Breaking down MakerDAO: part2

We demonstrated in the previous note the need to build a homeostatic stablecoin, the example of MakerDAO token, in this note, we will illustrate how it actually works.

What is a stablecoin?

A stablecoin is literally a stable cryptocurrency.

The operation of a dollar-backed stablecoin is simple. If the price of one cryptocurrency is x U.S and you exchange 1 unit against this stablecoin, you’ll have x units. If that cryptocurrency price drops or rises by 10%, you will still have x U.S.

Different types of stablecoins

All stablecoins have the same purpose but each has a different mechanism.

  1. Fiat-collateralized: This model implies that the entity issuing the stable coin has a bank account containing the value of the issued tokens.
  2. Crypto-collateralized: A token supported by another cryptocurrency. To compensate for volatility, the stablecoin is over-backed. So if the value of the collaterals drops, the stable corner remains covered.
  3. Seigniorage shares: The stablecoin is supported only by its value thanks to a smart contract. If the total demand for the stablecoin increases or decreases, then the contract will automatically change the number of coins in circulation to keep the price stable.
Types of stablecoins

MakerDAO

MakerDAO is a decentralized autonomous organization working on the ETHEREUM BLOCKCHAIN and seeking to reduce the price volatility of its own token DAI, against the U.S. Dollar, through a collateral debt position process (CDP), a set of incentivized performers (Keepers) and a price feed mechanism (Oracles).

The Maker platform consists of a series of complex smart contracts.

It has two native tokens, Maker (MKR) and Dai (DAI). DAI is the asset that is supposed to be pegged to the US dollar. MKR is closer to “traditional” token in that its supply is deflationary. MKR holders are the governors of the system, they can set the parameters that controls the generation and burn of the stablecoin Dai, borrowers also need this asset to pay for “stability fees”.

MKR-DAI

Collateral Debt Position (CDP)

A financial security that locks collateral assets to emit an amount of debt depending on the value of the collaterals held. Assets are locked until the user repays his debt, pending CDP always has a greater collateral value compared to debt value.

The process can be summarized in 4 steps:

  1. User instantiate the CDP and deposit collateral
  2. User retrieve the debt from the collateralized CDP
  3. User Pay down the debt and additional stability fees
  4. User retrieve collateral and close the CDP
MakerDAO Collateralized Debt Position

Collateral Token: PETH

Users who wish to open a CDP and generate DAI during the first phase of the Maker Platform need to first obtain PETH (ERC20 token pegged to ETH value). This is done instantly on the BLOCKCHAIN by depositing ETH into a special smart contract that pools the ETH from all users, and gives them corresponding PETH in return.

Stable Token: DAI

A token that is backed by escrowed collaterals, users lock PETH into CDP, to retrieve a newly generated amount of DAI (depending on the amount locked).

Governance token: MKR

In contrast to DAI which is a stable-coin, MKR is a token that has a volatile price because of its role on the Maker platform. MKR is a utility and governance token. The MKR owes its value to the interest taken by the DAI borrowers: these interests are payable only in MKR.

  1. An utility token: MKR is required for paying the stability fees accrued on CDPs. Only with MKR a user can pay these fees.
  2. A governance token: MKR is used by its holders to vote on specific risk parameters for the management and business logic of the system. Risk management is crucial for the Maker platform’s success and survival.
Volatility VS Stability

Price volatility

The supply of MKR in circulation fluctuates (so its value) according to the performance of the network:

If the user manages to pay his debt, thanks to the collaterals value rise up, the stability fees paid in MKR, will be burned, the supply decreases and its value increases as a reward for the governors for setting the right parameters,

If the user doesn’t pay his debt, due to the collaterals value fall down to break the odd (0.66 ratio), a newly generated MKR is auctioned against DAI in an OTC market (0x), to cover the loss, as the supply of MKR increased, its value decreased as a punishment for the governors for setting bad parameters.

This means that depending on the adoption and demand for Dai and therefore CDPs, and the price of the collateral asset, the MKR price maintain its value, through its supply on the market.

Price stability

DAI maintains its stability out of its scarcity and the demand on it, and importantly, the ability of CDP owners to pay back their debts. One active CDP allows its owner to generate DAI tokens (depending on the value of the collaterals held), creating DAI out of nothing increases its scarcity which decreases its value.

