What is MakerDAO?
How the quest for a stablecoin might be coming to an end? Cryptoassets always display a volatile, fluctuating price since their true valuation is constantly evolving through market forces. This characteristic, however attractive to investors and speculators, is a hindrance for daily currency usages.
1. The pursuit of the perfect stablecoin
Crypto assets, as an emerging asset class, have a price that fluctuates greatly as their true valuation is difficult to establish by the market. This characteristic, while it may attract investors and speculators, poses a problem when it comes to using them as a currency.
The entire crypto ecosystem has long been looking for an asset that would replicate the value of fiat currencies, with a stable price equal to a US Dollar for example. It would simplify the experience of less technical users and the accounting calculations of app creators, provide a payment system without fear of market reversal, or manage the outflow of funds from smart contracts easily.
The first attempts to create stablecoins came in the form of collateralization-replication systems against fiat currencies such as Tether. The principle is simple: Tether simply issues as many tokens as the company has USD in its bank account.
Even though Tether has been very successful in the ecosystem, as there are currently more than two billion units on the market, this project presents many risks: how to trust the actor who generates the USDT? Who guarantees the convertibility of the asset? How can we trust the audits that will verify the presence of the funds? What happens if a state entity “freezes” or seizes the funds on deposit at the bank?
2. A decentralised stablecoin based on pawned Ethers
At the end of 2017, MakerDAO proposed an alternative solution that does not rely on the physical world or a central authority: a system analogous to pawning an object in exchange for a loan. And just like pawning a physical object, the entity that receives the pledged object has the option to resell it if the borrower does not pay back.
In the case of MakerDAO, the object that is pledged is a crypto asset, and the loan is expressed in a cryptocurrency created for the occasion and whose price does not fluctuate, the DAI.
The entity that holds the pledged crypto asset is a smart-contract called Collateralized Debt Position or CDP, which only the creditor has the ability to unlock.
The MakerDAO system therefore makes it possible to obtain loans without a trusted third party, without the need to set up a file, at a particularly attractive interest rate and with repayment terms left to the discretion of the borrower, all with a complete guarantee of security since they are managed through smart-contracts.
3. So what could go wrong?
The value of the DAI stablecoin, in order to be considered constant, must be guaranteed by the fact that the collateral is always worth at least the amount equivalent to what was borrowed. For now, only ETH can be used as collateral, although the system plans to add new cryptoassets soon. Ether is available for purchase and sale on our platform.
Since the value of ETH is fluctuating in nature, in case the price of Ethereum increases, the pledged value increases proportionally, so it is not a problem. On the other hand, if the Ethereum price decreases, it would be possible for the value of the collateral to become less than the loan amount. The borrower would then have no interest in repaying the loan and the system would collapse.
This is why a safety mechanism is put in place when the loan is created: the collateralization of the loan can never go below 150%. If the price of Ethereum ever drops enough for the collateralization to reach 150%, a liquidation process is activated and anyone acquires the ability to pay back the debt in place of the borrower to balance the situation.
These actors do not do this out of the goodness of their hearts but out of greed: the one who liquidates the loan earns 13% of the amount of the debt, taken out of the borrower’s funds.
In any case, the borrower must consider the degree of risk he is taking by choosing the value of his deposit compared to his loan, which he can control through the speed and regularity of his repayments.
4. You didn’t understand ? Let’s take an example
Let’s say a computer developer has a capital of 100 ETH, the result of long-term savings, with a short-term need to buy a computer worth $2000, but does not have the necessary amount of cash immediately.
This person has several choices:
- Take out a traditional loan and put together a file, agree on an interest rate and monthly repayments, with all the difficulties that a precarious work situation can entail, which is the case for many “digital nomads” or self-employed people in the digital sector.
- Sell 16.5 ETH at $120 and risk, if the ETH price rises in the medium term, to lose an opportunity for capital gain.
- Pledge these 100 ETH in a CDP, create 2000 DAI, and exchange them for euros through a service such as Coinhouse.
If the latter option is chosen, it will have to be repaid at an annual interest rate of 1%, calculated to the second. With a very comfortable collateralization rate of 632%, the ETH price would have to fall to $28.83 to trigger a liquidation.
