Introduction

DeFi is steadily reshaping the traditional financial system, creating a new financial landscape. Following Bitcoin, DeFi is leading the way with new value propositions, with lending protocols, decentralized exchanges (DEXs), yield farming, and staking at the forefront of financial innovation.

Among the many DeFi applications, stablecoins play a crucial role. They are key to ensuring the smooth operation of DeFi and the entire crypto space. Stablecoins like USDC, USDT, and DAI play a central role in maintaining stability in the crypto market, providing traders and investors with an effective means to avoid market volatility. MakerDAO aims to combine stablecoin generation with DeFi lending to create an ideal environment for DeFi and its development. As of September 9, 2024, MakerDAO’s TVL stands at $5.122B. On August 27, MakerDAO announced its rebranding to Sky Protocol, with significant upgrades to its governance token MKR and stablecoin DAI. MKR will be upgraded to the new governance token SKY, while DAI will be upgraded to the new stablecoin USDS (Sky Dollar). The following will introduce MakerDAO before the upgrade.

Source: Defillama.com

What is MakerDAO?

MakerDAO is an Ethereum-based protocol designed to maintain the stability of DAI through decentralized means. DAI is a stablecoin pegged to the US dollar, backed by the Maker protocol. Users can generate DAI by locking up crypto assets (such as BTC and ETH) and retrieving the collateral when needed.

This system eliminates dependence on traditional centralized financial institutions, allowing users to manage their currency more autonomously.

The Maker protocol relies on two core tokens: DAI and MKR. DAI is the stablecoin generated through collateralized assets, while MKR is the governance token, granting holders voting rights on protocol proposals. MKR holders can vote to adjust key parameters such as interest rates and debt ceilings, ensuring the smooth operation of the protocol.

Unlike traditional financial systems, MakerDAO’s decision-making process is community-managed, making the governance process more decentralized. This open governance structure avoids the potential opacity and unfairness that can occur in traditional centralized financial institutions.

What is DAI?

DAI is a specific type of cryptocurrency generated by the MakerDAO system, with its core feature being its soft peg to the US dollar—1 DAI is approximately equal to 1 USD. As a stablecoin, DAI’s value is relatively stable, unlike other cryptocurrencies like Bitcoin or Ethereum which experience significant volatility. Because of this stability, DAI is widely used both within and outside the DeFi ecosystem. DAI’s stability is maintained through an algorithmic mechanism—any user who generates or borrows DAI must open a collateral vault on the Maker platform and deposit assets as collateral. The collateral’s value must always exceed the amount of DAI generated, and if the collateral’s value drops below a critical point, the smart contract automatically triggers liquidation.

Key Functions of MakerDAO

In the DeFi ecosystem, MakerDAO and its DAI stablecoin are highly regarded for their wide range of use cases, including lending, trading, and serving as a stable store of value during market fluctuations. Below are some of

MakerDAO’s key functions:

• DAI Stablecoin
  DAI is a stablecoin pegged to the US dollar, designed to maintain a 1:1 exchange rate with the dollar. Unlike stablecoins issued by traditional financial institutions, DAI’s collateral primarily consists of BTC, ETH, and other assets MKR holders approve. Users generate DAI by locking collateral on the MakerDAO platform, obtaining a decentralized and collateral-backed stablecoin.

• Collateralized Debt Position (CDP)
  Generating DAI requires users to create a Collateralized Debt Position (CDP) on the MakerDAO platform. This smart contract allows users to lock assets as collateral and generate DAI based on the collateral’s value. Users must maintain a certain collateralization ratio to ensure system stability. If the collateral’s value drops below a threshold, the CDP is liquidated, and the locked collateral is auctioned off to repay the debt.

• MKR Token
  In addition to DAI, MakerDAO has a governance token called MKR. MKR holders play a key role in platform governance, making decisions related to parameter settings, risk management, and system governance. MKR is also used to pay system fees and penalties. When a CDP is liquidated, a portion of the collateral is used to buy back and burn MKR, reducing the token supply.

• Governance and Voting
  MKR holders participate directly in MakerDAO’s governance by voting on platform proposals and parameter adjustments. The decentralized governance mechanism allows the community to collectively decide on stability fees (i.e., the interest rate for generating DAI), acceptable collateral types, and other key parameters.

