Deep Dive: MakerDAO, DAI and Decentralized Lending

Summary

  • Maker allows users to collateralize their ETH to take out loans in DAI using Collateralized Debt Positions (CDP)
  • DAI is a stablecoin soft-pegged to USD and can be a more reliable and secure form of crypto lending and medium of exchange
  • DAI can be used for crypto trading, hedging, and transfers, among other use cases
  • Maker also has a native governance token (MKR) which is also used to pay loan interest on CDPs
  • MKR tokens represent the holder’s right to vote on Maker’s functions, mainly the governance function for stabilizing DAI
  • The concept of over-collateralization helps maintain DAI’s stability and each loan requires a minimum ETH collateral ratio of 150%

Introducing Maker

Maker (MKR) and DAI

Maker is a Decentralized Autonomous Organization (DAO) that manages its stablecoin, DAI. Maker has two different tokens: Maker (MKR), a governance token, and DAI.

Maker allows people to collateralize their Ethereum to obtain DAI loans through a system called Collateralized Debt Positions (CDPs). These are smart contracts that lock Ethereum (ETH) as collateral and returns them when the DAI loan is repaid.

ETH locked into CDPs become ‘wrapped’ (Wrapped ETH or WETH) to make locked ETH tradeable and ERC-20 compliant. WETH is consolidated into Maker’s Pooled Ether (PETH), which is a pool of all collateralized ETH.

Borrowers can use their DAI loan in any number of ways including crypto trading, hedging, or transfers. However, they must always ensure that their CDP meets the minimum 150% collateralization ratio or risk their collateral being liquidated.

So far, Maker only supports collateralization of ETH but is planning to expand into a multi-collateral system to include other crypto assets.

What is DAI?

DAI is a decentralized USD-pegged stablecoin, meaning that each DAI is worth roughly $1. DAI maintains a soft peg to the USD, and its value tends to fluctuate around the $1 target.

A key difference between DAI and Tether (USDT) is that DAI is decentralized while Tether is not. Tether is dependent on the traditional banking system that holds its physical USD reserves. If they lose access to these bank accounts, or if the adequacy of their reserves is called into question, Tether’s USD peg may break down. DAI, being decentralized, is insulated from these risks, although its own peg can still fluctuate.

How do CDPs work?

CDPs are responsible for generating the DAI that is loaned out. Users determine how much ETH they are willing to lock up in CDPs in exchange for a DAI equivalent. Apart from the loaned DAI, borrowers also pay a stability fee in MKR when closing out their loan. The fee currently sits at 3.5%, but will soon be increased to 11.5%. This fee increase is designed to lower the supply of DAI so that the price of DAI moves closer to $1. Since Feb 2019, the price of DAI has consistently fallen short of the $1 benchmark, sometimes trading as low as $0.95. While 11.5% is a high fee, the stability fee will likely drop back down once DAI has sufficiently stabilized. Sill, borrowers need to factor in this fee increase for now to ensure that they can afford it.

The MKR tokens paid in fees are burned and this reduction in supply may support an increase in value for MKR tokens, all else equal.

The concept of over-collateralization underpins DAI’s stability. The collateral locked up must be greater than 150% of the DAI borrowed. For example, for $100 of DAI to be generated, $150 worth of ETH must be collateralized. This results in a Loan-to-Value (LTV) ratio of 67%. Collateral remains locked in the CDP until the loan is paid back in full, including stability fees.

As long as ETH is locked as collateral, the borrower can keep the DAI generated. Should a user choose to retrieve the ETH they locked up, they have to repay their loan plus the stability fees accrued over time.

DAI is used for lending purposes, and MKR gives voting rights to holders in Maker’s governance functions to maintain the stability of DAI value.

DAI Use Cases

DAI can be a more reliable and secure form of crypto lending as it is commonly used to provide affordable crypto loans. It differs from traditional loans because it reduces middlemen, processes loans more efficiently, and lowers fees for borrowers. As a stablecoin, DAI is less volatile than other cryptocurrencies and be used to buy other cryptocurrencies. Borrowing in DAI can be a way for many people to maximize the cumulative value of their crypto assets as it allows them to lower capital gains taxes that apply in some situations.

There are numerous use cases for DAI, some of which are covered below.

Buy crypto or hedge crypto positions

DAI is especially useful for Ethereum holders. For example, consider a situation where an ETH holder wants to increase their ETH exposure but does not want to use USD or another fiat currency. In this case, they can open a CDP, collateralize their current ETH, take out a DAI loan, and use it to buy more ETH. This is essentially decentralized leverage.

Of course, DAI can also be used to buy other cryptocurrencies as well, which in turn can be used for any number of reasons.

