DAI Stablecoin: The Philosophy Behind

Author: Abdur Rehman
May 25, 2021

 |18 min read

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DAI Stablecoin

Background

Suppose you sleep at night thinking about the eight-digit balance in your digital wallet, and suddenly, when you wake up in the morning, the balance is not even worth half the actual amount; what will be your reaction? Most of the cryptocurrency assets are highly volatile, token prices experience various price fluctuations every instance and storing value in terms of assets is a major cause of concern in the digital world.

Therefore, to cater this issue in a decentralized way, the concept of stablecoins is used. A Stablecoin achieves its stability by pegging itself to a less volatile store of value such as fiat or gold; in this way, it represents real money, which makes for its price stability. With this unique value proposition, it would not be an overstatement to claim that the idea of stablecoins fuels the entire concept of digital currencies, and whether you are an institutional user or a retail user, stablecoins are of major significance.

In the next few sections of the article, we will understand more about stablecoins, their use cases, types, and different stablecoin protocols functioning in the decentralized finance ecosystem. We start by defining stablecoins.

Stablecoins

As its name implies, a stablecoin is a digital token which maintains a stable value or price. The stability of the token is maintained by pegging it to a real-world asset such as gold, fiat, or other valuable assets. So, for instance, 1 stablecoin is equal to $1. Usually, stablecoins are backed by fiat because it maintains its purchasing power over a certain period of time. There are fluctuations in fiat currencies as well but these variations are minor as compared to the irregular changes in cryptocurrencies. A peg with a fiat currency such as a US dollar allows the stablecoin to maintain its value over time. A stable currency consequently attracts rational investors to put their assets in the digital space.

Value Proposition

As described previously, the main objective of stablecoins is to create stability in the crypto space so that people invest in the digital asset market without the fear of its speculative nature. Without this stability in the market, users would not be willing to carry out digital asset investments as a direct replacement of traditional fiat currency investments. Therefore, stablecoins offer a double incentive to users in the crypto space: a) a secure and decentralized nature and b) value stability mechanisms similar to a fiat currency.

Types of Stablecoins

Based on the collateral or the type of asset used to back the stablecoin, there are four different types of stablecoins in the cryptocurrency market,.We will briefly talk about each of these stablecoin types in this section.

1. Fiat-backed Stablecoins

These are the most commonly used stablecoins in the crypto space backed at a 1:1 ratio, which means that the denomination of exchange between the stablecoin and the fiat is the same. Fiat-backed stablecoins keep fiat currencies such as USD, EUR, etc., as collateral and for each stablecoin, reserves of a particular fiat currency are kept in the treasury. However, the process is not completely trustless as there is a central authority which acts as a custodian of all the reserves and manages the processes of issuing fiat-backed tokens in exchange for real fiat money. The mainstream fiat-backed stablecoins in the crypto space are USD Tether, True USD, PAX (Paxos Standard) and Gemini Dollar.

2. Crypto-backed Stablecoins

The concept of crypto currency backed stablecoins is similar to fiat-backed stablecoins in which an asset acts as a collateral, however in this case, instead of locking some fiat currency, other cryptocurrency tokens are kept as collateral and those particular tokens back up the stablecoin. Also, since the value of cryptocurrencies differ, the stablecoin does not maintain a 1:1 peg in this case, there are mechanisms designed by the crypto-backed stablecoin protocols to manage price fluctuations of the collateral. A better explanation of these types of stablecoins will be provided when we study the MakerDao protocol later in the article.

3. Non-Collateralized Stablecoins

Non-collateralized stablecoins are also termed as algorithmic stablecoins, since it is based on the implementation of a smart contract. The target price is maintained by either minting and burning or buying and selling the tokens, so for instance if the price of the stablecoin drops below $1, the protocol will burn some of the tokens in supply to restore the value back to $1. Similarly, if the price exceeds $1, 

the protocol will mint new tokens and increase supply so the original value of the coin is restored. Popular examples of such stablecoins are Ampleforth (AMPL), Frax, Carbon, etc.

4. Commodity-backed Stablecoins

Some stablecoins in the crypto space are also backed by precious metals such as gold and commodities such as real estate, oil, etc. The main advantage of such stablecoins is that the prices of commodities are the least volatile as compared to other assets, therefore using them as a collateral would ensure stability. The operations of commodity-backed stablecoins are centralized and the collateral has to be trusted with a third party. Some examples of commodity-backed stablecoins are Tether Gold (XAUT), Paxos Gold (PAXG), Digix, etc.

