hole in the code to disrupt the smooth operation of the system or steal money from the platform. To protect, MDAO uses formal verification, conducts audits, and rewards users who find vulnerabilities.
The outflow of users to other platforms. Despite the fact that MakerDAO has a lot of popularity, the platform is difficult to understand. It is likely that users will prefer a different platform with a more understandable system. To do this, MakerDAO has created an intuitive way to conduct any DAI transactions, and also produces useful materials for beginners.
Irrational dynamics in the market. Prolonged bearish periods in the market can change the price of DAI for a long time, which can lead to a loss of confidence in Maker. To do this, the platform can use various incentives to raise capital. This decision will help increase the efficiency and rationality of the market, which means that DAI will continue to increase volumes.
Attention of regulators to the stablecoin. DAI acts as a financial mechanism that maintains price stability. This may attract the attention of regulators, as some stablecoins in the US may be treated as securities, and DAI falls into one of the three categories of stablecoins that may be subject to US law.
Growth of MakerDAO and further development
The MakerDAO platform is evolving rapidly. Since its inception, a long way has been made. Here are a few significant developments that have happened to the platform over the past few years:
In 2020, MDAO broke the record by becoming the first DeFi protocol to reach $1 billion in TVL. The total value of funds locked up has now exceeded $8 billion. consortium Global DeFi Alliance.
In 2021, with the help of MakerDAO, real estate recovery investment company New Silver launched a credit line with Centrifuge to generate $5 million worth of DAI. which means the transition to full decentralization. The Maker Foundation has handed over the reins to the MakerDAO community.
Along with this, the platform expands the list of collateral assets: Ether, Tether, USD Coin, Chainlink, Wrapped Bitcoin, renBTC and many others. Diversifying your collateral portfolio can help ensure DAI is reliable. According to Maker, any tokenized asset can be added to the DAI collateral portfolio, provided that it has optimal risk parameters and is approved by MKR holders.
Today, MakerDAO is also testing the waters among real-world assets. A vote was recently launched to invest $500 million DAI in US corporate and government bonds in an attempt to generate income by diversifying their holdings.
There was also a proposal to allow Pennsylvania's Huntingdon Valley Bank to take out a secured loan of up to DAI 100 million, with over 80% of participants agreeing. This marked the first time that a traditional financial institution has received a loan from a DeFi protocol. MakerDAO may very well be the first protocol to offer conventional loans to traditional institution borrowers.
To learn more about the project, follow MakerDAO socials and useful links:
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