DAI can also be used to hedge your crypto position, much like Tether is currently used. For example, ETH holders that want to temporarily exit their position during times of market volatility can move into the USD-pegged DAI.

Pay or save and earn interest

If you owe a friend money and they don’t want to be paid in BTC or ETH due to its volatility, you can pay them in DAI instead.

Maker will also launch a feature called the DAI Savings Rate (DSR), which pays interest to DAI holders, provided that they lock DAI in a DSR contract. This feature will be available with the launch of multi-collateral Dai, which will allow collateralization in cryptos other than ETH.

Global transfers

DAI can be used as a global medium of exchange and store of value. As a stablecoin, DAI enables global transactions without the risk of price volatility. This is especially useful in countries like Argentina, Venezuela, and Nigeria where local currencies suffer from high inflation rates. DAI offers quick cross-border money transfers without the worry of price volatility. Since its value is pegged to the USD, DAI is insulated from the fluctuations of the crypto market. People can protect their savings using stablecoins, making it a reliable alternative to other fluctuating crypto assets or local fiat currencies.

DAI has a current debt ceiling of $100 million, which caps the amount of loans that can be issued within the system. This limitation, however, could affect the model’s scalability since even single banks make loans far in excess of this amount. According to CoinMarketCap, DAI’s current market capitalization sits at over $86 million with 88 million tokens already issued.

Acquiring DAI

 

Source: Gregory DiPrisco, Plain Explanation of the DAI stablecoin.

The ‘official’ way to obtain DAI is to open a CDP. Users go about opening a CDP and getting a DAI loan as follows:

  1. Determine how much ETH you want to put up as collateral.
  2. Open a CDP. ETH from your wallet is locked in the CDP.
  3. DAI is generated when the CDP is opened.
  4. DAI can be used for transfers, to trade crypto, or to lend in the crypto market.
  5. You eventually pay back the DAI loan plus pays stability fees in MKR tokens. MKR tokens are available on crypto exchanges such as Coinbase, Coinbase Pro, and Cex.io.
  6. The CDP is closed and the MKR tokens used to pay the fees are subsequently burned.
  7. The ETH collateral is returned to your wallet.

Users can visit the Maker website and click on ‘Products’ >> ‘CDP Portal’ to get started. The CDP portal guides users through loan generation and ongoing CDP management including repayment and loan liquidation terms.

It is also possible to obtain DAI through:

  • Direct transfers: when someone sends you DAI as payment or a gift, for example.
  • Exchanges: a study by Beneath, a blockchain analytics service, found that decentralized exchanges are a more popular way of obtaining DAI than centralized exchanges. Exchanges such as Kyber and OasisDEX were popular places to obtain DAI.

DAI Risks

Loan risks

As with any loan, being under-collateralized or unable to repay will put your capital at risk.

DAI CDPs requires a 150% collateralization ratio. If a CDP falls below this level, the CDP is liquidated, which means that the borrower loses their collateral. This is the worse case outcome and can be guarded against by ‘over-collateralizing’ – locking more ETH into the CDP than is required.

The main reason that a CDP will fall below the 150% collateralization ratio is when ETH prices fall significantly. Over-collateralizing will protect CDPs against larger price drops. Borrowers should also avoid collateralizing their entire ETH (or crypto) holdings so that they have some funds to repay the DAI loan in full.

The CDP Portal contains information for keeping track of things like liquidation price and repayment. Of course, borrowers need to do the math themselves to decide how much to borrow and collateralize. This Maker Reddit FAQ is a great resource that provides key formulas.

USD peg risks

 

DAI 30-day price. Source: https://dai.stablecoin.science/

 

DAI is soft-pegged to the US dollar and has often traded under $1 in 2019, and is trading at $0.97 at the time of writing. This peg breaking down further is a risk to DAI holders, who rely on it as a USD substitute and store of value. Maker has increased stability fees to help bring the peg back in line, but it remains to be seen if this will solve the problem.

MKR Token

MKR is Maker’s native ERC-20 token. It is the system’s custodian and profit accumulating token. MKR tokens are burned when used for payment of DAI loan fees.

MKR tokens represent the holder’s right to vote in Maker’s functions, mainly the governance function for stabilizing the price of DAI. MKR also acts as a backstop in case DAI faces insolvency. In this scenario, MKR tokens will be used to cover unpaid DAI loans to prevent DAI value from crashing.

Maker creates new MKR tokens and sells them on the open market for recapitalization purposes (to support Dai). This encourages good governance since MKR token holders would otherwise be called on to bail out Dai in case of insolvency.

Modification of internal governance variables for the Maker platform is managed through Active Proposals. These are smart contracts that MKR holders can elect through community voting, which self-execute to implement the modifications the community voted for.

