Why is MakerDAO considered the "craziest" DAPP on Ethereum?
In an interview with Vitalik Buterin, the host asked him, “What’s the craziest application of the Ethereum that you’ve come across lately?” Vitalik Buterin's response was, “I am definitely impressed by MakerDAO”![
MakerDAO is the first DAO organization established on Ethereum (based on the establishment time rather than the product launch time, currently recognized as the first DAO on Ethereum is The DAO based on product launch time). In the entire stablecoin market, DAI is number one in terms of the scale of decentralized stablecoin applications, and in the DeFi field, MakerDAO has a disruptive role and significance. The over-collateralization mechanism of MakerDAO eliminates the risk of "printing money out of thin air" and is a fully on-chain system, with no risk of centralized custody.
This article is a personal analysis and does not constitute any investment advice. If there are any inaccuracies, please feel free to point them out.
MakerDAO is a DeFi project running on Ethereum that integrates over-collateralized stablecoins, lending, storage, and user governance and development, and it is currently the DeFi project with the highest TVL on Ethereum.
The core of MakerDAO is the Maker Protocol, which allows users to collateralize crypto assets to mint a decentralized stablecoin DAI pegged to the US dollar. DAI maintains price stability through over-collateralization and adjustments to the DSR (DAI Savings Rate) deposit interest rate.
When the value of the DAI minted by users exceeds the collateral value allowed by the Maker Protocol, it will face liquidation auction and incur a liquidation penalty. If the auction amount is sufficient to repay the debt, it will enter a second stage auction to ensure that the liquidated party can recover more collateral. If the debt exceeds the collateral, the Maker Protocol will bear the unfulfilled debt.
MakerDAO once experienced a "zero-dollar purchase" incident, but the loophole did not originate from the protocol itself but from issues with the liquidation mechanism parameters. MakerDAO has an emergency handling mechanism to ensure that the Maker Protocol can withstand systemic risks.
MKR is the governance token of the Maker Protocol and also serves as a source of capital restructuring. Holding MKR allows participation in MakerDAO governance. When the Maker Protocol is insolvent, funds can be raised through the over-issuance of MKR auctions to repay debts. When the funds in the Maker Protocol treasury reach a certain amount, DAI will also be auctioned to buy back and destroy MKR.
The governance system of MakerDAO shows a trend towards centralization, with a high concentration of MKR leading to "oligarchic" governance, as the top 100 addresses control 83.41% of the total MKR supply.
Table of Contents
- MakerDAO - The King of DeFi
- What is a decentralized stablecoin - DAI?
- How to generate DAI? How does DAI maintain price stability? How to leverage DAI using the Maker Protocol?
- How does the DAI liquidation mechanism work?
- Is the Maker Protocol really safe?
- What is MKR? What can MKR be used for?
- Decentralized governance or oligarchic governance of MakerDAO?
1. MakerDAO - The King of DeFi#
What is MakerDAO?
MakerDAO is a project running on the Ethereum blockchain that integrates over-collateralized stablecoins, lending, storage, and user governance and development. The core of MakerDAO is the Maker Protocol, also known as the Multi-Collateral Dai (MCD) system, which allows users to use protocol-approved assets as collateral to generate the decentralized stablecoin DAI. As of July 26, 2022, MakerDAO's TVL is $8.03B, firmly sitting at the throne of DeFi.
How was MakerDAO established?
Rune Christensen was an active member of the Bitshares community before Ethereum emerged in 2014 and explored launching the stablecoin DAI on the BitShares platform. However, Rune Christensen found that the Bitcoin network was insufficient to support a complex financial system and ultimately chose Ethereum, known as the "world computer," because, unlike Bitcoin, which has a very limited scripting language, Ethereum is a general-purpose programmable blockchain that runs a virtual machine capable of executing arbitrary and infinitely complex code, enabling smart contracts on Ethereum.
MakerDAO founder Rune Christensen first presented the vision of Maker to the world through Reddit in March 2013, aiming to create a US dollar-pegged stablecoin supported by Ethereum. MakerDAO was officially established in 2014, becoming the first decentralized autonomous organization on Ethereum (by establishment time). In March 2015, the prototype of the Maker Protocol was born, and founder Rune Christensen shared the design of the protocol, contract code, and test front-end with members of the Ethereum community, including Vitalik Buterin. Between 2015 and 2017, he began the first iteration of the code, architecture, and documentation with developers from around the world. In mid-2016, MakerDAO launched the first decentralized trading platform on Ethereum: OasisDEX (now Oasis.app). In December 2017, MakerDAO officially launched the first version of the MakerDAO white paper on Ethereum, introducing the DAI stablecoin system. Founder Rune Christensen published a blog post on July 20, 2021, titled "MakerDAO Has Come Full Circle," announcing that the Maker Foundation had completed its mission and would dissolve in the coming months, fully transferring governance to the community, achieving true decentralization.
