What is the MakerDAO and DAI?

What is the MakerDAO and DAI?

The MakerDAO is a cryptocurrency protocol – a set of rules and actions that determines how a specific type of cryptocurrency works. The MakerDAO (which stands for “Decentralized Autonomous Organization”) started in 2014 and runs off the Ethereum blockchain. It issues a governance token, called MKR, which allows the holder of the token to participate in the governance and policy making of the DAO, as well as the DAI stablecoin. 

DAI is the specific type of cryptocurrency that is governed by the rules[1] of the MakerDAO. DAI is a type of cryptocurrency token known as a stablecoin, which means that the value of 1 DAI is “soft-pegged” to $1 USD at all times. It is a more stable form of cryptocurrency given that its rate does not fluctuate constantly – hence the term “stablecoin”. 

This peg is maintained as anyone looking to generate or borrow DAI must open a Maker collateral vault and deposit Ethereum-based assets as collateral. The value of the collateral deposited at the vault must always exceed the value of the DAI issued.  If the value of the collateral falls below the value of the DAI generated, the collateral will be liquidated automatically by smart contracts to ensure that the value of the DAI doesn’t fall below the soft-peg of $1 USD.  

This makes DAI an algorithmic stablecoin that also has some characteristics of a crypto-backed stablecoin.

Importance of the MakerDAO and DAI

DAI was not the first stablecoin to be presented in the world of cryptocurrency, but it may be one of the most successful. Other stablecoins, such as Tether and TrueUSD, were introduced to address the volatility of value that frequently plagues various forms of cryptocurrency, but none have been perfect.

Holders of the MKR governance tokens can influence procedures such as how to shut down the entire protocol in the event of an emergency, including a sudden crash in the price of Ether, the native Ethereum cryptocurrency[2] that backs the value of DAI. Individuals can also contribute to determining features such as the amount of the annual borrowing fee and the amount of collateral that is necessary to back each collateralized debt position (CDP).

DAI is one of the most successful projects on the Ethereum blockchain network, holding 2% of all the Ether coins in the network within MakerDAO smart contracts. Maker has seen a consistent 20% month-on-month growth in the use of DAI tokens. The majority of users, more than 70%, spend their DAI tokens quickly after acquiring them.

How the MakerDAO and DAI Works

Essentially the MakerDAO invites traders to earn interest on the DAI that are held in the MakerDAO bank. The MakerDAO functions like a credit processing facility, with stability fees acting like interest rates.

When these fees are low, people lock up more ETH tokens, but when these fees rise, people are more likely to close their CDPs. Because new DAI tokens can only be generated by the opening of new CDPs, market fluctuations and preferences can affect the value of DAI.

The process to generate and withdraw DAI involves multiple steps:

First, you (the trader) deposit Ether (the native cryptocurrency of the Ethereum network) or another acceptable cryptocurrency into a smart contract provided by the MakerDAO. The MakerDAO now accepts BAT, USDC, TUSD, ZRX, and MANA, among others.

When you deposit crypto into a smart contract with Maker it creates a CDP[3], or Collateralized Debt Position. This CDP is how DAI is created: by locking collateral into the Maker smart contract to produce DAI, the stablecoin. The value of the collateral in a Collateralized Debt Position has to be more than 150% of the value of the DAI tokens that the collateral was used to create.

To unlock this collateral and recoup the value of the smart contract, you will have to pay back the equivalent value of the DAI generated by your initial collateral plus the price of the stability fees. This ensures that there is always a sufficient amount of capital to support the value of the money being withdrawn.

If the value of the collateral you have initially deposited into a smart contract to generate DAI tokens sinks below 150% of the DAI it generated, then your locked collateral will be sold. The proceeds from the sale will then cover the costs of the DAI generated, as well as liquidation penalties and stability fees.

So, for example, if you deposit 1 Ether token with a value of about $100 into a Maker smart contract, you will be able to take out as much as 40 DAI tokens. If after this point the value of Ether drops to less than $100, then your CDP (collateralized debt position) will be closed, and you will have to pay back the full amount of DAI plus additional fees.

Maker also offers a DAI Savings Rate[4]. This provides DAI token holders with a method for locking up their DAI and earning interest as the value of the cryptocurrency rises. This interest is financially backed by the stability fees that DAI token holders pay when withdrawing DAI from the MakerDAO.

Where You Can Use DAI

Due to its stable value ratio, at $1 USD per token, DAI is a good choice for money transfers. It can be used with more than 400 integrated apps and services, and that number continues to expand.

DAI can be a good starter cryptocurrency for those new to the crypto sphere. For example, 65% of millennials use mobile payments[5] on their smartphones. DAI can easily be integrated with digital wallets, allowing DAI token holders to seamlessly use the cryptocurrency for purchases. DAI can also be used with integrated services such as DeFi staking platforms, or on integrated apps such as games.

The stability of this type of cryptocurrency also makes it a good choice for exchanges between cryptocurrencies. Most different forms of crypto will support exchanges with DAI, so it has high levels of interoperability among different types of cryptocurrency. When you transfer the equivalent of 1000 USD in DAI, it will almost certainly still be worth the same amount, either in real USD or in another form of crypto.

This makes it stand out from other forms of cryptocurrency, where the price may fluctuate significantly during any single transaction, leading to transfers that are higher or lower by $100 USD depending on the specific moment in time. This can make them much harder to use reliably.

Challenges of Using MakerDAO and DAI

The MakerDAO generally provides a stable, fairly consistent stablecoin[6], which is all the more impressive considering that it is governed by a completely decentralized body of individual token holders. There are, however, still some issues that DAI users should know about.

First and foremost, since DAI is not backed by third parties with the specified collateral amount, but instead by Ether, the native Ethereum cryptocurrency, the true stability of DAI is reliant on the value of Ether. Ether is a more volatile form of cryptocurrency, and so these frequent fluctuations in value present some notable challenges to maintaining the stable 1 token to 1 USD ratio for DAI token holders.

Another challenge facing MakerDAO and DAI users is that it is currently undergoing major transformations. Rather than relying on the value of USDC, MakerDAO is instead transitioning to pinpoint the value of DAI[7] on US Treasury bills. This transition could make waves among stablecoin users, as it affects the underlying value of the stablecoin cryptocurrency. Time will tell how it affects the price value of DAI in the long run.

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