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The Open Finance Series Part 1: MakerDAO

The Open Finance Series Part 1: MakerDAO

Decentralising many of our financial institutions (or rather, the purposes they serve) has long been a goal for many blockchain projects. Bitcoin began life as a “A Peer-to-Peer Electronic Cash System”, with payments being one of (alongside deposits/savings) the most frequently used banking facilities.

Recent months have seen the proliferation of the idea of ‘Open Finance’, yet another narrative designed to explain or to assign value to protocols. The term has already earned the scorn of many but it is clear there are numerous projects aiming to facilitate and decentralise elements of financial systems and institutions. Over the next couple of months I will be taking a look at some of the projects which make up this ‘Open Finance’.

 A nice overview of the many Open Finance services in development;  Felix Feng

A nice overview of the many Open Finance services in development; Felix Feng

First on the list is MakerDAO (henceforth Maker), a project I wrote about in this month’s issue of 21Cryptos as the ‘DApp of the Month’. The idea of the segment is to look at DApps that are operational and open for business, in an attempt to encourage people to try these nascent services out. As a sidenote, I would encourage giving the magazine a read as there are many talented and interesting authors featured. The publication is also both level-headed and free from many of the ills that taint the space which is why I was keen on contributing to it and I’ll be doing five articles a month focusing on the ‘Learn’ section.

Now, on to Maker…

What is it?

Maker is positively an elder statesman by crypto standards. Announced in 2015, the project has been one I’ve followed for a considerable period. If I was ever asked to give an example of a DApp it would have inevitably have been Maker but curiously I have never owned or traded it. I’ve also been meaning to do a write-up of it for at least two years but for one reason or another have never got around to it.

This series provides the perfect reason to finally do it, however, as Maker covers two elements crucial to any financial system — stable money and easy lending/borrowing.

It has a reputation for being a complicated project to understand but I would contend it has one of the simplest visions which, when understood, allows the constituent parts and designs of its system to become clear.

Maker’s avowed goal is the facilitation of a decentralised stablecoin.

Why a stablecoin?

Because it frees users from having to worry about the extreme price volatility current cryptoassets suffer from which should encourage them to transact using crypto. For those unfamiliar, a stablecoin is one, which as the name suggests, remains at or near a fixed value. These are usually, but not always, pegged to another currency (such as Tether, pegged to USD1) or other assets (such as gold).

Why decentralised?

Because it should allow for lower interest rates to be charged (no banking overheads to worry about), provide transparency (thanks to all transactions being visible to all on the blockchain) and means that it is open to everyone — no need to worry about KYC, being turned down for a loan, complying with onerous requirements, asset seizure or any of the other myriad of banking issues. And of course, removing the need for an intermediary removes the need to trust any intermediary

What problem is it trying to solve?

In addition to the above issues, Maker is trying to solve issues with competing stablecoin implementations. Chief amongst these is inextricably linked with the decentralisation point above. The most (in)famous and widely used stablecoin is Tether, believed to be either a useful tool to move in and out of crypto or a mechanism to pump the markets depending on whom you listen to.

Tether is ultimately reliant upon a bank. To buy Tether an investor must buy Tether from the source, who ‘print’ new Tether which are put into circulation. These Tether are then exchanged for Bitcoin or other cryptoassets.

There are two obvious issues here:

  1. We have to trust the company behind Tether that for every Tether (USDT) produced it has received USD 1. If, instead, the company are just printing USDT and exchanging them for BTC themselves then there are no assets backing Tether and therefore it is based on a house of cards which will eventually see USDT crash to zero

  2. Tether, as a company, must rely upon external banking relationships. This means that they are at risk of their banking partners refusing to serve them, as has happened before. This means that they are unable to offer unfettered service and ensures it is incumbent upon them to comply with KYC and AML regulations

Although the stablecoin aspect takes the lion’s share of attention, the trustless mechanism for borrowing and lending is also exciting and should open up new opportunities for users and entities alike.

How does it work?

Maker comprises two elements:

  • DAI: Dai is the stablecoin implementation. 1 Dai = 1 USD.

  • MKR: Whereas Dai is what is intended to be created and used by people, MKR is the more typical cryptoasset. Holders of MKR are afforded a proportional say in the running of the system. Owing to the way Maker works, as shall be shortly seen, the success of Dai should correlate with an increase in price of MKR. Therefore, if you wish to benefit financially from any future success of Maker, you would buy MKR. However, you do not need to buy MKR to buy DAI — the two are related, but functionally separate.

The process of acquiring, using and divesting Dai follows this rough process:

  1. User creates what is known as a Collateralised Debt Position (CDP) by sending a transaction to the Maker address.

  2. They then choose an amount of ETH to deposit. This funds the CDP. This also has the effect of converting the ETH into first Wrapped Eth (WETH) which basically turns ETH into a ERC20 (e.g. like all other tokens running on the Ethereum network). This WETH is then turned into Pooled ETH (PETH) in order for it to be merged with the rest of the collateral which underpins the generated Dai.

  3. User sets their Loan to Value (LTV) rate (there is a minimum as to how much leverage a user can take on). A deposit of 10 ETH at a LTV rate of 50% would mean that if ETH was worth $300 a user could borrow 1,500 Dai (10 ETH *300 = $3000, 50% LTV = $1500 = 1,500 Dai).

  4. User receives Dai in return for pledged collateral. You don’t have to withdraw all the Dai available to you at once — you can draw it out over time or not at all.

  5. When user wants to pay back the loan and get their ETH back they pay the necessary amount of Dai back. If they borrowed 100 Dai they would pay back the 100 Dai and then pay an interest payment on top. This interest payment burns an equivalent amount of MKR, making MKR a deflationary asset (hence why increased Dai usage should see MKR rise in price ceteris paribus)

  6. The price of ETH is set throughout the process by use of oracles (which take price data from external sources and relay it to the Maker system).

