What is MakerDAO and how does DAI work?

Perhaps the most popular feature of cryptocurrencies and the crypto market is volatility. The dynamic changes in the price of tokens and other crypto assets have placed some strain on the reputation of the industry. As a result, traditional investors and finance enthusiasts are wary of entering the crypto space. Investing in cryptocurrency can quickly go left because there is little to no form of stability in the prices of most coins. Financial service providers also restrain from building financial service models in the industry because they have nothing to fall back on.

A major aspect of traditional finance, and possibly the foundation for most financial service products, is the concept of borrowing and lending. Now that crypto has become more mainstream, the objective of most blockchain developers and the DeFi movement is to expand crypto use cases. Their aim is to transform traditional financial services into completely open-source, decentralized finance options on the blockchain. One result of this objective is crypto loans. However, this concept posed a serious problem. How can you borrow an asset that is subject to continuous fluctuation? The price of a coin at the time of the line could change drastically before it was paid back. MakerDAO, a name within the industry, proposed a solution to this problem in two forms: Collateralized lending and a decentralized stablecoin DAI.

What Is MakerDAO?

MakerDAO, the longest-running project on the Ethereum blockchain, began in 2014. Rune Christensen founded the project and established its headquarters in Santa Cruz, California.

In 2017, MakerDAO’s stablecoin was launched via an Ethereum-based smart contract on the Maker protocol.

One year later, Andreessen Horowitz, a venture capital firm, purchased 6 percent of the total supply of the project’s governance token, MKR. This investment boosted the project’s capital by $15 million. MakerDAO has grown to become one of the most widely used Ethereum projects in the DeFi space. Today, the platform has up to $7.25 billion locked in the platform.

MakerDAO is a decentralized autonomous organization on the Ethereum blockchain seeking to advance crypto lending and borrowing. This aim is supported by DAI, the organization’s decentralized stablecoin or stable cryptocurrency that is pegged to the US dollar, and the Maker protocol, a decentralized application (dApp) on the Ethereum blockchain.

With the Maker Protocol and DAI, users can get crypto loans at a predetermined interest rate. Any person who owns ETH (Ether) tokens and a Metamask wallet can lend money from the protocol.

To borrow money on the MakerDAO protocol, users have to deposit their ETH first, which serves as collateral, into a smart contract and then collect their loan in the form of DAI. To unlock their deposit, they must pay back their loan, also in the form of DAI.
Additionally, MakerDAO has a governance mechanism where MKR token holders vote on important protocol changes and upgrades.

What Is DAI?

Launched by MakerDAO, DAI is the industry’s premier decentralized collateral-backed stable cryptocurrency. It is an ERC-20 token. To maintain stability, DAI is soft-pegged to the United States Dollar at a 1:1 ratio. Thus, 1 DAI token is equal to one 1 USD.

Unlike other stablecoins, DAI’s value is not supported by US dollars in the custody of a bank. MakerDAO’s stablecoin derives its value from the total Ether value of collateralized debt held in the Maker protocol.

DAI is generated only through the MakerDAO crypto lending process. Once a user deposits their ETH as collateral to the Maker protocol, a smart contract generates the value of their loan in DAI. Once generated, the token can be used like any other coin.

There is also an option to get DAI from brokers and exchange platforms.

DAI Use Cases

Like any other Stablecoins, DAI has many uses in the crypto industry. Its use cases are outlined as follows.

• Exchange: DAI can serve as a decentralized currency and be used in any form of transaction.

• Store of Value: Because DAI is a stablecoin, it can withstand crypto bear markets. Users can decide to save their DAI.

• DAI Savings Rate (DSR): For users who acquired DAI on exchange platforms, saving their DAI can bring some yield if they use the DAI Savings Rate. The process begins with automatically locking DAI in a DSR smart contract on the Maker protocol. The DSR contract is available via the Oasis Save portal and other gateways on the Maker Protocol.

How Do DAI and Maker Vaults Work?

Now, we know that MakerDAO makes collateralized crypto lending possible with its stablecoin, DAI. But how does the whole thing work?

