MakerDAO: Ethereum's "Craziest" DAPP

Why is MakerDAO referred to as the “craziest” DAPP on Ethereum?

In an interview with Vitalik Buterin, the host asked, “What’s the craziest application of Ethereum that you’ve come across lately?” Vitalik Buterin’s response was, “I am definitely impressed by MakerDAO.”

MakerDAO was the first DAO organization established on Ethereum, in terms of inception rather than product launch. According to product launch dates, the first DAO recognized on Ethereum is “The DAO.” In the stablecoin market, DAI ranks number one in terms of application scale among decentralized stablecoins. Moreover, in the DeFi sector, MakerDAO plays a transformative role. The over-collateralization mechanism of MakerDAO eliminates the risk of “unbacked minting” and operates as a fully on-chain system, eliminating the risks associated with centralized custody.

• MakerDAO operates on Ethereum, integrating over-collateralized stablecoins, lending, storage, and joint user governance and development, classifying it as a DeFi project. It also boasts the highest Total Value Locked (TVL) among Ethereum-based DeFi projects. At its core, MakerDAO centers on the Maker Protocol, which allows users to mint the decentralized stablecoin, DAI, pegged to the US dollar. DAI maintains its price stability through over-collateralization and adjustments to the DAI Savings Rate (DSR).
• If the value of the DAI minted by a user surpasses the collateral value stipulated by the Maker Protocol, the user faces a liquidation auction and pays a liquidation penalty. If the auction amount covers the debt, it enters a second-phase auction to ensure those being liquidated can reclaim more collateral. If the debt exceeds assets, the Maker Protocol absorbs the outstanding debt. MakerDAO once faced a “zero-dollar buy” incident, but the flaw was not in the protocol itself, but in the liquidation mechanism parameters. MakerDAO has an emergency response system to safeguard against systemic risks.
• MKR is the governance token of the Maker Protocol and also the source of capital restructuring. Holding MKR allows one to participate in MakerDAO governance. When the Maker Protocol faces insolvency, it mints additional MKR for auction to cover debts. When the funds in the Maker Protocol treasury reach a certain amount, DAI is auctioned to repurchase and burn MKR.
• The governance system of MakerDAO is showing a centralization trend. The high concentration of MKR has led MakerDAO into “oligarchic” governance, with the top 100 addresses holding 83.41% of the total MKR supply.

MakerDAO: The King of DeFi

What is MakerDAO?

MakerDAO is a project running on the Ethereum blockchain, encompassing over-collateralized stablecoins, lending, savings, and shared user governance and development. At the heart of MakerDAO is the Maker Protocol, also known as the Multi-Collateral Dai (MCD) system. This allows users to generate the decentralized stablecoin DAI using assets approved by the protocol as collateral. As of July 26, 2022, MakerDAO’s Total Value Locked (TVL) stands at $8.03B, firmly establishing it as the leader in the DeFi sector.

Data Source: DeFiLlama

How Was MakerDAO Established?

Before the advent of Ethereum in 2014, Rune Christensen was an active member of the Bitshares community. He had explored the idea of introducing the stablecoin DAI on the BitShares platform. However, Rune Christensen realized that the Bitcoin network was inadequate to support a sophisticated financial system. He eventually turned to Ethereum, often referred to as the “world computer”. Unlike Bitcoin, which has a very limited scripting language, Ethereum is a universally programmable blockchain. It operates a virtual machine capable of executing any code, regardless of its complexity. This capability makes it possible to implement smart contracts on Ethereum.

In March 2013, MakerDAO’s founder, Rune Christensen, first presented his vision for Maker to the world via Reddit: to create a dollar stablecoin backed by Ethereum.

• In 2014, MakerDAO was officially established as the first decentralized autonomous organization on Ethereum (established date).
• In March 2015, the prototype of the Maker protocol was born. Founder Rune Christensen shared the design of the protocol, contract code, and testing frontend with members of the Ethereum community, including Vitalik Buterin, on Reddit.
• Between 2015 and 2017, developers from around the world began the first iteration of code, architecture, and documentation. By mid-2016, MakerDAO had launched the first decentralized exchange on Ethereum: OasisDEX (now Oasis.app).
• In December 2017, MakerDAO officially introduced the first version of the MakerDAO whitepaper on Ethereum, presenting the DAI stablecoin system. On July 20, 2021, founder Rune Christensen published a blog post titled “MakerDAO Has Come Full Circle”, announcing that the Maker Foundation had fulfilled its mission and would be dissolving in the coming months, handing over full control to the community, achieving true decentralization.

