The Use Case & State of MakerDAO in Nov. 2021
Analysis of the Premier Decentralized DeFi Stablecoin + Lending/Credit Market Protocol
Introduction
Maker has an established history, being one of the oldest DeFi protocols on Ethereum. Maker functions as the primary peer-to-peer lending and credit platform that uses over-collateralized loans backed by Ethereum and other crypto assets and provides the user DAI stablecoin, pegged 1:1 to USD.
Since its inception by MakerDAO, Maker has seen many changes and improvements, and even to this day in Nov 2021, it leads in TVL (Total Value Locked) across the Ethereum network and other lending protocols across all chains, with a whopping $18.42 Billion USD locked as of 19 Nov 2021.
Author Note: Do I use Maker?
No, I don’t fancy paying $200 per transaction in ETH gas fees. When this changes I may use Maker.
In a future publication I will share other protocols on other blockchains besides ETH on which an investor with a smaller DeFi portfolio can seek yield.
Regardless, any DeFi participant can learn a lot from the use case, structure, and governance of Maker.
Who should care about Maker?
- The DeFi-curious investor who prefers to use the most established & audited DeFi protocols (note that audited does not necessarily guarantee security of funds).
- The investor deploying large amounts of capital into DeFi to offset the ETH gas fees.
- Anyone else who is interested in learning the inner workings of an established DeFi protocol which has successfully created an open-access lending market, given that future credit & lending iterations in DeFi may rely on similar protocol structures.
Maker is one of the earliest pioneers of decentralized finance, hence it is important to understand its history and improvements, tokenomics and mechanism, as well as the competitive landscape.
The History of MakerDAO
Maker is a protocol created by the organization MakerDAO (founded 2014) that allows for creating a decentralized stable coin — Dai. The MKR token launched in 2015, the Dai stablecoin launched in 2017, and in 2019 the Maker Foundation transferred control of MKR to Maker governance.
Originally launched as supporting only ETH as collateral, the protocol expanded to allow multi-collateral Dai (MCD) in 2019. This allowed support for collateral involving other ERC-20 tokens, with BAT being voted as the first additional collateral option. MCD also introduced design changes including a Dai Savings Rate which allows Dai holders to earn yield.
Even during the crypto bear market of 2018, whilst the collateral of ETH saw a 94% decrease in value at its lowest, the system remained healthy and Dai maintained a peg close to 1 USD.
Due to its proven resiliency, and at the time being the only widely used stablecoin without USD collateral backing, Dai became an integral part of the growing DeFi ecosystem and has enjoyed growing liquidity across DEX’s and chains.
Today, the community that holds the MKR governance token MKR decides on improvements and prospective changes to the protocol such as collateral rates and types, fees, and more.
Use Case & Tokenomics
The use case of MakerDAO is to serve as an open-source credit and lending protocol accessible to anyone that is involved in Web3, unlike credit/lending protocols available in the traditional financial system.
Its primary value is the creation of a decentralized & crypto-collateralized stablecoin, pegged 1:1 to USD called Dai, which serves as an alternative to fiat-backed centralized stablecoin competitors such as USDT, USDC, and others.
This means the entire system can run from within the Ethereum blockchain without having to rely on centralized institutions such as banks to back, vault, and audit the stablecoin. The health and backing of the system can be verified by open-source blockchain data, and removes the need for trust of a counterparty for solvency.
The Maker ecosystem involves two tokens — MKR and Dai. Dai is a crypto-collateral backed stablecoin that is pegged to the value of 1 USD and the flagship product that the Maker ecosystem is known for.
The MKR token is a governance token that the organization MakerDAO uses. Owners of the MKR token are allowed to vote on parameters involved in this system among other benefits.
There are numerous ways the protocol maintains the stability of Dai, the main benefit of which being that Dai can be freely sent to others, is liquid, composable, and interoperable with other dApps and smart contracts, and can therefore also be used as a medium of exchange for payment or even held as savings to generate yield.
The product-market fit of MakerDAO is in the value-stabilized functionality of Dai within DeFi with its pegged 1:1 USD value, its interoperability and composability across DEX’s, allowing users to both lend and borrow, maintaining a system to maintain said peg.
Mechanics of Dai
The Dai stablecoin is generated by the user depositing ETH or other supported ERC-20 assets into a vault.
A vault is a smart contract that escrows collateral and keeps track of its USD-denominated value. The user can then mint Dai up to a certain collateralization ratio on their assets. This creates a debt in Dai that must be paid back by the vault holder.
The Dai received in return for the collateral deposited can then be used in any way the vault holder wishes. The user can do anything from selling the Dai for cash to using the Dai to buy more of the originally deposited collateral asset, and in effect create a more leveraged position.
Due to the volatility of ETH and other collaterals in the cryptocurrency markets, the collateralization requirement is far in excess of 100% and is usually in the 150–200% range.
This can be described as a collateralized debt position. It is the same idea as when a homeowner in need of liquidity pledges their house as collateral to a bank and receives a mortgage loan structured to include a cash takeout.
One key difference is in the volatility and risk since the collateral is crypto, the collateralization ratio for the ETH-Dai contract is higher.
Example Use Case
An example case where a DeFi user may use the MakerDAO protocol is in the case of a user having a net long spot ETH position.
Suppose this user desires more liquidity but does not wish to sell his or her ETH. The user can deposit the ETH into the ETH-Dai Vault and receive Dai which functions as the USD-denominated liquidity desired.
