Let me start by convincing you why you should read this article. First off, it’s awesome. But most importantly, MakerDAO is the foundation for the DeFi ecosystem.
If you are Argentinian, you may know this. Building a financial system based on an unstable currency is quite a challenge. And, as it is known (yes, this is a GoT reference), Cryptocurrencies have been very volatile assets.
As DeFi holds no regulation, why should it be built over volatile assets? This makes no sense. This is why Stablecoins were created, especially those pegged to the U$D. This is the case for $USDT or $USDC, but they have something in common: they’re managed by a central authority. MakerDAO created DAI, the first U$D pegged decentralized stablecoin.
What is behind the mechanism of a Decentralized Stablecoin? Hint: cool stuff and inventive mechanisms. Before diving, let’s recap: Dai is the product of the Maker Protocol, which is managed by MakerDAO.
Dai is generated with a series of smart contracts that, together, create & manage CDPs (Collateralized Debt Positions). Investors that wish to acquire (in a primary market) DAI, will deposit crypto as collateral. Maker Protocol, in order to protect the stablecoin from market volatility, will ask for deposits to be over-collateralized. For example, if you deposit U$D 150 worth of ETH, you will receive at most (approximately) U$D 100 worth of DAI. In this case, we say that the liquidation ratio is 150%.
Crypto deposits are deposited inside “Maker Vaults”. When users open a Maker Vault, they deposit their crypto in the vault, get DAI in return, and also the obligation to pay back the minted DAI + “stability fees”. These can be withdrawn at any moment, partially or totally.
But remember, crypto is volatile. This flow is only one scenario, the one in which your crypto deposited isn’t exposed to a (big enough) drop in prices. How can Maker Protocol determine whether each asset has dropped “enough” to be considered risky? How does Maker act upon determining that holding those assets in their vaults is risky?
I previously mentioned that with a 150% liquidation ratio, for U$D 150 worth of ETH one could get (at most) U$D 100 worth of DAI. This liquidation ratio is the threshold each CDP must uphold. This means that at all times, for a 150% liquidation ratio, your borrowed assets must be worth at least 1.5 the amount of minted DAI. While this relation is upheld, the flow will be the previously mentioned.
When the CDP becomes “sub-collateralized” (a.k.a your collateral has dropped “enough”) Maker Protocol (via Smart Contracts) gets possession of the assets within the vault and also contracts the debt (that was originally from the investor). Finally, it begins an auctioning process to liquidate the assets and repay for debt that was contracted. Vault’s assets are auctioned in an internal market.
If the value offered for those assets is enough (auction is only in DAI) to compensate for the debt that was contracted, then Maker will try to save as much collateral as possible, and return it to the Vault owner. If the value offered is not good enough, this deficit then trespasses to the Protocol. If Maker Protocol holds enough reserves (remember paying for “stability fees”? This is the source of their income, plus other streams) then it will be settled with Maker reserves. If this is not the case, then Maker will auction off the debt, mint $MKR (Maker DAO governance token), and offer those MKR Tokens for the value in DAI of their debt.
One of the most amazing factors is that everything that I have explained so far is done entirely by smart contracts (except setting the value of the liquidation ratio for each asset, this is proposed by an external Risk Team that is hired by MakerDAO and later approved by MakerDAO governance process)
What’s in it for the investors? Getting less money lent doesn't sound like the best deal. But this allows investors to borrow ETH (or many more assets) and still get -indirect- exposure to the asset while also gaining access to greater returns in DeFi protocols using their newly minted DAIs.
Example(Not Financial Advice!): You’re bullish on ETH, open a Vault (depositing X ETH, measured in U$D), get freshly minted DAIs (Y); turn around and invest in whatever DeFi protocol you’re interested in, win Z. Oh! Meanwhile, ETH has gone up 20%. Go back to your vault, pay Y + Stability Fee, get back 1.2*X ETH. This makes up for 0.2*X + Z - Stability Fees in earnings. If you would’ve held the ETH, then you would’ve lost the opportunity to earn Z-Stab Fees
In Conclusion, this world never ceases to amaze me.
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Disclaimer: The content reflected in this analysis is intended to be used and must be used for information and education purposes only. It is very important to do your own research before making any investment based on your own personal circumstances.