What is a Decentralized Stablecoin – DAI?

DAI is a decentralized stablecoin pegged to the US dollar, generated through over-collateralization via the Maker Protocol on MakerDAO. Its total supply depends on the value of collateral on the Maker Protocol. As of July 26, 2022, a total of 7,320,165,935 DAI had been minted, ranking it fourth in total market value among all stablecoins and making it the largest decentralized stablecoin by market value.

Source: CoinMarketCap

What exactly is a decentralized stablecoin? What’s the difference between centralized and decentralized stablecoins?

Decentralized Stablecoins

Decentralized stablecoins, typically categorized into algorithmic and over-collateralized types, are minted through a series of algorithms and smart contract designs rather than by centralized entities. Over-collateralized stablecoins are not created out of thin air; they are minted by locking up a certain amount of assets. To retrieve the locked assets, the corresponding over-collateralized stablecoins must be destroyed. However, purely algorithmic stablecoins are minted through a pre-designed mechanism and may have design flaws, with the LUNA crash being a classic case, where UST was pegged to LUNA (its own created anchor).

Notable decentralized stablecoins include:

• DAI: An over-collateralized stablecoin minted within Ethereum’s MakerDAO by over-collateralizing designated assets.
• UST: A pure algorithmic stablecoin on the Terra blockchain, created by burning $1 worth of LUNA to mint 1 UST.
• FRAX: An algorithmic and over-collateralized stablecoin from Frax Finance, minted by algorithmically collateralizing a certain ratio of designated assets and FXS (governance token).
• AUSD: An over-collateralized stablecoin on AlpacaFinance, minted by collateralizing deposits on AlpacaFinance.

Centralized Stablecoins

Centralized stablecoins are crypto tokens with an “anchoring” attribute, aiming to peg to certain off-chain assets, maintaining equal value. To stabilize prices, centralized stablecoins are backed by off-chain assets. For instance, for every USDT issued, Tether prepares one dollar in reserve. To assure the peg between the stablecoin’s value and the supporting assets, centralized issuers often engage independent accounting firms or auditing entities to verify the custody accounts.

Notable centralized stablecoins include:

• USDT: Tether’s stablecoin, pegged 1:1 to the US dollar, with a 1:1 reserve guarantee claimed by Tether. However, the actual reserve account details are not publicly disclosed.
• USDC: A fully-collateralized stablecoin pegged to the US dollar, issued and managed by a joint venture between Circle and Coinbase, audited monthly by Grant Thornton.
• BUSD: A 1:1 dollar-pegged stablecoin, approved by the NYDFS and issued in collaboration with Paxos and Binance. It is the first stablecoin with its independent client app, and each circulating BUSD is backed by a corresponding dollar in bank reserves.
• TUSD: A stablecoin launched by TrustToken, pegged 1:1 to the US dollar, audited by third-party trust companies and independent accounting firms, offering robust legal protection to holders.

DAI, as an over-collateralized decentralized stablecoin, doesn’t increase the overall value of the crypto market as its minting means locking up collateral assets exceeding the value of the minted DAI, making them non-circulating. However, the minting of centralized stablecoins can increase the crypto market’s total value as they represent real-world assets - fiat currency.

How is DAI generated? How does it maintain price stability? How can leverage be added to DAI?

Generation Mechanism

DAI is minted by users over-collateralizing assets through the Maker Protocol, achieved via Oasis.app. Users create a Vault on Oasis to lock crypto assets as collateral, then decide the amount of DAI to generate, restricted to less than the collateral value. When redeeming collateral, a stability fee is paid. The Maker Protocol supports over 20 different assets like ETH and WBTC, with collateralization ratios and stability fees governed by asset risk and MKR holders. For example, to mint 1000 DAI, users must pledge $1700 worth of ETH, $1750 of WBTC, or $1850 of stETH, with respective stability fees of 0.5%, 0.75%, and 0.75%. The generated interest belongs to the Maker Protocol, not Oasis.app.

Source：Oasis.app

How does DAI maintain its price stability mechanism?

Although designed to be pegged 1:1 to the US dollar, DAI can still experience market-induced price variances. The MakerDAO community uses the Dai Savings Rate (DSR) to balance market supply and demand, allowing all DAI users to automatically earn savings by locking their DAI into the Maker Protocol’s DSR contract, without a minimum deposit requirement and with the freedom to withdraw at any time.

When DAI’s market price deviates from its target due to market changes, MKR holders can vote to adjust the DSR to maintain price stability. Who pays the interest for this?