MKR holders can vote on different risk parameters like setting debt ceilings (maximum debt attributed to a single CDP), liquidation ratios, stability fees (interest on PETH), and penalty ratios (the fee applicable to CDP liquidaion on top of the total outstanding debt). MKR holders can also vote on which Oracle they trust to serve as the data feed for the Maker ecosystem. Oracles are trusted parties functioning as real-time information providers about the market value of assets that can be used in CDPs.

MKR 24-hr trading volume is currently around $2M, but this fluctuates significantly even though MKR is ranked in the top 30 by market cap. According to analysis by Picolo Research, this creates liquidity risks that investors must be prepared for. The market can also be affected by the need for collateral, possibly reducing the value of MKR tokens if there is lower demand for CDPs.

Key Statistics: DAI and MKR

All statistics are as of 9 April 2019.

Market Position

  • According to research from Delphi Digital, Maker represents roughly 90% of US dollars locked in all decentralized finance projects.
  • Nearly 2 million ETH were held in CDPs as of March 2019. 8,200 unique addresses are actively using DAI.
  • Maker has raised total funding of $27 million with the latest funding round of $15 million.

 

User Growth

 

MKR and DAI Token Stats

  • MKR is currently trading at $710.96 with a market cap of $711M according to CoinMarketCap
  • 9,984 unique addresses hold MKR tokens
  • MKR’s annual burn rate is 9,096 MKR tokens, expecting almost 610 tokens to be burned across all CDPs
  • As the time of writing, system collateralization ratio is 334.24%, which is considered safe
  • DAI has a circulating supply of 93M tokens with 18,871 unique token holders

 

Challenges

Restricted Scalability

DAI has a current debt ceiling of $100 million. As the time of writing, 93M DAI has already been issued, which represents over 90% of the ceiling. CDPs hold almost 2% of all ETH in circulation.

Maker is not increasing DAI’s debt ceiling to guarantee that the system would grow at a comfortable pace as it proves itself in the market. In addition, Maker and DAI have not been around long enough to prove their stability and capacity to weather a possible black swan event, or a widespread failure in the cryptocurrency market.

Maker can maintain the current debt ceiling and continually minimize the risks to DAI but this sacrifices scalability. This is most noticeable when you look at the market trend for all stablecoins. DAI’s overall market value is only $89 million, while the overall market cap for major stablecoins is hovering at $2.5 billion. This shows that DAI only makes up 0.06% of the total stablecoin market.

MKR holders and its governance function will continue to face the dilemma of this difficult trade-off between scalability and stability. This is because the system might not be fully prepared to take on the substantial downside risks of increasing the debt ceiling.

Another potential concern is the principle of over-collateralization. Not every ETH holder has enough ETH to collateralize to open sizeable CDPs and receive meaningful loan amounts.

Therefore, DAI’s limited scalability currently puts a limit on the value to users.

Low trading volume

MKR’s average 24-hr trading volume fluctuates and has touched lows of $0.23M in January 2019. This can potentially create substantial liquidity and systematic risks for MKR holders. The liquidity risk MKR holders face can be compounded by the possibility of a deepening bear market.

DAI’s stability can be potentially put to the test if sudden drop in ETH price drags down MKR’s value. If ETH’s value goes down following a black swan event, MKR’s value will also be affected.This effectively reduces MKR’s capacity to cover possible DAI insolvency and volatility.

Future Prospects

An attractive option for a truly decentralized financing model

Compared to other tokens, the governance and decision-making system for MKR is entirely controlled by MKR token holders. Maker wants to deliver sovereignty and financial autonomy to its users, reduce intermediaries in the financial system, and pioneer the democratization of financing in the digital age. The growing interest in blockchain and the trend of digitizing financial activity (e.g. internet banking & payments) could attract people towards the likes of Maker.

Multi-collateralization

The option to provide CDP collateral in cryptocurrencies other than Ethereum is already in the pipeline. While today only ETH is accepted as collateral for CDPs, more users could sign up if more coins are supported. Apart from the potential for creating a more enticing platform for users when more cryptos can be collateralized, it adds additional use cases for cryptocurrencies.

Investors

Andreessen Horowitz, an American venture capital fund, invested $15 million into Maker via its investment fund a16z in September 2018, acquiring 6% of the total MKR token supply. This investment allows Maker to cover operating costs for three years on top of the operational support provided by a16z’s team and community members. Andreessen Horowitz has previously invested in Dfinity and Coinbase.

Partnerships and the Maker Ecosystem

CDP Management

CDP.MakerDAO

CDP.MakerDAO is Maker’s dapp for opening a CDP, depositing collateral and generating DAI.