After developing a thorough understanding of stablecoins in general, the article progresses to dissect “The Maker Protocol”.

The Maker Protocol

The Maker Protocol is one of the largest decentralized applications operating on the Ethereum blockchain which allows its users to create digital currency. The aim of the protocol is to promote economic empowerment around the world through a decentralized solution that provides people easy access to the global financial marketplace, sounds interesting right?

However, before we dive into the core functionalities of the protocol, let’s try and understand the basic structure that it follows. So, there are three major stakeholders of the protocol: its users, governors, and maintainers. The users include Dai holders and vault owners, the governors are the MKR holders and risk management teams and the maintainers are defensive units like oracles, developers, and keepers. The overall functioning of the protocol depends on the performance of each of these stakeholders. Therefore, to develop a coherent understanding of the protocol, we will look into each of their roles and try to decipher as to what makes Maker the first Defi application to gain significant adoption in the Defi ecosystem. 

We will start by explaining the most significant aspect i.e., what does the Maker protocol offer to its users?

Multi Collateral Dai (MCD) System

Introduction

The Maker protocol employs a two-token system, one is the collateral-backed stablecoin that the protocol creates, named DAI and the other is a governance token called MKR. The remaining part of this section will talk about DAI; its core functionality, the value proposition it offers, etc. We will cover MKR in much detail in the governance section.

The Dai Stablecoin

As highlighted in the previous section, Dai is a cryptocurrency-backed stablecoin that can be generated by keeping any asset as a collateral in the protocol. According to the whitepaper of Maker protocol, Dai is a decentralized, unbiased, collateral backed cryptocurrency soft pegged to the US dollar.

The generation of Dai is fairly simple, users can deposit collateral assets in Maker Vaults within the Maker protocol. Based on the size of the collateral, the user can mint a certain amount of Dai. This is how the token enters into circulation and users get access to liquidity. Apart from the regular minting of the token, users can also obtain Dai by trading it on exchanges or receiving it as a form of payment. In a nutshell, once generated: the token can be used like any other cryptocurrency.

Single Collateral Dai Vs Multi Collateral Dai

In the previous version of the Maker protocol, the users could only leverage Ethereum (ETH) as collateral to generate Dai. With ETH being the only asset accepted as a form of collateral, the system was called as Single Collateral Dai (SCD) or Sai, however, the latest version of the Dai Stablecoin system accepts any ethereum based asset as collateral, that is why it is also called Multi Collateral Dai (MCD) system. 

Collateral Assets

As mentioned earlier, users can keep any ethereum based asset as collateral as long as its risk parameters are identified and it is approved by the governance i.e., MKR holders. The risk parameters differ from asset to asset, if MKR holders believe that a certain asset is more risky, its risk parameters would be strict and vice versa. 

Also, the collateral kept by users to generate Dai should be greater in value than the amount of Dai being borrowed, the minimum ratio is 1.5 is to 1 which means that if the user is borrowing $100 worth of Dai, he has to deposit $150 worth of ETH or any other accepted collateral.

Maker Vaults

Maker Vaults refer to the unique set of smart contracts which execute the entire process of holding an asset as collateral and generating Dai. When the user deposits a collateral in the Maker Vault and generates Dai, the collateral is locked in the vault and an obligation is created to repay the debt in Dai, along with a stability fee (the stability fee is similar to an interest charge in centralized finance).

Maker Vaults are non-custodial which means that the protocol has no control over the collateral that the user locks in, each user has complete control over their deposited collateral. However, there is an exception, if the value of the collateral falls below a certain level, the vault can liquidate the asset. We will study more about the liquidation ratio in the governance section.

Also read about stable but flexible currency Ampleforth.

Process of Interacting with a Maker Vault

• Creating a vault

A Maker vault can be created by the user through a network access portal such as My EtherWallet. The user has to fund a certain amount of collateral to generate Dai. The first step is completed when the vault is funded.

• Generating Dai

Then the vault owner has to create a transaction from his wallet to generate a certain amount of Dai in exchange for the collateral. The maximum amount of Dai that can be generated is two-thirds of the total value of the collateral.

• Debt Repayment

If the user wants to retrieve the collateral, he has to repay the debt plus a stability fee, both of these payments are only accepted in terms of Dai.

