This first generation of blockchains was an incredible leap forward, enabling trustless peer-to-peer transactions through incentivized security and consensus models. However, it wasn't until 2017 that the technology was used for more than simple transactions. While other projects were trying to find more efficient solutions, MakerDAO was tweaking the formula.
Decentralized Finance (DeFi) is an exciting and potentially disruptive concept that is reshaping ideas around the future of finance. DeFi brings a world of benefits with its commitment to transparency, sovereignty and decentralization. However, there's still more than enough room for DeFi to improve, particularly in terms of integration and user-friendliness, especially when it comes to exchanges attempting to figure out how best to facilitate this.
Rune Christensen founded MakerDAO in 2015 to create the world's first crypto-collateralized stablecoin. The results of this initiative were clear: a growing number of teams were becoming interested in building their own DeFi protocols.
But what is MakerDAO, and how did it become such a significant player in the crypto lending space? In this article, we examine the origins of MakerDAO, its transition from a simple stablecoin offering to a decentralized lending platform, and how it plays a crucial role within the Ethereum ecosystem.
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What Is MakerDAO?
MakerDAO, often referred to simply as Maker, is a decentralized finance project that aims to mute issues stemming from volatility in cryptocurrency and ETH markets by introducing a stable currency (DAI) that isn't pegged to any real-world asset.
The single-collateral DAI (SCD or “SAI”) backed by ETH was launched in 2017, and has become an important building block for decentralized applications (DApps) that form the wider DeFi movement. In November 2019, DAI began to support multiple collateral assets in addition to ETH, further driving user adoption. Since then, market cap for DAI has grown exponentially, reaching a high of $10.38B in February 2022.
The MakerDAO protocol allows anyone with ETH, or other crypto-assets, and a MetaMask or other crypto wallets to lend themselves money in the form of a stablecoin called DAI. As one of the few decentralized stablecoins in the world, DAI uses smart contracts to maintain its value in relation to assets held in collateral. This means that unlike fiat-collateralized stablecoins like USDT and USDC, which are backed by fiat-based reserves, DAI is backed by crypto-native assets.
How Does MakerDAO Work?
DAO stands for 'Decentralized Autonomous Organization,' and MakerDAO is a collection of smart contracts operating on the Ethereum blockchain. Besides peer-to-peer trading through DAI, MakerDAO also enables users to participate in system governance through the Maker Governance Token (MKR). This makes the platform a transparent, decentralized ecosystem — providing risk-free loans and stability in a volatile crypto world.
MakerDAO uses three types of tokens:
MKR, which works as a governance token, is used to vote on crucial protocol decisions like the DAI Savings Rate.
DAI, a multi-collateral stablecoin pegged 1:1 with $1 worth of ETH and other cryptoassets
ETH, and other ERC-20 tokens like YFI, UNI, LINK and more, are used as collateral for loans, as well as paying for liquidations and network fees.
Together these three tokens ensure the system functions securely, using blockchain technology to manage itself with minimal human involvement. This allows anyone anywhere in the world to borrow against their collateral without having to deal with the tedium of banking, government regulations and inefficient middlemen.
What Is a Collateralized Debt Position (CDP)?
A collateralized debt position, or CDP, is a type of smart contract used by MakerDAO to create its DAI stablecoin currency. CDPs are essentially margin accounts explicitly tailored for Ethereum-based stablecoins. The big difference is that they can only hold ETH or other ERC-20 tokens as collateral, generating (DAI) tokens tied to the value of the locked crypto collateral.
Voting and Governance In MakerDAO
MarkerDAO MKR token offers users the opportunity to join a participatory governance system. Besides serving as a means of payment, the MKR token also makes it possible to vote on the platform's strategic direction.
MakerDAO allows users to vote directly on decisions every 14 days. Using the governance portal, users can see the current list of votes and the campaign's results since the week prior. If a vote passes, it becomes part of the system and automatically affects both DAI (stability fee) & MKR (liquidation ratio).
The Maker forum is an excellent resource for anyone interested in the Maker project. It is a public forum dedicated to governance and community development. The Maker forum is the best way to get in touch with the community if you have an idea, question, or even just a project you'd like to share.
Benefits of MakerDAO
A Decentralized Lending Protocol
DAI has effectively become a decentralized lending protocol where ETH and other crypto-assets serves as collateral for loans. This allows anyone anywhere in the world to lend themselves money without dealing with burdensome bank regulations and KYC procedures.
Relatively Low Volatility
Since Ethereum and other crypto-assets algorithmically back DAI at a 1:1 ratio to USD $1, it will not change value drastically overnight, unlike volatile cryptocurrencies like Bitcoin. However, this also has its downsides, which we'll go into further detail later.
Emergency Shutdown Measures
The Emergency Shutdown protocol has been designed to protect MakerDAO and its stakeholders in highly unpredictable and unforeseen circumstances. It is intended as a last resort, like if the MakerDAO platform faced an existential threat, such as permanent failure of the MKR voting system. To prevent catastrophic losses, the system initiated its emergency shutdown measures, allowing the target price to plummet.
Shutdown immediately shorts the market and enforces the purchase or sale of all MKR through liquidation and auctioning of CDPs linked to collateralized debt positions. This is only used in extremely dire situations where there is no other option for maintaining stability, safety and functionality at a reasonable cost to both users and the Foundation.
Drawbacks of MarkerDAO
Since ETH and other crypto-assets back the system, DAI is much more volatile than other stablecoins backed by fiat reserves since the Ethereum network runs a much higher risk of crashing than a fiat currency. Further, DAI doesn't have the level of liquidity that other stablecoins like USDT and USDC have.
Since MakerDAO requires users to lock up ETH in return for DAI, a lot of trust needs to be placed on the code managing the system's funds. Furthermore, since it is a blockchain cryptocurrency, you need to use a custodial wallet to store the DAI. Therefore, the security of your stablecoin depends on the safety of your wallet.
In March 2020, ETH value dropped by nearly 50%, causing the MakerDAO protocol to initiate a massive liquidation to cover the lost collateral value. This cost Maker almost $7 million in DAI, and while the platform has taken measures to minimize the effect of such events on the system, there's no saying what could happen in the future.
Investors will undoubtedly question whether their investments are secure and safe in the MakerDAO system if this occurs again. For now, the biggest concern will be the continued stability of the MakerDAO network.
Making the Future of DAOs
The Maker team soon plans to unveil their latest project – a prediction market that will allow users to bet on DAI price fluctuations. This is just the beginning of applications that use the governance system, and the future of this platform could be interesting to watch.
MarketDAO also recently published a bug bounty program worth $10M. This is one of the largest initiatives in blockchain history, and will allow developers to test the security of MakerDAO's smart contracts aggressively. The program includes three separate bounties, with each bounty offering a varying degree of rewards depending on severity.
MakerDAO is a well-designed, highly transparent system that could create an entirely new infrastructure for global lending. It has already been used to significant effect within the Ethereum ecosystem, and it will be interesting to see how this project continues to develop.
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