The good scenario is when the user pays back his debt (plus the stability fees paid in MKR, which will be burned), the amount paid with DAI will be redeemed to recover the previously generated amount, removing it from the supply will decrease its scarcity, hence increase its price.

However, the bad scenario consists of a downfall of the price of the collateral asset (Black Swan), the user would probably not pay his debt, in order for the Maker platform to recover the DAI generated, a liquidation process is triggered, and the collateral assets are exposed to a sell-off to be exchanged with an equal amount of the lost DAI, if the system could not reach this amount, it will generate new MKR to be exchanged with DAI to recover the missing sum, finally, the recovered DAI is burned, supply is decreased and the value is increased.

The liquidation process

Liquidation is a process whereby the system automatically sells CDP guarantees for DAI to cover and close the CDP. Automated liquidations are required to mitigate the risk of sub-collateralised CDPs. If there is not enough collateral to support the ongoing DAI of the system, confidence in the value of DAI can quickly erode.

liquidation of collaterals

There are two possible outcomes in a liquidation. If the sale of a portion of the guarantee generates enough DAI to cover the vulnerable CDP, the remaining collateral is returned to the CDP creator, less a commission known as the “liquidation penalty”. Things get interesting when there are not enough collateral to sell to cover the created DAI. This case will only happen when the warranty price has collapsed so quickly that even oversizing has not been enough to secure the CDP. In this case, the system will begin to create and sell MKR tokens for more DAI until the liquidated CDP is fully covered. This increases the total supply of MKR tokens that dilutes the value of each token. After the liquidation, the creator of the CDP is left with all the guarantees that the system has not automatically sold, minus the liquidation penalty, plus the DAI they created in the first place.

Liquidation ratio

A collateral-to-debt ratio at which the CDP is deemed unsafe and is exposed to liquidation.

Stability fees

For a user to payback his debt, he also has to pay an annual percentage of the debt that can only be paid with the governance token MKR, once paid, the amount will permanently removed from the supply.

The OTC Market

It is a market on which the transaction is concluded directly between the seller and the buyer. It opposes an organized market, where the transaction is done with the stock market. Operations are often less standardized or in a more flexible regulatory environment.

Maker has its fully-decentralized OTC Market for all its tokens: DAI, MKR and PETH, its purpose is to handle the backbone of exchange by focusing on high liquidity trading for token pairs, high security and custom logic.

The backup

Backup means that every USD of DAI is covered by more than one USD worth of collateral PETH. A backup is needed to defend against the very volatile price of BLOCKCHAIN assets. We never want a situation where, for example, the price of PETH drops and the system ends up with a larger DAI than the PETH supporting it.

The arbitrage

In the broadest sense, arbitrage in finance means choosing from among several similar, most advantageous strategies. By extension, this term refers to the possibility of making a gain without risk. An arbitrage opportunity is defined as a financial investment strategy that, by combining several operations, ensures a profit and does not require any initial down payment.

Arbitrage in crypto market

Arbitrage is performed by external actors called keepers, who profits from the sell-off triggered once a CDP becomes unsafe.

External Actors

In addition to its smart contract infrastructure, the platform relies on a set of external actors to maintain its operations.

  1. Keepers: Independent external actors who take advantage of the arbitrage opportunities of the Maker platform when a sell-off is triggered.
  2. Oracles: Independent external actors who feed the Maker platform with real time information about the price of the collateral asset.
The process of maintaining stability by MakerDAO

Conclusion

MakerDAO is an incredibly complex system that aims to solve a very difficult but promising problem. Stablecoins, if successfully deployed, will be the “Holy Grail in Cryptocurrency”. They combine all the benefits of the blockchain with the predictability and security of centrally managed fiduciary currencies.

However, this is certainly not an easy problem to solve and as many safeguards as MakerDAO built into the system to keep their peg to the dollar, there are still some very valid concerns as to whether they are sufficient. For these types of systems, only time will tell how robust they are.

Determined, passionate and hardworking individual with unyielding self motivation, highly driven and well-versed in open source technologies.

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