• Withdraw Collateral

The amount of debt repayment depends on the portion of collateral the user wants to withdraw. After all the debt is repaid and the collateral is retrieved, the vault becomes empty, however, it can be made active again by depositing another collateral. Also, each collateral asset has a separate vault, so if a user wants to deposit two different assets or keep a different level of collateral, he has to open multiple vaults.

Liquidation of Risky Maker Vaults

The provision of debt in the decentralized world is a bit different when compared to traditional finance. In a decentralized setting, a collateral asset is the only thing through which trust is established and from a debt provider’s perspective this could serve as a major risk as the value of the collateral can fluctuate. Also, the concept of liquidation is the reiteration of the point that the value of Dai is derived from the value of the collateral. If there is a significant change in the value of the collateral, Dai would become unstable.

Therefore, in order to ensure that the value of the collateral covers all the outstanding debt (the amount of Dai generated in this case), maker vaults deemed risky by the governance are liquidated through automated Maker protocol auctions. There are two ratios at play while determining the risk of a vault, the liquidation ratio and the collateral-to-debt ratio. The liquidation ratio of each vault is determined by the governance based on the collateral asset type and its associated risk, whereas collateral-to-debt ratio is a simple calculation involving the division of two variables: the total amount of collateral and total amount of debt. 

Maker Protocol Auctions

The auction mechanisms of the Maker protocol are specifically designed to conduct automated liquidations of vaults in case of any instability in the value of the collateral. Let’s have a look at each of these mechanisms:

Collateral Auction

In a collateral auction, the collateral in the liquidated vault is sold by the protocol through an internal market-based auction mechanism. The amount received from the auction is used to cover the debt accumulated by the specific vault collateral type and the corresponding liquidation penalty.

Reverse Collateral Auction

A regular collateral auction is converted to a reverse collateral auction if the amount of Dai bid in the auction is enough to cover the vault obligations and liquidation penalty. The aim of the reverse collateral auction is to sell as little collateral as possible so that the leftover is returned to the vault owner.

Debt Auction

In case the collateral auction is not able to cover the outstanding debt and the liquidation fee, the leftover amount is converted into protocol debt. Protocol debt is sponsored by a fund called Maker Buffer (Dai proceeds accumulated from the Collateral auction). If there are not enough funds in the Maker Buffer, the protocol triggers a Debt auction. During a debt auction, MKR tokens are minted by the system and these tokens are sold to bidders in exchange for Dai.

Surplus Auction

The purpose of surplus auction is to sell the excess amount of funds in the Maker Buffer accumulated through Dai proceeds from auctions and stability fees. It also acts as a measure to reduce the amount of MKR supply in circulation. During a surplus auction, bids are made by MKR holders to receive Dai. After the auction, the amount of MKR tokens collected are burned to reduce its total supply.

Dai Savings Rate (DSR)

To incentivize holding and offer an added use case to Dai token holders, the protocol introduces the concept of Dai Savings Rate (DSR). The function works as a savings account for Dai holders as they can earn interest on the Dai tokens sitting idle in their wallets.

The feature allows users to deposit their Dai in the DSR contract in the Maker protocol. Unlike collateral deposits, there is no restriction on the amount of Dai the user wants to deposit or withdraw from the DSR contract. 

The amount of Dai that a user earns is decided by the Dai savings rate: a percentage value which changes according to the market dynamics. DSR is decided by the MKR holders through voting, it varies as per the typical demand-supply principles i.e., if the price of Dai is above the $1 peg, the DSR is decreased and if the price of Dai is below the $1 peg, the DSR is increased. The adjustments usually take place every week where MKR holders discuss market conditions and reach a conclusion through mutual consensus.

Maintainers of the Protocol

With a thorough understanding of Maker protocol’s core functionalities and internal mechanisms, let’s briefly discuss the role of maintainers: a group of external actors who maintain the operations of the protocol. There are three major maintainers of the protocol:

Keepers

The role of a keeper is similar to an arbitrageur, keepers are external agents who are incentivized to keep the target price of Dai ($1) and its market price in balance. They sell Dai if the target price is greater than the market price and buy them if the case is opposite. Keepers can be humans but usually they are automated bots who can also participate in auction mechanisms when Maker Vaults are liquidated.

Oracles

Like any other protocol, to gauge the real time market prices of collateral assets and decide when to trigger liquidations, the Maker protocol uses price oracles. Internal collateral prices are derived from a decentralized oracle infrastructure that consists of a set of individual nodes called Feeds. Feeds are bots, controlled by individuals, that publish the prices of assets in real time. The published prices are pooled together and a standard price is derived in a smart contract which can then be used by a decentralized application. The maker protocol’s governance selected trusted feeds to deliver price information to the system. 

