How MakerDAO Works

Stablecoins. The name is a bit of a misnomer In theory, stablecoin prices are pegged to various fiat currencies or hard monies, like gold or silver, in an effort to keep the crypto tokens price, you guessed it, stable. The benefits to a business that a stable token could provide are great. A stablecoin makes finance far easier than a volatile coin. Since the price is predictable budgeting becomes less of a headache. But in practice this is a tough solution to make work. Take Dai for instance, the stablecoin designed by the Ethereum project MakerDAO. In the last three years MakerDAO has become the most popular decentralized finance application on Ethereum. The MakerDAO project includes two tokens: MKR and Dai. Dai is the stablecoin. MKR is the governance token. To understand the MakerDAO system it’s important to note its role as a lending platform. So let’s get into it. While both tokens can be purchased directly on exchanges Dai is created when users of the system lock up Ether. When users lock up ETH they can withdraw Dai which maintains a soft peg to the U.S. dollar. Users can withdraw up to two thirds of the value of Ether that was locked up. There’s currently over 400 million dollars in Ether locked up in MakerDAO. So someone depositing three hundred in ETH at today’s prices could then borrow up to around fifty thousand Dai which would be worth roughly fifty thousand dollars. Yet because the price of Ether fluctuates so much, the MakerDAO system encourages users to over-collateralize. Meaning they’ll have to lock in more Ether than they’ll get back in Dai. The minimum amount a user must collateralize their Dai alone with ETH, is one point five times but people usually collateralize much more. Much like a traditional credit card, Dai loans accrue interest. In January the interest rate which is called the Stability Fee for a Dai loan, was half a percent. Sounds like a good interest rate compared to the range banks charge anywhere from 10 percent to 30 percent depending on a person’s credit score. But that low rate hasn’t remained. Over the last couple months Dai interest rates have fluctuated dramatically. Dai’s price, one to one with the dollar, is kept by backing the token with an equal amount of debt. If there is more Dai in the world than the market demands, an oversupply, the price will drop. So the system began to adjust by increasing the interest rate on all borrowers in order to encourage them to pay down part of the amount they took a loan for or close the line of credit altogether. When people paid down their debt they pay it with Dai. That Dai gets burned or destroyed when they do, which contracts the overall supply. A smaller supply should drive the price back up. And that’s what happened in recent months. In order to close a loan, the user can only repay the principal with Dai They have to repay the interest accrued in MKR, both those coins are then burned as debt gets retired. Dai is destroyed because Dai is only backed by debt. So without that debt in the ecosystem those coins are not needed. MKR is destroyed as an incentive for the MakerDAO community. With the present supply of roughly 1 million, destroying some of those MKR tokens makes the price of the rest appreciate Or go up. A Dai loan could also be liquidated automatically. Should a person’s collateral dip below the minimum one hundred and fifty percent the system will liquidate their ETH holdings automatically with a 13 percent penalty fee. That’s on top of the interest owed as well. It’s a fee big enough few users want to get hit with. This is why the rapid increase in the interest rate has been so controversial. While it was clear to everyone participating in the ecosystem that interest rates could be increased in the future these rates have been increased from half a percent to 19 and a half percent over the past five months which has pinched borrowers, especially those who didn’t use the loans just to speculate on tokens. The cost to borrow has gone from an amazing deal to more than many people would pay for completely unsecured debt with a credit card presumably to evade the sort of nosy questions bankers tend to ask before lending money. So who decides when to increase the interest rate and by how much. To explain that we have to explain one more concept: A decentralized autonomous organization or DAO. The idea of the DAO is that lots and lots of people can manage and run an organization taking advantage of the wisdom of the crowd to make the optimal choice. MakerDAO is a programmatic loan system but it’s also a DAO The DAO is governed by people who hold its MKR token. They get to decide on things like the interest rate, how much of one type of loan can be issued and more because of this and the possibility of appreciation. The MKR token has been attractive to hold As long as people keep taking out Dai loans and repaying them, the value should go up as MKR tokens get burned and interest is repaid. MKR is currently worth over six hundred dollars so far only about 1000 MKR tokens have been burned. Holding MKR also gives participants the chance to be a decision maker in an interesting new kind of financial organization. Collectively these people pay attention to the price of DAI and decide whether or not the interest rate needs to go up and down. So far they’ve been mainly choosing to drive it up. As pioneers of a new financial instrument there’s not much prior data for MKR holders to drawn on to make an optimal decision. Nevertheless as of this recording Dai’s price appears to have returned to a steady dollar valuation across major cryptocurrency exchanges and over-the-counter trading deska. What’s more, MKR holders are now looking towards potentially lowering interest rates. Given that the price of Dai has increased. In that way MakerDAO functions as one of the best versions of a decentralized autonomous organization the industry can point to so far.

9 thoughts on “How MakerDAO Works”

  1. Soooo.

    Whats the point if loans are 19%
    Seems a lil odd..

    If thats the best a community could agree on then….


    Seems like a double f up…

    I don't think you want the people who are profiting off the system to actually come up with the percentage rate.

    That seems like a no-brainer..

    Isn't that how we got into this mess in the first place.

    It's like me saying here's a solution to credit cards and banks…. how about higher interest rates

    or am I missing something here

  2. Let me ask you this. How much eth does it cost your to buy $100 of DAO????? Correct me if i'm wrong but $300 of ETH will get you $100 of DAO. I don't get it. In the mean time ETH could sky rocket but you will miss out on that because you bought a stable coin with it.

  3. You will need more efforts to clarify your concept !! Who wants to pay 19% interest decided by MKR holders ???

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