Skip to main content

Maker Protocol, DAI Stablecoin, and MKR Token Explained

I have been fascinated by crypto for a long time now, and I enjoy sharing what I have learned about it on ToughNickel.

The Maker logo

The Maker logo

What Is Maker?

Maker is a DeFi protocol on the Ethereum network that allows its users to mint stablecoins that are backed by collateral. A stablecoin is a cryptocurrency that always has the same value as the "real" currency that it is based on. In most cases, this is the US dollar. Most stablecoins (like USDC) depend on a central entity that holds physical money to back up their value. The Maker protocol offers a unique, decentralized U.S. dollar-based coin called DAI.

What Is the DAI Stablecoin?

Most stablecoins depend on a third party that holds money to back up the value of the tokens. This can be a problem because users need to trust this third party with their money, which destroys the entire point of using cryptocurrency. In some cases, this third party isn't transparent about their holdings; this was the case with Tether, the most used stablecoin, for example.

DAI is not backed up by real-world assets but instead by digital ones. To get DAI, users must lock up ETH on a smart contract that is part of Maker, and in exchange, the same wallet that sent the ETH receives DAI. Because this is done with a smart contract, users don't depend on a third party, and there are no transparency issues.

Similar to Aave and Compound, Maker allows collateralized loans that are useful if users need liquidity but don't want to sell their crypto because they expect it to rise in value. Currently, Maker requires a collateral of 150%, which means that users can receive $100 worth of DAI for $150 worth of ETH.

The DAI logo

The DAI logo

How Is the DAI Price Kept Stable?

If a user wants their ETH back, they need to pay back the DAI they received back plus a stability fee. This fee is set by the system and is automatically lowered or raised if necessary to stabilize the value of DAI.

Once a user has DAI, they can use it like any other stablecoin. It can be used in many different DeFi protocols to earn interest, for example. Maker itself allows users to hold their DAI in a smart contract where it receives interest. The DAI savings rate is lowered or raised to keep the DAI price stable.

The value of DAI is stabilized by supply and demand. The stability fee can be raised to lower the supply of DAI because, with a high stability fee, users are less likely to take a loan with DAI. The DAI savings rate can be raised to increase the supply of DAI because it incentivizes users to get DAI to earn interest. Maker can increase or lower the demand for DAI if its value isn't at exactly $1.

The DAI price is held relativly stable at $1.

The DAI price is held relativly stable at $1.

What if the Collateral Falls in Value and Cannot Cover for Its DAI?

Since DAI is backed by cryptocurrencies that can be very volatile, it is possible that the value of the collateral could fall beneath the value of the DAI issued. This would trigger a collateral action where the collateral is automatically sold to pay back the issued DAI. Any surplus left would be sent to whoever took the DAI loan but with a 13% cut.

Here is an example: You have $150 ETH as collateral and $100 DAI as a loan. If the value of your ETH falls to $130, Maker will sell your ETH, and you will get $30 with a cut of 13%. You can keep your $100 DAI and don't have to return it because you have no ETH you could get back anymore.

The 13% cut goes to the Maker Buffer that holds these funds in a treasury in case the value of the collateral falls beneath what was issued as DAI. If your $150 ETH fall in value to $90 ETH and can no longer cover your $100 DAI, Maker will still sell your $90 ETH and compensate for the $10 loss with what is held in the buffer.

The MKR price performance from July of 2017 to July of 2021

The MKR price performance from July of 2017 to July of 2021

What Is the MKR Token?

MKR is the governance token of Maker. All decisions about changes in the Maker protocol are made collectively by all of its holders. MKR holders can vote on:

  • When a new collateral asset type should be added (or not)
  • Whether to increase or decrease the DAI savings rate
  • Whether to increase or decrease the stability fee
  • Whether to make updates to the protocol

The token also serves as a last line of defense in case the collateral somehow cannot cover the DAI issued and not even the Maker buffer can help. If the $150 ETH you used as collateral dropped in value to $50, the buffer would not be able to cover the shortfall. If this happened, Maker would create new MKR tokens and sell them for a fixed amount until the shortfall is covered.

Increasing the supply of MKR would lower the value of existing MKR, which means that MKR holders have a strong incentive to keep the system safe because a failure would lower the value of their MKR tokens.

Final Thoughts

Voting rights for a DeFi protocol rise in demand as more money is added to its ecosystem. There is a high demand for dollars to be used directly on blockchains like Ethereum, and DAI is the only decentralized option. As such, Maker may grow quite a lot as a platform, and with it, will the value of the MKR token may rise substantially.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Krypton Currency