The interest on DAI is covered by the revenue from MakerDAO’s stability fees. If the stability fee revenue doesn’t cover the total DSR expenditure, the shortfall is recorded as bad debt and covered by issuing more MKR (the governance token and capital restructuring source of the Maker Protocol), with MKR holders becoming the risk bearers.

How to use leverage with the Maker Protocol?

After establishing a Vault, users can borrow more DAI to purchase additional collateral positions via the Oasis Multiply function, paying interest determined by MKR holders. This allows users to gain more from the rise in collateral asset value but also face higher liquidation risks if the asset value falls.

Source：Oasis.app

Users can also choose to mint DAI and USDC, participate in liquidity mining in Uniswap V3, and borrow DAI on leverage through Oasis.app for higher liquidity mining rewards.

How does DAI’s liquidation mechanism work?

After users mint DAI, to retrieve their assets locked in the Vault, they must return the DAI. This allows them to reclaim their collateralized cryptocurrency from the Vault. The returned DAI is automatically destroyed by the protocol to maintain a balance between the value of the collateral and the value of DAI.

Liquidation Mechanism

Everything functions normally as long as the value of the DAI generated by users remains within the allowed range based on their collateral. However, if the value of the collateral decreases, making the value of the generated DAI higher than the maximum allowed by the collateral, liquidation is triggered. For example, suppose the collateralization ratio for minting DAI with ETH is 2:1, and a user mints 1000 DAI using ETH worth $4000. In this scenario, the $4000 worth of ETH could allow minting up to 2000 DAI. If the value of Ethereum falls below $2000, the value of the 1000 minted DAI exceeds the maximum DAI value allowed by the Ethereum now worth less than $2000, triggering the liquidation process. Liquidation means the user no longer needs to return the DAI. Their Vault is seized for a collateral auction to recover the DAI owed to the system. Additionally, the user being liquidated must pay a liquidation penalty. The Maker community’s MKR holders set different liquidation penalties for different types of collateral. The value of the auctioned collateral, plus the liquidation penalty, is included in the auction process.

The auction process consists of two phases: Collateral Auction and Reverse Collateral Auction:

• Collateral Auction: In this first phase, bidders start bidding on the auctioned collateral. The highest bidder pays DAI to acquire the collateral at a lower price, using the repurchased DAI to cover the Vault’s outstanding debt and liquidation penalty.
• Reverse Collateral Auction: If the DAI obtained from the first phase is sufficient to settle the debt in the Vault and pay the liquidation penalty, the auction moves to the second phase. Here, bidders offer a fixed price of DAI to take away less collateral. The goal is to allow the original Vault owner to recover as much collateral as possible while ensuring all DAI debts are paid.

The auction process is as follows:
When the first phase auction is sufficient to settle the debt, the second phase begins.

If the first-stage auction is not sufficient to repay the debt, the second stage is not initiated, and the unpaid debt is covered by the Maker Buffer.

A new concept here is the Maker Buffer. What is it?

The Maker Buffer is part of the Maker protocol, a vault that belongs to no one. Stability fees generated by users of the protocol and the profits from auctions (like liquidation penalties) flow into the Maker Buffer. Debts incurred by the Maker protocol (such as insufficient funds from an auction) are borne by the Maker Buffer. If there is not enough DAI in the Maker Buffer to repay Maker protocol debts, a Debt Auction mechanism is triggered.

Debt Auction Mechanism: When the DAI in the Maker Buffer is insufficient to cover Maker’s debts, the protocol will over-issue MKR to start an auction process. Bidders can use DAI to bid for MKR, and the DAI obtained from the auction enters the Maker Buffer to repay debts.

This raises a question: Wouldn’t this lead to severe over-issuance and devaluation of MKR?

The Maker protocol has another auction mechanism to prevent severe over-issuance of MKR — the Surplus Auction mechanism.

Surplus Auction Mechanism: When the DAI in the Maker Buffer accumulates to a certain amount (determined by Maker governance), the excess DAI is auctioned off in a Surplus Auction. During the Surplus Auction, bidders use MKR to bid for a fixed amount of DAI. The highest bidder wins. Once the Surplus Auction is concluded, the MKR obtained from the auction is automatically destroyed by the protocol, thereby reducing the total supply of MKR.

This might lead you to wonder:

How does the Maker protocol know when my assets are facing liquidation?

The blockchain world and the real world are not interconnected, so a bridge is needed to link the two worlds. How does the Maker protocol obtain the prices of these cryptographic assets in the real world? This is achieved by something called a Price Oracle.

