The Maker protocol and its DAI stablecoin are the oldest and most durable building blocks of DeFi. The Maker protocol regulates the number of DAI stablecoins in circulation. It can be seen as a decentralized central bank. This article explores Maker’s history, its features, and the two tokens of protocol (MKR and DAI).
MKR is a governance token and DAI is stablecoin
Cryptocurrencies can be divided into three different categories depending on their purpose: currencies, platforms, and tokens.
Currencies have no significant purpose other than the transfer and/or preservation of value. Bitcoin is the most well-known representative in this category. Other currencies include Litecoin and Monero, for example.
Platforms are operating systems for smart contracts and decentralized applications (Dapps). The most famous platform is Ethereum. We have recently seen an increasing number of competitors, such as Cardano, Avalanche, and Solana. Platforms can be compared to iOS and Android operating systems.
Tokens are issued on these platforms and do not have their own blockchain. Tokens can be divided into governance and utility tokens depending on the use case.
Maker falls into the token category. It is a governance token for the Maker & DAI ecosystem. The DAI, issued by the Maker protocol, is a stablecoin. It goes to the currency category.
Maker is one of the first DeFi projects
Maker was founded already in 2014 by a Danish entrepreneur Rune Christensen. It didn’t hit the mainstream until the cryptocurrency mania of 2017. That is when Maker released its white paper and smart contracts on the Ethereum blockchain.
During 2017 and 2018, Maker raised about twenty million dollars in funding from investment companies such as Andreessen Horowitz and Polychain Capital. Unlike many other projects launched in 2017, it did not organize an ICO (Initial Coin Offering) but carefully selected its investors by their contributions.
How Maker works
The purpose of the Maker project is to enable loans to be issued without centralized intermediaries. The role of a bank is replaced by smart contracts and cryptocurrencies operating on the Ethereum platform. At the time of writing this article, Maker is the largest DeFi protocol in May 2021 with a Total Value Locked (TVL) of about $14 billion.
Maker is also a DAO, a decentralized autonomous organization. The MKR token is used to govern the protocol’s policies. Among other things, the holders of MKR decide what can be used as collateral and what the specific risk variables are.
MKR token entitles you to one vote in protocol decisions. Anyone can put proposals to the DAO for voting, not just the holders of the MKR token.
To learn more about Maker, check the video below.
Recently, even mortgages have been accepted as collateral for Maker loans. This has been made possible by the launch of the Multi-Collateral DAI launch in November 2019. In the beginning, only Ether (ETH) was accepted as collateral.
In addition to Ether, MKR holders have voted in favor of using BAT and MANA tokens as collateral for loans. In theory, any asset, which can be issued on a blockchain, can be used as collateral for a Maker loan.
One could see the Maker protocol as a kind of a pawnshop. However, instead of a watch or a diamond ring, it is cryptocurrencies that are pawned.
The DAI stablecoin
Next, let’s go through the concept of stablecoins and the DAI token. When a borrower pledges cryptocurrency into the Maker protocol’s smart contracts, they receive DAI stablecoins as a loan. The value of DAI is pegged to one U.S. dollar. This is also where the name stablecoin comes from.
Traditional cryptocurrencies, such as Bitcoin and Ethereum, are known to be volatile. Therefore, they are not the optimal mediums of exchange. Stablecoins have been created for this purpose. They are tied to the value of a particular currency, most often the U.S. dollar. However, a stablecoin can also be created to track the value of another asset, such as gold, euro, or pound.
Stablecoin can be launched on a blockchain in different ways. The first stablecoins, such as Tether (USDT), were fiat-collateralized. It means there is a bank account with one dollar (or other assets) for each stablecoin issued on the blockchain.
The risk of such arrangement is the ambiguity of auditing and regulation, as well as the possibility of an exit scam.
You can read more about different stablecoins from our stablecoin guide.
