My View on Stablecoin: DAI & Maker — Part 1 – Hacker Noon

As a follow up to my introductory post on stablecoins, I thought I would take a look at some of the more popular ones out there. Hence the first one I chose to write about is DAI by Maker (aka MakerDAO).

As I was writing, I realize how long this became so I split it into a 2 parts. Part 1 is an introduction to the stablecoin as I understand it and part 2 covers my own opinions.

What is DAI Stable Coin and Maker (aka MakerDAO)?

DAI is the crypto-collateralized stable coin that aims to remain at $1 = 1 DAI and aims to achieve this by utilizing its protocol design and governance. This protocol design and governance framework is known as Maker Platform (formerly known as MakerDAO) and is a decentralized organization.

How Does It Work?

The way the DAI’s stablecoin ecosystem work can be a bit complicated. At the core, DAI is collateralized with Ether (ETH) to ensure its value and uses the Maker platform’s in-built protocols to maintain its price stability. To illustrate this, let us begin at the start: creating DAI.

Creating DAI

If you wanted to create DAI, what you would have to do is to send your ETH to a Collateralized Debt Position (aka CDP) and you would in turn receive a portion of DAI. Your ETH is now locked away within the CDP and you can only get it back if you repay the DAI you borrowed. Illustrated in an example below:

  1. Deposit 1 ETH (worth $200)
  2. Issue 100 DAI (worth $100 — so your collateralization ratio is 2:1)
  3. You can now us the 100 DAI as you please.
  4. After 1 year you want your ETH back. You have to then buy back your ETH with 101 DAI (assuming interest rate was 1%)
  5. You get back 1 ETH and the 1% interest rate charged goes to MKR token holders as this is their “fee” for maintaining the system.

This is a simplified version of the process but nonetheless illustrates how it works.

In layman terms what you did was kind of similar to getting a mortgage. You borrowed DAI using your ETH as collateral just like borrowing money using your house as collateral and only when you pay back your debt (with interest) would you get back your collateral (ETH or house).

Price Stability Mechanism

So far this explains the creation of DAI, but how does this help maintain price stability especially since ETH can have quite a lot of price volatility. Again without getting too technical the main factors that ensure price stability are (note some of these are slightly simplified):

Global Settlement
Global settlement is a design in the protocol that can get triggered when prices deviate too much in which DAI will get liquidated and settled at a pre-defined price e.g. its peg of $1 = 1 DAI. When this happens, holders of DAI would then get $1 worth of the collateral, so for example if you held 100 DAI when global settlement triggered, you would get $100 worth of ETH. As a result this expectation ensure DAI cannot deviate too far from its peg.

Arbitrage Opportunity
This is the belief that 1 DAI = $1 USD so that any price deviations would be a trading opportunity. This gets capitalized by traders.

CDP Creators — The DAI Borrowers/Lenders
Remember that the CDP creators are the ones that borrowed DAI. So if DAI is trading below $1, it is a good idea for CDP creators to buyback DAI since they need to use it to repay their loans. Alternatively if DAI is trading above $1 the CDP creators can look to issue more DAI to sell and buy it back once it reverts to $1.

Risks To Collateralization

ETH prices can be pretty volatile and so the collateral value can vary immensely

As with all stablecoins the biggest risk is whether it can maintain its peg which is mainly driven by its ability to stay collateralized. The issue here is that ETH’s price can be fairly volatile which means that the value of DAI’s collateral can fluctuate significantly. Hence the Maker’s system has protocols to minimize its impact. So for example…

ETH goes up in value

In this case DAI just becomes better collateralized and there is no real issue to DAI’s $1 USD peg.

ETH goes down in value

This is when problems can occur. This is because if ETH goes down in value and we reach a situation where the value of total DAI issued is less than the value of all the ETH in CDP then the system has become under collateralized and that if a “global settlement” event were to occur, 1 DAI ≠ USD$1.

In order to prevent this, what happens is the following (some if it is simplified for easier understanding):

  1. Firstly let us assume the following:
  2. ETH current price = $200.
  3. You committed one 1 ETH to create the CDP and created 100 DAI (collateralization ratio is currently 2:1).
  4. The minimum collateralization ratio threshold is 1.5:1.
  5. ETH price has fallen to $175
  6. The CDP you created has collateralization ratio of 1.75:1, so nothing happens.
  7. ETH price has fallen below $150
  8. The CDP you created has collateralization ratio of 1.5:1 which means the CDP is undercollateralized.
  9. CDP has to to now trigger a liquidation event in which it auctions off the committed ETH collateral to cover for the original debt (in this case 100 DAI) and a liquidation cost/penalty.
  10. So as the owner of the CDP you would get the original 100 DAI you borrowed (since you didn’t pay it back) as well as anything leftover from the collateral sale.
  11. This would in effect mean that your under-collateralized CDP is removed from the ecosystem and as this repeats for all CDPs at varying degrees it allows the overall ecosystem to remain at or above the collateralization ratio threshold.

Negative Feedback Loop & MKR the Buyer of Last Resort

If you’ve been able to follow the scenario earlier you will quickly realize that the liquidation of CDP itself can bring about a negative feedback loop. Since:

  1. CDP liquidation event gets triggered, ETH is sold.
  2. Since ETH is sold price falls further triggering other CDP liquidation events.
  3. This process continues until all CDPs are liquidated.

This is one of the key risks to the maker protocol but they have thought about having MKR tokens act as the “buyer of last resort”. I won’t go into detail on how this works but in simple terms when a CDP liquidates and if there is insufficient buying to even cover the debt + liquidation penalty fee, MKR tokens will get issued and sold in order to make up for this shortfall.

Key Players in MakerDAO

Phew, we’ve finally gotten through how DAI works. So let us put this together and look at the participants within the MakerDAO ecosystem:

Users

These are people that are buying and using DAI. They don’t actively participate in the creation/destruction of DAI but are important for the ecosystem (since no users = no demand).

Traders

Traders are the ones that are actively trading DAI to make a profit by strategies such as trading around the price peg of $1 = 1 DAI (buy below and sell above $1), looking to buy ETH for arbitrage trades during CDP liquidations etc. They are important as they help maintain the stability of the price system and allow the Maker system to function as intended.

CDP Creators

As explained earlier these are the people that are using DAI as a form of borrowing and to do so they need to create CDPs.

MKR Token Holders

MKR Token holders are actually the governance token of the Maker system. As mentioned, they act as the buyer of last resort but also have voting power over various decisions in relation to the Maker ecosystem. The upside they get from this role is that all fees within the Maker system needs to be paid in MKR. This means that as DAI adoption grows so will the demand for MKR increase (and price will increase as well). This keeps their interest aligned to providing good governance for DAI in order to attract more adoption.

Summary (For Now)

If you are still unsure of how it works, don’t worry as it does take time to digest. The key points so far are:

  • DAI uses crypto as a collateral; currently it is only ETH.
  • Various factors such as arbitrage, global settlement helps maintain DAI’s peg of $1 = 1 DAI.
  • As crypto prices can be volatile, DAI has a protocol to liquidate and do its best to ensure that DAI is well capitalized and can maintain its hedge.
  • MKR token holders govern the maker ecosystem and also act as a the lender of last resort.

To Be Continued…. Part 2 will be a discussion of my thoughts on DAI as a stablecoin

read original article here