In the blockchain world, an oracle is not a machine used to predict the future, but a tool for obtaining off-chain information. This is because smart contracts cannot actively fetch data from outside the blockchain; they can only passively receive it.

A Price Oracle, selected by MKR voters, consists of a group of trusted nodes that provide pricing information to the Maker system. The number of nodes in this group is also controlled by MKR voters. To prevent attackers from controlling a majority of these oracles, the Maker protocol acquires price information through the Oracle Security Module (OSM) instead of directly from the oracles. The Oracle Security Module is a defensive layer placed between the oracle nodes and the Maker protocol, which delays price updates by one hour. During this period, if any oracle is found to be under an attacker’s control, it can be frozen either through emergency input or a governance vote by MKR holders. Both the decision to delay price input and the emergency information input authority lie with MKR holders.

After DAI is minted, the collateral is locked in a Vault. The Price Oracle checks if the value of the collateral reaches the maximum collateralization ratio of DAI. If the value of the collateral exceeds this ratio, a liquidation auction is triggered. The liquidated party incurs a penalty, and the auctioneer acquires the collateral at a lower price. If the auction proceeds are insufficient to cover the debt, the protocol assumes the debt.

Is the Maker Protocol Really Safe?

In the digital world, no protocol or system is absolutely secure. This is especially true for a complexly designed DeFi protocol handling such a vast amount of funds, where some vulnerabilities are inevitable.

MakerDAO’s “Zero-Dollar Purchase”?

During the “March 12th” Black Swan event, due to a sharp drop in ETH prices, a large number of collaterals in the Maker protocol fell below the liquidation threshold, triggering the auction process. However, due to a sudden increase in the number of on-chain transactions on the Ethereum network, which caused GAS fees to skyrocket, the liquidation transactions requested by liquidation bots couldn’t be processed in time because of their low GAS fee settings. This led to a situation where a liquidator, without any other auction competitors, won the auction with a bid of 0 DAI. As a result of this liquidation mechanism failure, the ETH collateral sold for zero value amounted to $8.32 million. Furthermore, the Maker protocol system incurred an uncollateralized bad debt of 5.67 million DAI, emptying the DAI buffer pool. To cover the 5.67 million DAI of uncollateralized bad debt, MakerDAO initiated its first MKR auction to address the shortfall and later improved the protocol mechanisms to prevent similar incidents from occurring. From this event, it is evident that the loss suffered by MakerDAO was not due to a flaw in the protocol itself but a defect in the design of the auction mechanism.

MakerDAO’s “Nuclear Button”

What is Emergency Shutdown?

For Maker, the largest DeFi protocol in terms of the amount of money involved, having emergency measures in place for extreme situations is crucial. The Emergency Shutdown mechanism serves as MakerDAO’s last line of defense during extreme scenarios such as malicious governance activities, illegal intrusions, security vulnerabilities, and prolonged irrational market behaviors. Once the Emergency Shutdown is activated, the normal functions of the Maker protocol are suspended. Users will no longer be able to deposit collateral or generate DAI from the Maker protocol. The settlement system will ensure that any DAI holders can redeem the corresponding value of the collateral. To facilitate an orderly liquidation, MKR holders will decide on a waiting period before the collateral can be redeemed. Upon activation of the Emergency Shutdown, prices from all collateral type oracles in the system will be immediately frozen, and it will be assessed whether the collateral is sufficient to cover the outstanding DAI.

There are two methods to activate the Emergency Shutdown:

Emergency Oracle: Appointed by a vote of MKR holders, this emergency oracle can freeze individual price feeds (e.g., for ETH and BTC) and has the authority to unilaterally trigger the Emergency Shutdown. In extreme scenarios, MKR holders can authorize this oracle to activate the Emergency Shutdown.

Emergency Shutdown Module (ESM): This is a decentralized activation process that requires MKR holders to lock their MKR in the module to initiate it. The Emergency Shutdown is only triggered when the amount of locked MKR reaches a predetermined threshold, which is decided by MKR holders’ votes. The initial proposal was for 50,000 MKR.

The Emergency Shutdown proceeds through three stages:

1.Closure of the Maker Protocol: Upon activation, users can no longer create new Vaults to mint DAI or operate existing Vaults. The price feed mechanism also freezes, halting asset price updates. This freeze ensures that all users can retrieve the net value of their assets, and Vault owners can immediately withdraw collateral exceeding the required debt coverage.

2.Auction Mechanism Post-Shutdown: After activation, a collateral auction begins, with a longer duration than regular auctions. The duration is governed by MKR holders to ensure all auctions are completed smoothly after the end.