  7. User gets their original collateral back

The whole process works pretty seamlessly and is worth trying out if you’re unconvinced. It is important to note this is simply how you use Maker to acquire Dai — you can also just buy it as with any other cryptoasset on exchanges.

The collateralisation is important because it is intended to ensure that no matter what, the holdings of Maker are enough to sustain the amount of Dai that has been generated. For example, if users could deposit 1 ETH @ $300 and receive 300 Dai back, then if ETH dropped in price to $200 the next day then the system would effectively be underwater and it would be in the users interest to default on the loan (because they could sell their 300 Dai for $300 and then buy back 1.5 ETH).

If the price of the pledged collateral was to drop then the user would be faced with either having to pledge more collateral (to make sure their CDP didn’t go underwater) or see enough of their ETH liquidated to bring their CDP back to the requisite borrowing level. This happens automatically, and only liquidates enough to bring the user back to the required level rather than taking the whole amount.

MKR holders are incentivised to prevent risky borrowing behaviour by users as a whole. If the wider userbase was to go underwater on their collateral (e.g. if all cryptoassets dropped sharply and suddenly) then an additional and proportional amount of MKR would be generated to make sure there was enough collateral backing again. This should, again all things being equal, see the value of MKR reduce owing to the increased supply.

This is one of the common arguments against Maker’s long term viability — if there was an unexpected and wide ranging event which caused all cryptoassets (or even all global assets) to drop precipitously overnight then Maker could enter a death spiral from which it could not recover. The value of assets drop, necessitating liquidation. Liquidation would (if Maker got large enough) mean values would drop further, which would require further liquidation and so forth. If all other assets were to drop then MKR would likely drop too, meaning that more and more MKR would need to be generated as collateral.

In addition to the aforementioned governance and MKR generation to ccover losses, the system uses target prices and target rates to keep Dai at or near $1. This is done automatically by the Maker system and essentially incentivises either increasing or decreasing supply in order to reciprocally increase or decrease supply to bring the price back to $1.

As a result of this, and ensuring that $1 of Dai is always backed by at least $1 of collateral, the value of Dai should (and it is by no means assured at this stage until proper stress testing and unpredictable events are experienced) remain near $1, even if it is never exactly $1.

If the worst-case scenario did happen and the value of Dai irredeemably broke with its peg or the system suffered a failure so severe it could not recover then MKR holders are able to invoke what is known as ‘Global Settlement’. This essentially shuts down the system and distributes all collateral to users. The project would be dead, but funds would at least be protected (to a degree).

Anything else?

One of the big issues with any working crypto products is that of adoption. In a bid to encourage wider usage, Maker has recently slightly amended its reward structure and continues to partner widely across the Ethereum landscape.

These aforementioned amends saw Maker announce changes in a bid to encourage the demand for Dai which sees Dai holders given a proportion of the rewards previously allocated to MKR holders. The idea is that by doing this, it will lead to Dai generation and therefore adoption, which will ultimately enrich MKR holders.

An important goal on the roadmap is to move to a multi-collateral Dai. This means that users could then pledge a variety of different assets, including DigixDGX and OmiseGo, as opposed to solely ETH. This is set to launch imminently, with the testnet deployment coming on September 17th.

The team has also been working to make Dai a feature of the many decentralised exchanges, such as AirSwap, Bancor, Radar Relay and Kyber Network. Again, this is an obvious fit. We can’t trade USD on decentralised exchanges, but many will prefer to trade against a USD replacement than against ETH. This extension of fiat is reflected also in the recent announcement that Dai would be a trading pair on Wyre, a blockchain money transfer company, which facilitates fiat on and off-ramps.

These partnerships are complemented by a number of other ventures with other Ethereum projects, including bZx, CargoX, STK, Request.Network and Lendroid. There are many more projects that will likely benefit from a trusted stablecoin.

Conclusion

I chose to start this series with Maker not solely because of its longstanding nature, but also because it fulfils a clear need. It focuses on a couple of problems, and the team have done a good job of focusing just on elements needed to solve those pain points. Having used it myself, I find it one of the most compelling projects around with clear use cases.

For anyone who has had to deal with a bank when trying to obtain a loan, the ability to create and take one out without needing to pass multiple tests, prove earnings and provide identification is a pretty amazing experience.

For example, many people around the world (and it is certainly not confined to poorer countries) live month to month. They often have to resort to payday loans and are forced to use rapacious and often under regulated companies. Maker solves a big part of that immediately. Instead of pledging watches or jewellery and paying steep fees, or taking out unsecured loans at even higher fees, a system like Maker allows for instant and low interest borrowing. There remains issues with on ramp/off ramp so people can use their borrowed funds for their everyday purchases, but it is a start.

The other reason I chose to begin with Maker was because one of the problems it solves is one of the most obvious issues crypto faces to widespread adoption (ignoring the store of value debate). There is plenty of justified scepticism around stablecoins, and particularly around if they can maintain their peg under unpredictable market circumstances. Time will tell how it holds up; caution should be preached until rigorous challenges are faced. It is a complex and difficult challenge to solve.

However if it can produce a tried and tested stablecoin then, given its position as both an established project as well as the relative lack of competition, Maker could emerge as a central pillar of not just open finance but of the Ethereum ecosystem as a whole. The exciting aspect of Maker is what new uses and products a stablecoin could give rise to, for a stablecoin is a central pillar upon which many other teams could build upon.

If you enjoy my articles then please follow me @flatoutcrypto.

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