To protect the system from any malfunctioning, there are several other layers of defense between the oracle and the protocol. One of them is Oracle Security Module (OSM) which sends price inputs to the Maker protocol. The protocol does not receive price inputs directly from the oracles, instead it receives it through OSM. The reason is that oracles can be manipulated and it is not safe for the protocol to receive prices from a third party beneficiary.

Emergency Oracles

Emergency oracles act as a last layer of defense against an attack on oracles. These oracles are able to freeze individual oracles in case a large number of users try to withdraw their assets from Maker vaults in a short time period. Emergency oracles can shutdown the entire system if such a threat exists. We will discuss more about emergency shutdown, when we talk about price stability mechanisms.

Governance of the Maker Protocol

As discussed earlier, MKR is the governance token of the Maker Protocol. MKR token holders are allowed to vote on changes to the protocol. However, the voting is not restricted to MKR holders only, anyone can submit proposals for an MKR vote.

MKR’s role in recapitalization

Apart from the governance, MKR also plays a role in recapitalizing the debt position of the protocol. If the system’s debt increases the surplus, MKR tokens are minted and sold through a Debt Auction (see above in auction mechanisms) to receive the required amount of Dai by recapitalizing the system. The risk of excessive debt inclines MKR holders to govern the protocol more responsibly.

MKR holder responsibilities

MKR holders can vote on the following activities of the protocol:

  • Introducing a new collateral asset with different risk parameters.
  • Changing existing risk parameters or adding new parameters to the existing or new collateral asset types.
  • Choosing the set of oracle feeds (organizations).
  • Determining the Dai Savings Rate (DSR).
  • Triggering liquidations
  • Choosing emergency oracles and triggering emergency shutdowns.
  • Upgrading the overall system through new and efficient mechanisms.
  • Allocating funds from the Maker Buffer to pay for different infrastructure needs or services. The funds in the Maker Buffer are accumulated through Stability fees, liquidation fees, etc.

Risk Parameters of Maker Vaults

As discussed earlier, Maker Vaults have a unique set of risk parameters to ensure that the protocol doesn’t suffer from the collateral depreciation. These parameters vary from asset to asset and are controlled by MKR holders through voting. Some of the key risk parameters are:

Stability Fee

The stability fee of the protocol is similar to an interest rate on a loan. It is an annual percentage yield calculated in addition to the amount of Dai generated against a collateral. The stability fee can only be paid in terms of Dai, after the fee is paid the amount is transferred to Maker Buffer.

Debt Ceiling

Debt ceiling is defined as the maximum amount of debt that the user can accumulate with a given collateral type. The user cannot generate extra debt beyond this ceiling unless some of the debt is paid back. Maker governance assigns debt ceilings to different collateral types.

Liquidation Ratio

The liquidation ratio is decided by the governance on the basis of asset volatility. If the asset is expected to be highly volatile, the liquidation ratio for the vault will be high and if the asset is expected to have low volatility, the liquidation ratio for the vault will be low.

Liquidation Penalty

In case a collateral is liquidated, a small fee is added to the outstanding debt in addition to the stability fee. Liquidation penalty is used to encourage users to keep appropriate collateral levels.

Collateral Auction Duration

The duration of collateral auction depends on the collateral type. Other auction mechanisms such as debt and surplus auction durations are global system parameters.

Auction Bid Duration & Step Size

It refers to the amount of time before the expiry of an individual’s bid and closure of the auction. Auction step size is the specific amount of gap between bid intervals, to prevent people bidding a small amount above the existing bid.

Conclusion

The concept of the Maker protocol is not just a typical innovation in the DeFi industry, it is a decentralized solution to the problems existing in the centralized world as well. The idea of financial inclusion and economic empowerment has been an important concern all around the world in recent years and Maker protocol has addressed these concerns in a secure and trustless manner. The protocol enables people to get credit without any extensive screening, discursive documentation and other rigorous processes that they have to usually go through in a centralized setting. The credit obtained can be used to trade on exchanges, transferred as a form of payment or even converted to fiat currency to meet real world needs. With this unique value proposition and efficient governance mechanisms, MakerDao is considered one of the finest projects operating in the DeFi ecosystem.

Trade Stablecoins with Curve Finance.

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