Suppose the value of ETH drops by 25% from $4000 USD to $3000 USD. In this event, the vault owner has three choices:
- Owner can increase the amount of collateral in the contract by adding additional ETH
- Owner can return some Dai to reduce the collateralization ratio and repatriate some collateral
- In the event of a liquidation, an external party called a keeper liquidates the loan wherein the depositor loses access to the collateral. The keeper will then auction the ETH for Dai to pay off the loan, while getting an incentive fee.
Hence, two forces in this process reinforce the stability of the Dai stablecoin…
- Overcollateralization — market participants know there exists sufficient backing in collateral, this is open-source financial data within the Ethereum blockchain
- Market actions- i.e. in the liquidation scenario above, ETH are sold and the Dai are purchased, exerting positive price pressure on Dai
The viability of the MakerDAO ecosystem depends on Dai maintaining its peg. Various mechanisms are in place to incentivize demand/supply in order to drive the price of Dai toward this peg.
These mechanisms include a debt ceiling, a stability fee (variable interest rate charged on Dai debt), and the Dai Savings Rate (DSR — a variable rate earned on Dai deposits). These parameters are controlled by holders of the governance token Maker (MKR) and MakerDAO governance.
A buffer pool of Dai also exists in the event of a mass liquidation event of collateral wherein the value drops so excessively such that the Dai debt cannot be fully repaid, which closes the positions and protocol debt accrues.
Fees Charged
- Stability Fee — variable rate fee dependent on governance
- Liquidation Fee — fee added to outstanding debt in Dai in the event of liquidation
As of 20th Nov 2021, the minimum collateral ratio is 145% — if the vault reaches below this level, it is considered undercollateralized and subject to liquidation. The collateral is then partially auctioned off to cover the outstanding debt and liquidation fees.
Governance
Holders of the MKR token have the right to vote on protocol upgrades, including support of new collateral types, and changes to the parameters discussed. MKR holders are expected to make decisions in the best interest of the platform; a well-functioning platform should increase the value of their share in the governance.
MKR token holders benefit from income generated by the protocol.
There exist last resort safety mechanisms in the protocol in the event of poor governance leading to a situation where protocol debt is unable to be paid back.
In this case, newly minted MKR tokens are auctioned off in exchange for Dai which is used to pay off said protocol debt. This process is called Global Settlement and has the drawback of diluting the MKR share, hence stakeholders are incentivized to avoid it.
Note that Dai can also be purchased on an exchange or DEX without depositing collateral to generate it. The end user does not need to know the underlying mechanism behind Dai creation.
Maker Competitive Landscape & Risks
Maker competes in both the stablecoin and lending markets. Across stablecoins, the main benefit of MakerDAO is their reserves can be audited on chain and they are not fiat-backed (volatility of reserves being a drawback in turn), while the fiat reserves of centralized stablecoin competitors USDC and USDT must rely on external auditors.
This decentralization factor is a major competitive advantage especially in terms of trust by market participants and can be seen as reflected in its increased market share over the last year. Over 400 apps and exchanges today use Dai and Dai is a common trading pair across DeFi today.
The advantages that MakerDAO has created as a protocol are several:
- de-centralized control and governance by MKR holders instead of centralized control
- open access for any market participant with a web3 wallet and relevant collateral
- instant liquidity with minimal transaction costs
- interoperability of Dai across other DeFi applications and smart contracts
- transparency given the fact that collateralization ratios are visible to everyone
One disadvantage of Dai is that the supply of Dai is always constrained by demand for ETH-collateralized debt. No clear arbitrage loop exists to maintain the peg as does for other stablecoins like USDC. Since the stability of Dai’s peg depends on said incentive mechanisms and over-collateralization, the peg is slightly more volatile than its fiat-backed competitors.
There also exist governance related risks given that protocol changes are based on MKR holders voting.
It should also be noted that regulatory clarity especially from the US SEC is non-existent currently around MKR as to whether it is deemed a security or not.
Future Developments and Roadmap
As of Nov 2021, the existing single collateral system continues to function. In the future, the single collateral system will be phased out completely and users will be encouraged to migrate to the new Dai.
Future developments involve a multichain strategy to ensure the protocol remains relevant across multiple blockchains, with an Optimism DAI bridge being created to allow for fast withdrawals from Optimism L2 rollup (expected Q4 2021).
Another future development involves the Aave D3M- the Maker Direct Deposit Dai Module, in collaboration with AAVE. This will allow Dai to be minted on Aave with a maximum borrow rate enforced therein, helping MakerDAO improve capital efficiency, grow supply, and increase use case of Dai for stablecoin borrowers on Aave.
As of summer 2021, the Maker Foundation has dissolved and governance responsibilities are fully within done by the DAO.
Maker is also expanding into using real assets including new silver to spread collateral risk to assets not correlated to crypto.
Conclusion
Given its success despite the volatility of cryptocurrency collateral throughout 2018, Maker has established itself and successfully increased liquidity over the last year across other DEX’s and chains, and to this day remains with the leading TVL across DeFi. It has use cases in both the stablecoin and lending markets which are both crucial for DeFi to function and scale in adoption.
Given the gains in market share and advantage Dai has over its centralized competitors, there is great potential for the growth to continue to be expanded especially in comparison to USDC/USDT as well as the increased use of Dai across other protocols and chains.
