Maker, a crypto lender, is one of the pioneers of decentralized finance (DeFi), Maker uses smart contracts on the Ethereum blockchain to make loans based on DAI, a stablecoin.
MakerDAO is a cooperative organization that manages the Maker protocol. As one of the most valuable and widely used platforms in DeFi, investors and crypto users are closely watching how Maker’s governance and operational model evolves.
Ever since Ethereum went live in 2015, it has become the host of hundreds of decentralized applications (dApps). The most popular by far are dApps for lending, borrowing, and token swapping because these services can be executed without the need of intermediaries such as banks or credit scoring outfits. The Maker protocol was in the DeFi vanguard.
Maker’s Origin and Purpose
In 2014, Rune Christensen created MakerDAO for the Maker ecosystem. He is a Danish entrepreneur who studied at the University of Copenhagen.
Inspired by the Ethereum Foundation, he launched the Maker Foundation in 2017. It was a coordinating body for programmers and started Maker, an open-source project to spearhead a completely decentralized and permissionless banking system without banks.
Specifically, Maker’s mission is to generate and maintain a stable on-chain digital asset pegged to the value of the dollar — the DAI stablecoin.. To do so, Maker deploys smart contracts that automate loan issuance and debt/stablecoin collateralization.
From this centralized beginning, the Maker Foundation gradually turned over its control to MakerDAO, the decentralized governing body for the Maker protocol. It used MKR as a governance token that grants voting rights on all aspects of Maker’s management and development.
This transition is ongoing, and it has had some mishaps. In late 2018, Maker Foundation established Maker Ecosystem Growth Fund (MEGF). This fund oversees MKR token treasury to spur MakerDAO ecosystem adoption. Due to disagreements on how the funds should be allocated, five out of nine of its board members were fired by Christensen.
MakerDAO’s key product is Dai stablecoin, launched in December 2017 and collateralized by Ethereum. In November 2019, MakerDAO upgraded DAI issuance so it’s backed by dozens of crypto assets but mainly by USDC stablecoin.
Maker’s Dai (DAI) Stablecoin
For any blockchain lending service to be reliable, the collateral used for loans must be stable. Consequently, Maker’s entire lending ecosystem revolves around DAI. Maker protocol uses smart contracts to create Maker Vaults. These are token repositories in which investors add liquidity. Therefore, Maker Vaults serve as liquidity pools to collateralize Dai stablecoin.
After liquidity is added into Maker Vaults, they mint new DAI stablecoins. In turn, the newly minted Dai stablecoin is collateralized by the crypto asset provided. Typically, investors add USDC to mint new DAI, alongside Wrapped Bitcoin and Ethereum.
The reason for this allocation is that both Ethereum and Bitcoin are cryptocurrencies with the largest market caps. Therefore, they are least prone to wild price swings that could affect DAI’s one-to-one peg to the dollar. Conversely, USD Coin is the most used centralized stablecoin because it is 100% backed by USD cash reserves or equivalents.
As a result, DAI is far from being decentralized. Nonetheless, it has the potential to be so, if its collateralization structure shifts away from centralized stablecoins like USDC or USDT. Such a decision is in the hands of MKR token holders.
Maker’s MKR Governance
To be truly decentralized, everyone who has a stake in the protocol must be able to vote on its features. Like shareholders in a company, MKR token holders can do so for the Maker protocol. They can use MKR tokens as a voting weight to:
- Select which new crypto asset to add as DAI collateral
- Determine by how much to overcollateralize DAI with each crypto asset. This reduces or increases DAI’s peg instability risk.
- Determine the staking rewards rate for DAI stablecoin
- Approve or propose new Maker upgrades
- Select or add oracle networks that feed off-chain data to on-chain smart contracts, such as Chainlink.
- Select liquidation ratios for each crypto asset collateralizing loans. Typically, this reflects the coin’s market cap; the lower it is (under $10B), the more volatile it tends to be.
- Stability and liquidation fees. The first one is a Dai-denominated fee for retrieving collaterals, while the second one is the fee (penalty) paid if Maker Vault’s asset is liquidated.
As with every other blockchain governance protocol, MKR token holders have as much voting power as they have tokens. If a Maker Vault is deemed too risky, it is then liquidated via automated auctions, generating new DAI.
Because MKR token holders get to decide every aspect of the Maker protocol, its governance role is also its utility. When a voting smart contract is initiated, one MKR token is equivalent to one vote. Just like they would add liquidity to smart contract liquidity pools, MKR token holders add their stake into a locked voting smart contract.
In addition to voting, MKR encourages responsible economic activity. If Maker’s ecosystem of loans is overburdened with too much debt, MKR supply is increased as a backup. Because this devalues the price of each MKR, it discourages irresponsible risk-taking.
How Does Maker’s Loan Issuance Work
Many dApps are tied to Maker protocol to issue loans. One of them is Oasis.app. When a user wants a loan through such a dApp, Maker protocol issues a smart contract called collateralized debt position (CDP).
Let’s say that a borrower wants to collateralize their CDP loan with ETH, Ethereum’s native cryptocurrency. ETH is then used to mint DAI stablecoin via Maker Vault. Put it another way, ETH serves as a collateral for the loan, issued in DAI.
Once the loan is repaid, the minted DAI tokens are burned, i.e., permanently removed from the circulating supply.
Maker (MKR) Tokenomics
When MakerDAO first launched in December 2017, it issued 1,005,577 MKR tokens, as the maximum supply. As of September 2022, 97% of that supply is in circulation. At its peak price, MKR reached $6,339 in May 2021, growing to a $5.98B market cap during a bullrun.
As noted previously, although MKR has a maximum supply, this can always be changed with a vote, depending on how much debt is in the system. For this reason, MKR’s value shifts with the market winds.
For instance, if DAI stablecoin supply exceeds the necessary baseline to ensure loan collaterals, the excess is used to buy MKR tokens and burn them. When this happens, MKR circulating supply is reduced, which typically increases its price, per the economic law of supply and demand.
In addition to decentralized exchanges, like Uniswap, Maker token is available on all major exchanges, such as Binance, Coinbase, Kraken, and OKX.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.