• Decentralization and Stability
  MakerDAO aims to provide a stablecoin (DAI) that does not rely on centralized institutions or traditional financial systems, enhancing market stability. Its decentralized and transparent design reduces manipulation risks and ensures DAI’s stable value.

• Transparency
  MakerDAO operates on the blockchain, and the system’s processes are highly transparent and auditable. Users can track the issuance and circulation of DAI on the blockchain, ensuring the system’s openness and transparency.

Token Upgrade Rules

MakerDAO’s new token and product releases took place on September 18, 2024. The updated tokens following the brand upgrade include the following two tokens:

USDS

USDS is the upgraded stablecoin of the Sky ecosystem. It can be upgraded from Dai or converted from USDC at a 1:1 ratio. USDS can also be converted back to Dai, and the token upgrade is a voluntary choice for users.

SKY

The governance token of the Sky ecosystem is SKY. MKR holders can upgrade their MKR to SKY, and SKY can be converted back to MKR. During the token upgrade, each MKR will be exchanged for 24,000 SKY, and the upgrade is a voluntary choice for users.

DAI Tokenomics

As a core component of the MakerDAO ecosystem, the DAI token’s economic system relies on a complex mechanism to maintain DAI’s value near 1 USD. Below are several key elements of the DAI token economic system:

• Stability and Peg: The core goal of DAI is to maintain its value close to 1 USD. The system achieves this through an over-collateralization mechanism and smart contracts to ensure stability.
• Collateral Mechanism: DAI is generated when users lock crypto assets as collateral in smart contracts, forming Collateralized Debt Positions (CDP). In addition to BTC and ETH, other crypto assets the community recognizes can also be used as collateral.
• Over-Collateralization: When generating DAI, users must maintain a collateralization ratio well above 100%. This high collateral ratio ensures that the collateral’s value far exceeds the DAI generated, reducing the risk of under-collateralization.
• Stability Fee: Users must pay a fee when generating DAI through collateralization. The fee is set by the MakerDAO community via governance mechanisms and is designed to incentivize users to repay DAI promptly, helping to maintain its stability.
• Liquidation Mechanism: When the market value of the collateral falls below the set threshold, the system initiates a liquidation process, selling the collateral to repay the outstanding DAI, ensuring sufficient collateral backing for DAI.
• DAI Savings Rate (DSR): The DAI savings rate is a mechanism that allows DAI holders to earn interest by locking their DAI in the DSR smart contract. The rate is adjusted by community governance based on market conditions.
• Spark: Spark’s mission is to enhance the DAI ecosystem. As part of the ecosystem, Spark builds and manages DeFi infrastructure. Spark primarily includes three product categories: SparkLend, Cash and Savings, and SparkConduits. SparkLend is a decentralized lending market built on Aave v3’s open-source code.
• Debt Ceiling: The total amount of DAI generated through CDP is limited by a debt ceiling, which MKR token holders set to manage the system’s overall risk exposure.
• Burn and Auction: When users pay stability fees or penalties, the MKR tokens paid are burned, reducing the total supply of MKR in the market. Additionally, in the case of CDP liquidation, MKR tokens may be sold to repay the system’s outstanding debt.
• Automated Market Makers (AMM): The system relies on decentralized automated market makers to support DAI’s trading, playing a crucial role in maintaining DAI’s peg to the US dollar.

DAI Use Cases

DAI’s stability provides it with a wide range of use cases. As a stable store of value, DAI is widely used to hedge against market volatility, helping to avoid the risks associated with the dramatic price fluctuations of other cryptocurrencies. In decentralized trading, traders use DAI as a unit of account, offering relatively stable trading pairs. DAI is also one of the core assets of DeFi lending platforms, allowing users to borrow DAI by collateralizing assets, benefiting from its stable value without worrying about currency value fluctuations when repaying loans.

In terms of earning yield and providing liquidity, DAI also plays an important role. DeFi users often provide DAI to decentralized exchanges (DEX) and liquidity pools to earn transaction fees and rewards. Its stability makes it a preferred asset for liquidity provision. Additionally, DAI is widely used for cross-border remittances and international payments, with its low fees and price stability making it an ideal choice for transferring value.