At the foundation of the MakerDAO crypto lending process are smart contracts. The smart contracts responsible for crypto lending on the platform are known as CDPs.

These CDPs are used to lock up a user’s collateral and to generate a liquidation ratio. The liquidation ratio is set alongside a penalty fee. For example, if a user’s liquidation ratio is set at 150%, this means that they must provide ETH up to 150% of their DAI loan as collateral.

DAI, the stablecoin, is at all times over-collateralized. That means for a user to get a loan in DAI, the ETH they deposit as collateral must be higher than the value of DAI they want to borrow.

The collateralization rate for any loan on the platform stands at 150%. And users can borrow DAI up to 66% of their total deposit value.

Now, if the market experiences a dip and the value of a borrower’s collateral falls below the value of the loan, the collateral is liquidated. The Maker Vaults releases the collateral to an internal market-based auction system. The proceeds of the auction are then used to pay back the loan and penalty fee.

What if the value of a user’s ETH collateral falls too far and is not enough to cover the loan? The collateral is still sold, and the outstanding loan is converted into Protocol debt. This is then covered by the Maker Buffer, a collection of proceeds made from liquidation auctions, including penalty fees.

How to Create a Maker Vault and Generate DAI

To generate a crypto loan that is in DAI, a user only needs an Ethereum wallet like Metamask or MyEtherWallet. Once they have the wallet, they can deposit the token they would like to take the loan against. This can be ETH or any other ERC-20 token that has been approved by the MKR governance community, such as LINK or WBTC.

The steps are as follows:

1. Head to the Maker’s Oasis Borrow portal to create a Maker vault.

2. Connect the portal to the wallet holding your collateral and click Get Started .

3. You will be prompted to select a collateral type from the options available. Search for your preferred collateral type and click Open Vault.

4. Several prompts will come up that direct you on how to configure your Vault. Here, you will enter the value of your deposit, click Confirm and Create Vault.

5. Your generated DAI will then be deposited into your wallet.

What Is MKR? MakerDAO’s Governance Token

MakerDAO, as explained earlier, is a peer-to-peer organization. What this means is that its core decisions are determined by members of the organization. Members of the organization are essentially holders of the governance token, known as MKR, for the project. MKR is an ERC-20 token that is compatible with any Ethereum wallet. It can also be traded on a number of cryptocurrency exchange platforms.

The DAO is made up of all the holders of this token and they make important decisions like modifying the DAI savings rate by voting. The MKR token is also helpful in stabilizing the price of DAI by acting as a counterweight.

The value of the MKR token mirrors its sister token DAI. It is minted and burned in response to the fluctuations of the DAI. Where the ETH collateral on loans falls too far and too many liquidations happen, MKR tokens are sold to create additional collateral to pay off the loans.

The MKR token represents true decentralization within the Maker Ecosystem. The maximum supply of the MKR token is at 1,005,577, 40% of which is owned by the team and early investors.

The MakerDAO Governance System

First, the only way to have a say in the governance process of MakerDAO is to hold an MKR token. MKR holders are responsible for making decisions that include:

1. The annual fee on each loan, also known as the stability fee;
2. Initiating emergency shutdown, a process designed to protect the protocol against malicious attacks or other unforeseen circumstances.

There are two methods of making decisions on the MakerDAO governance system. First, Governance Polls involve users making non-technical proposals and bringing them forward for MKR holders to vote on. The mechanism of recording votes for the governance polls is the instant run-off system.

Executive Votes are related to technical changes in the smart contracts on the MakerDAO ecosystem. For executive votes, competing proposals can always be introduced. If the proposal is approved, changes will be made to the code running the affected smart contract.

Conclusion

The MakerDAO crypto financing platform was built on a core principle that offers promising long-term growth potential.

MakerDAO has established itself as the leader of the decentralized financial movement thanks to its robust and effective developer community and hundreds of partnerships. The Maker protocol places control in the users’ hands with the use of two unique tokens, namely DAI and MKR.

Should the protocol continue on its current path and incorporate its plans to increase adoption in the market, MakerDAO is sure to become a beacon in the world of crypto lending.