The amount of DAI issued is linked to the value of the cryptocurrency used as collateral. This can be also checked from the blockchain at any time. When borrowing DAI dollars in the Maker protocol, the borrower must set the loan collateral to at least 150%. Often the collateralization ratio is even higher to avoid liquidations during fast price movements.
Therefore, the value of collateral in the Maker protocol is always greater than the value of DAI stablecoins in circulation. The DAI dollar gets its dollar-peg from the cryptocurrencies guaranteed by the Maker protocol’s smart contracts.
In addition, DAI’s fluctuation in value around $1 is driven by protocol incentives. If DAI is above $1, owners of the MKR token can vote to drop the DAI Savings Rate. This reduces the demand for the DAI dollar and moves the price closer to one dollar.
Similarly, if DAI is less than $1, MKR owners can vote to raise the key interest rate, which in turn will increase demand and DAI will move closer to one dollar.
DAI holders can earn a yield on their stablecoin in the Maker protocol’s Oasis lending app. The yield is the same as the above-mentioned key interest rate and consists of the Stability Fee accrued on DAI dollars borrowed in Maker’s ‘vaults’.
A $1000 DAI stablecoin loan
If a Maker protocol user wants to create their own “vault” and take out a $1000 loan in DAI, they must collateralize a minimum of $1500 worth of ETH (or other accepted currencies).
When a loan is repaid, the user receives back the collateral and DAI will be removed from circulation. If the value of the collateral falls below $1500, the borrower will lose his collateral until his debts have been paid. There is also a 13% penalty fee for the liquidation of the loan.
The purpose of the penalty payment is to make Maker users avoid the liquidation and to provide sufficient collateral. The protocol also increases the number of MKR tokens in circulation if the collaterals are insufficient to cover the amount of DAI dollars in circulation. This would be bad for MKR-token holders, increasing MKR’s supply on the market and lowering its value.
See the video below for an in-depth DAI guide.
The holders of MKR tokens, therefore, have an incentive to keep the risks of Maker collaterals in check. MKR tokens also go out the circulation with a certain number whenever a Maker loan is repaid. The more the protocol is used, the fewer MKR tokens are in circulation and the more valuable they are.
If the value of the collateral increases, the user can take out additional loans. This makes it possible to leverage your collateral. The user borrows DAI against Ether, buys more Ether with it, re-invests this as collateral, loans more DAI, uses this to buy more Ether, and so on.
The March 2020 crisis
The Maker protocol was subjected to a severe test in the so-called black Thursday in March 2020, when the World Health Organization (WHO) declared a global coronavirus pandemic. Cryptocurrencies crashed dozens of percent in one day.
The value of Ether locked in Maker no longer corresponded to the amount of DAI dollars in circulation. The crash in ETH price was so fast and severe, that borrowers didn’t have time to add more collateral. Maker’s automatic mechanism for selling collateral could not keep pace with falling prices.
In a so-called “black swan” situation, Maker’s protocol creates new MKR tokens to circulation until the protocol is able to buy back the un-collateralized DAI.
In the March 2020 crisis, $4 million of such DAI dollars were circulating and the value of one DAI had increased to as high as $1.11. In the aftermath of the crisis, Maker DAO voted to bring the key interest rate down to zero in order to bring DAI closer to one dollar again.
After the crisis, the Maker governance has also approved the use of the centralized stablecoin, the USDC, as collateral for DAI. This has somewhat impaired DAI’s properties as a distributed and trustless stablecoin.
Threats over DAI were also posed in December 2020 by the so-called STABLE Act proposal in the United States. STABLE Act would require all stablecoins, including decentralized stablecoins such as DAI, to have banking licenses. However, the STABLE Act was only a proposal and there is still no guarantee that it will be taken to practice.
Maker price and how to buy MKR
If you want to invest in the Maker protocol, MKR is the token you want. That’s the governance token with price fluctuations, while DAI is always valued at one dollar.