For businesses and individuals, DAI can help reduce the risk of price fluctuations associated with holding other digital assets. For example, businesses or individuals accepting cryptocurrency payments can convert their funds to DAI to ensure the value of their funds does not fluctuate with the market. Many DApps and blockchain projects have also integrated DAI as a stablecoin within their ecosystems, further enhancing platform usability and user experience.

How Does MakerDAO Operate?

MakerDAO’s governance is led by MKR token holders. MKR holders vote on key decisions through “executive votes,” and if a proposal passes, the corresponding code is modified to implement it. Before an executive vote, proposals undergo initial community evaluation, known as proposal voting. While anyone can submit proposals on the MakerDAO forum, only MKR holders can vote on these proposals, and voting weight is based on the number of tokens held, not the number of holders.

MKR holders are also responsible for setting the DAI Savings Rate (DSR), which is the rate DAI holders earn when saving DAI on the platform. When DAI’s price exceeds 1 USD, the savings rate is typically lowered to reduce demand, and when DAI’s price falls below 1 USD, the savings rate is raised to stimulate demand.

Generating DAI involves depositing Ethereum (ETH) or other approved cryptocurrencies into MakerDAO’s smart contracts as collateral to generate DAI. The value of the collateral must be at least 150% of the generated DAI. If the collateral’s value falls below this ratio, the CDP will be liquidated, and the collateral will be sold to repay the DAI debt and associated fees. The DAI Savings Rate (DSR) allows users to earn interest by locking their DAI, with the interest funded by the stability fees charged when generating DAI.

Relevant Data

In 2020, MakerDAO created an RWA vault using real estate development-backed loans from project 6s Capital as collateral and partnered with the RWA-based lending platform Centrifuge to tokenize collateral. In MakerDAO’s Endgame Plan, released in May 2022, one of the key aspects emphasized for building a decentralized stablecoin is using RWAs as collateral.

According to MakerBurn data, there are currently 11 RWA projects, with assets totaling $1.25 billion serving as collateral for MakerDAO.

Source: MakerBurn, data as of 2024.09.12

In July 2020, MakerDAO launched the PSM (Peg Stability Module) for DAI’s liquidity to provide bilateral protection for DAI’s price. Users can deposit stablecoins like USDC, supported by the protocol, and mint DAI at a fixed 1:1 exchange rate, with a transaction fee of 0.1%. According to Dune data, approximately 32.9% of MakerDAO’s collateral currently consists of PSM-related assets, and 23.5% consists of RWA assets.

Revenue from RWA assets has significantly increased MakerDAO’s profits, accounting for approximately 27.6% of total revenue.

Source: Dune.com

Source: Dune.com

What Risks and Challenges Does MakerDAO Face?

• Stability Dependence on Collateral Price Volatility

The chart above shows that approximately 20% of MakerDAO’s collateral consists of BTC or ETH-related assets. DAI’s stability depends on the volatility of its collateral value. Since BTC and ETH are highly volatile, maintaining DAI’s stable exchange rate with the US dollar presents a challenge.

• Liquidation Risk

When market fluctuations cause collateral to be insufficient to cover the debt, MakerDAO initiates liquidation through an automated process. If the liquidation does not generate enough DAI, the unpaid debt is transferred to the “Maker buffer.” The system mints and sells MKR tokens through debt auctions if there is insufficient DAI in the buffer.

• Regulatory Risks of New Collateral

As shown in the chart above, 32.9% of MakerDAO’s collateral currently consists of PSM-related assets and 23.5% consists of RWA assets. This reliance on centralized stablecoins and Real-World Assets (RWAs) could introduce regulatory risks, causing the decentralized DAI stablecoin system to lose credibility.

• Oracle Price Deviation

MakerDAO relies on oracles to input price data into its smart contracts. Due to slow block generation, oracles may introduce price deviations, potentially forcing MakerDAO debt holders into liquidation due to inaccurate price inputs.

Conclusion

As one of the most mature decentralized applications on the Ethereum blockchain, MakerDAO empowers the decentralized finance platform with its unique dual-token model (MKR and DAI). The platform allows users to collateralize crypto assets and generate the DAI stablecoin, enabling participation in various decentralized financial activities. With continuous technological and application expansion, MakerDAO has broad potential for future development and may continue to play a leading role in decentralized finance.