Users enter how much ETH they’re willing to collateralize and how much DAI they want to create. Included in the portal is a dashboard for overall CDP management. It contains essential functions such as deposit, withdrawal, DAI generation, closure of CDPs, and the history of transactions made. The portal supports major web3 clients such as Metamask and other hardware wallets like the Ledger Nano S and Trezor.

InstaDApp

InstaDApp is a decentralized bank built on MakerDAO aimed at simplifying functions such as banking transactions, loan applications, and loan processing. Through the platform, anyone can create and issue CDPs in DAI. InstaDApp also allows users to turn their CDPs into a wallet, remove DAI or add ETH in CDPs. At the time of writing, InstaDApp owns 307 CDPs and has locked more than 6,749 ETH.

Bloqboard

Bloqboard is a crypto-lending platform that allows peer-to-peer borrowing or lending via smart contract. Over $150,000 in loans have been processed through Bloqboard, where users can create and manage loans on the Ethereum blockchain.

Loan requests can be made to borrow ERC-20 tokens and manage these loans through the Dharma Protocol, which allows tokenized debt issuance through smart contracts.

Secondary Markets

Compound

Compound is a crypto-lending platform built on Ethereum that allows users to earn interest or lend crypto assets without having to transact directly with others. Currently, it has four different crypto money markets: ETH, BAT, REP, and ZRX. It also supports web3 clients such as Metamask and Coinbase.

bZx

The bZx protocol runs on the Ethereum blockchain to enable decentralized exchanges, peer-to-peer margin lending, shorting, and leveraging of ERC-20 tokens. bZx also allows users to earn from their DAI by functioning as a secondary market for lenders and traders, and through smart contracts that lets users short and leverage up using tokenized margin loans.

Reloanr

Reloanr is a secondary market for borrowing and lending DAI at a fixed interest rate. The goal of the program is to increase liquidity, offset the capital cost of holding DAI, and ease transaction settlements for DAI. Currently, it seeks to build a non-custodial protocol for margin trading and shorting ERC-20 tokens.

Nuo

Nuo is a decentralized lending platform on Ethereum that links lenders to borrowers and utilizes smart contracts for its transactions. The objective is for lenders to earn interest from their crypto assets and to provide easy loans. Nuo also supports the use of Wrapped Bitcoin (WBTC) in lending or borrowing.

ETH Lend

ETHLend is a decentralized application on the Ethereum blockchain aiming to offer secure, peer-to-peer loans for ERC-20 compatible tokens. Through the platform, borrowers can create loan requests and have lenders decide how they can meet them on their terms. All of these functions do not require finding an intermediary to settle the transaction.

cdp.Auction

cdp.Auction is a secondary market for CDPs where users can list distressed CDPs they wish to trade. It is usually used by users when they seek to avoid the 15% fee for liquidating their CDPs.

Competitors

Maker’s DAI is part of a growing field of stablecoins and crypto lending instruments. Here, we list a few notable players in the field.

Tether

Tether is a USD-pegged stablecoin and is the largest stablecoin by market cap (USD 2 billion). Tether claims that each USDT is backed by 1 USD held in reserve.

Tether has had its fair share of controversy. It was hacked for a loss of almost $31 million and there were allegations that Tether was used for Bitcoin price manipulation. In addition, there has been near-constant questions of whether Tether actually has enough USD in reserve to back the 1.9 million USDT in circulation. Still, it is the most popular stablecoin on the market and is widely used by traders to store value when they exit crypto positions.

DigixDAO

DigixDAO has a stablecoin reportedly backed by gold bars. One DGX is priced at roughly one gram of gold. It plans to release more stablecoins pegged to silver, platinum, and other rare earth metals. DGX currently has a relatively small market cap of USD 4.2 million with low daily volumes.

BlockFi

BlockFi is a decentralized lending platform that offers USD loans to crypto-asset owners. So far, these loans can be collateralized through BTC or ETH. BlockFi aims to provide liquidity for crypto assets, transaction transparency, and greater efficiency in settlement of crypto lending transactions. At the time of writing, BlockFi has consolidated almost $35 million in crypto which is usually lent to institutional borrowers.

Maker Team

 

Rune Christensen

Chief Executive Officer and Co-Founder
Twitter | LinkedIn

Christensen was previously a Co-Founder of Try China, an international recruiting company. He studied International Business at the Copenhagen Business School and Biochemistry at the University of Copenhagen.

Steven Becker

President and Chief Operating Officer
LinkedIn

Becker has over twenty years of investment experience, including owning and managing an alternative investment consulting company. He is a Chartered Alternative Investment Analyst (CAIA) and a certified Financial Risk Manager (FRM). He studied Business Science and Financial Engineering at the University of Cape Town.

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