The developer can choose to pay back his debt according to his means, in total freedom and getting back his entire deposit after paying back his debt, not endangering his long term savings by his short term needs.
Let’s compare MakerDAO’s credit offer with the traditional banking system: where the traditional credit world is mostly based on real estate deposits in mortgages, MakerDAO has more counterparty risks due to the volatility of ETH, but represents an accessible, transparent, and untrusted credit system.
5. A source of stability
Some players in the ecosystem such as Aragon have made the choice to use the MakerDAO system in their business management. A project strongly linked to the success of Ethereum, but having been heavily impacted in its financial reserves by the fall in ETH prices and the sector in 2018, Aragon made the choice not to sell its ETH reserves obtained during the ICO at a low price to finance its operational costs. Therefore, the project managers opened a CDP that has very large reserves, and generates the necessary IAD for their current expenses.
If this choice is not without risk in case of a sudden drop of the ETH, it is a way to survive during long months or years of bear market without impacting the reserves of the project in the long run. If a bull market occurs in the medium term, Aragon will be able to buy back its debt for a much smaller amount of ETH.
Generally speaking, all these players have different needs and objectives and all have a more or less “speculative” profile. Their actions offset each other and balance the system as a whole, leaving the IAD open to all as an intrinsically non-speculative asset, a reliable unit of account, a decentralized medium of exchange, and a store of value that is immune to the high volatility of the industry. This type of asset is generally referred to as a currency.
6. Who gets the interest on the loan?
Each loan in DAI has an interest rate of 1% which, when repaid, triggers the purchase and destruction of an equivalent amount of MKR, a second token in the MakerDAO system, whose value fluctuates according to supply and demand. By destroying a quantity of MKR with each loan repayment made in the system, the value of each remaining MKR token tends to increase mechanically.
Each MKR token is in a way a share in the financial sense of the MakerDAO system. The more the system is used, the more the value of the MKR token should increase, because of its progressive scarcity. The MKR token also allows to vote on the evolution of the system, in proportion to the number of tokens each holder has. For example, a recent vote increased the interest rate on loans from 0.5% to 1%.
The duality between the DAI, a stable token in value, and the MKR, a governance token with a speculative capacity, ensures the stability of the system. MKR holders benefit directly from the use of the DAI and the operation of the DAI is managed by the holders who, in case of market crisis, protect the system.
The MKR is thus the last line of defense of the MakerDAO system: in case of a serious crisis and a sudden and prolonged fall of the ETH price, MKRs are automatically generated to repay the debts and destroy the DAIs that would no longer have sufficient collateral. This emergency shutdown would dilute the valuation of MKR, but has never been used before.
The MakerDAO system has several other complex safety mechanisms that guarantee collateralization and prevent this from happening. Apart from the classic CDP liquidation that takes place every day, none of these mechanisms have ever had to be implemented, even in a prolonged down market.
Owning DAI is therefore, from a financial point of view, “making available” one’s risk in exchange for stability, letting go of any opportunity for profit in order to protect oneself from the possibility of loss. In this system, speculators are at the service of stability by assuming the risks but collecting the potential profits.
6. A response to the need for speculation
MakerDAO can therefore be used as a speculative tool, allowing the use of leverage: from a purely financial point of view, generating DAI is the same as betting on the rise of ETH.
A smart speculator can deposit ETH in a CDP to generate DAI, sell this DAI to get more ETH, which will be deposited again in the same CDP to create more DAI and so on. The debt in DAI remains but the amount of ETH on deposit in the CDP contract increases.
If the price of ETH falls, a liquidation will take place, of course. But if the ETH gains in value significantly, the collateralization percentage of the CDP will mechanically increase. Since CDP contracts are dynamic, as long as the 150% collateralization limit is not exceeded, it is possible to withdraw more DAI from the contract, to redeem part of it, or conversely, to withdraw or add ETH to the CDP.
Increasing one’s exposure to risk to increase potential gains is a popular strategy for speculators.
Conversely, a speculator who bets on a fall in the ETH can also mobilize the MakerDAO system: sell ETH against DAI, wait for the ETH price to fall and use the DAI capital to obtain more ETH. In this case, there is no CDP to mobilize, a simple order on the markets is enough.
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