3.DAI Holders Redeeming Remaining Collateral: After the auction, DAI holders can redeem collateral at a fixed exchange rate using DAI, and the decision to restart the system is made by MKR holders.

From what we’ve seen, MakerDAO has already experienced a black swan event, learned from it, and improved its auction mechanism. The existence of the Emergency Shutdown mechanism equips MakerDAO with the capability to combat systemic risks in extreme situations, making it relatively safe overall.

What is MKR? What can MKR be used for?

MKR is the governance token and a source of capital restructuring for the Maker protocol. At the inception of the Maker protocol, there was a total of 1,000,000 MKR. The total supply of MKR fluctuates with the operation of the protocol system.

As a governance token, MKR holders can use MKR to vote on governance issues related to MakerDAO. Voting typically involves modifying internal parameters of the Maker protocol, such as the collateral value and the generation/liquidation ratio of DAI (Liquidation Ratio), the liquidation penalty rate (Liquidation Penalty), the DAI Savings Rate (DSR) deposit interest rate, auction mechanism parameters (bid increments, bidding duration, bid intervals, etc.), which crypto assets can be used as collateral, and the selection of oracle nodes.

As a source of capital restructuring for the Maker protocol, when there is a debt deficit in the Maker Buffer (the protocol’s buffer pool), the system will issue additional MKR to raise funds for debt repayment. Conversely, when the funds in the Maker Buffer exceed a certain amount (determined by MKR holders), DAI will be auctioned to repurchase MKR and then it will be destroyed.

Is MakerDAO Governed Decentralized or by an Oligarchy?

As of July 26, 2022, the total supply of MKR is 977,631.04, held across 86,785 addresses.

Source：etherscan

An interesting phenomenon emerges when examining the distribution of MKR tokens. Despite being held by 86,785 addresses, the top 100 own 83.41% of all MKR. This concentration of wealth is not uncommon, mirroring the real world where a minority controls a significant portion of wealth. As reported by BBC News in 2018: “World’s richest 1% get 82% of the wealth.”

Source: BBC News

What risks does the high concentration of MKR pose for MakerDAO?

The heavy concentration of MKR can lead to an oligarchic governance of MakerDAO, with a few individuals wielding control over its governance.

First, let’s understand the governance proposal process of MakerDAO

The Maker governance process is divided into two stages: proposal voting and execution voting. Technically, changes to Maker Protocol’s internal parameters are implemented through a Proposal Contract, each designed for one or more governance actions. All voting is managed by these contracts. After an execution vote is passed, the Proposal Contract enacts changes to the protocol’s parameters. Since these contracts are one-time use, they become obsolete after execution, and new smart contracts must be created for subsequent proposals.

Changes to the governance variables of the Maker Protocol do not necessarily take immediate effect after execution voting approval. If voters activate the Governance Security Module (GSM), these changes are delayed (with the duration set by MKR holders). This delay allows MKR holders to react, potentially triggering the Emergency Shutdown mechanism to oppose malicious governance proposals (e.g., proposals that alter collateral parameters against current monetary policy or disable safety mechanisms).

In summary, MakerDAO’s governance process involves forming a consensus in the community, initiating execution voting, and creating a Proposal Contract. Voters can choose to activate the GSM to delay the activation of approved changes, allowing more MKR holders to engage in further discussion or actions, such as objecting to the voting results or initiating the Emergency Shutdown.

Observing the actual governance of MakerDAO, as of July 26, 2022, in its latest governance proposal, we notice a pattern.

Fewer than 20 individuals actively participate in governance voting and can significantly influence outcomes. The top four voters alone often account for over 50% of the total votes, enough to decide the outcome of a proposal and amend internal parameters of the Maker Protocol. In some votes, a single individual can play a decisive role.

To some extent, MakerDAO can be considered an oligarchic rather than a truly decentralized governance system. This is not uncommon and can be attributed to a general lack of interest in participating in governance or the high cost of MKR making it prohibitive to engage in MakerDAO governance. While holders of large amounts of MKR, along with other MKR “whales,” can achieve complete control over the Maker Protocol, and even the top MKR holders have enough power to unilaterally initiate the Emergency Shutdown, such actions are generally not beneficial to the MKR holders themselves. The development of MakerDAO represents the collective interest of MKR holders.

Disclaimer:

1. This article is reproduced from [Buidler DAO], and the copyright belongs to the original author [菠菜菠菜 | Investment Research Association-Researcher]. If there are objections to the reproduction, please contact the Gate Learn team, and the team will process it promptly according to relevant procedures.
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