2. What is a decentralized stablecoin - DAI?#
DAI is a decentralized stablecoin pegged to the US dollar, generated through over-collateralization via the Maker Protocol on MakerDAO. The total supply depends on the value of the collateral on the Maker Protocol. As of July 26, 2022, a total of 7,320,165,935 DAI have been minted, ranking fourth in total market capitalization among all stablecoins, making it the largest decentralized stablecoin by market cap.
What exactly is a decentralized stablecoin? What is the difference between centralized and decentralized stablecoins?
Decentralized Stablecoins
Decentralized stablecoins are typically divided into algorithmic stablecoins and over-collateralized stablecoins. They can be understood as stablecoins minted through a series of algorithms and smart contract designs rather than a centralized entity. Over-collateralized stablecoins do not generate value out of thin air, as they are usually minted by locking up certain assets. To retrieve the locked assets, the corresponding over-collateralized stablecoins must be destroyed. In contrast, purely algorithmic stablecoins are minted through a pre-designed mechanism, which may have design flaws, with the classic case being the LUNA collapse, where UST was pegged to LUNA (which created its own peg).
Representative decentralized stablecoins include:
DAI: DAI is an over-collateralized stablecoin minted through the MakerDAO on Ethereum by collateralizing specified assets.
UST: UST is a purely algorithmic stablecoin minted on the Terra blockchain through a pegging mechanism that burns $1 worth of LUNA to mint 1 UST.
FRAX: FRAX is an algorithmic + over-collateralized stablecoin minted on Frax Finance by algorithmically collateralizing a certain ratio of specified assets and FXS (governance token).
AUSD: AUSD is an over-collateralized stablecoin minted on AlpacaFinance by collateralizing deposits on AlpacaFinance.
Centralized Stablecoins
Centralized stablecoins are crypto tokens with "pegging" attributes, aiming to peg to a certain off-chain asset and maintain the same value. To maintain price stability, centralized stablecoins are backed by off-chain assets. For example, when issuing a USDT, Tether prepares a one-dollar reserve guarantee. To ensure that the stablecoin's value is linked to the amount of supporting assets, centralized issuers typically hire independent accounting firms or auditing agencies to regularly verify the supporting assets in the custody accounts.
Representative centralized stablecoins include:
USDT: USDT, also known as Tether, is a stablecoin issued by the American company Tether to maintain parity with the US dollar, i.e., 1 USDT = 1 USD. Users can exchange USDT for USD at a 1:1 ratio at any time. Tether promises a 1:1 guarantee, meaning that for every new USDT issued, there will be an additional $1 in its bank reserve account, ensuring the safety of investors' funds (but the actual reserve account is not publicly disclosed).
USDC: USD Coin (USDC) is a fully collateralized stablecoin pegged to the US dollar, issued and managed by a joint venture between Circle and the exchange Coinbase, and its financial status is publicly reported monthly by the professional service firm Grant Thornton.
BUSD: Binance USD (BUSD) is a stablecoin approved by the New York State Department of Financial Services (NYDFS) and issued in partnership with Paxos, pegged to the US dollar at a 1:1 ratio. BUSD is also the first stablecoin with its own independent client app. For every BUSD in circulation, there is a corresponding $1 asset held in the bank, audited by an independent third-party accounting firm, with audit results disclosed regularly.
TUSD: TUSD is a stablecoin launched by TrustToken, pegged to the US dollar at a 1:1 ratio. TrustToken is a digital asset platform based in San Francisco, USA, primarily simplifying cryptocurrency trading services and cryptocurrency hedge funds. Unlike Tether, which controversially insists on bank account audits, TrueUSD uses third-party trust companies and independent accounting firms to provide regular audits, offering strong legal protection for holders. TrustToken also plans to launch stablecoins pegged to the Australian dollar, Euro, Canadian dollar, and Hong Kong dollar: TAUD, TEUR, TCAD, and THKD.
DAI belongs to the category of over-collateralized stablecoins among decentralized stablecoins. Essentially, the minting of DAI does not increase the total value of the crypto market, as the minting of DAI means that the collateral assets worth more than the minted DAI are locked in a smart contract and cannot circulate. In contrast, the minting of centralized stablecoins can increase the total value of the crypto market, as the minted centralized stablecoins reflect real value - fiat currency.
3. How to generate DAI? How does DAI maintain price stability? How to leverage DAI using the Maker Protocol?#
Generation Mechanism
DAI is minted by users through over-collateralizing assets via the Maker Protocol, which is implemented by users through Oasis.app. The principle is that users create a vault on Oasis to lock up crypto assets as collateral, and then decide how much DAI to generate. Users can only generate DAI worth less than the collateral value, and when redeeming the collateral assets, they must pay a stability fee. The collateral types supported by the Maker Protocol include over 20 types, such as ETH and WBTC, with each asset's collateralization ratio and stability fee determined by the asset's risk index and the governance of MKR holders. For example, if a user wants to collateralize mainstream assets like ETH, WBTC, or stETH to mint DAI, and they want to mint 1000 DAI, they would need to collateralize ETH worth $1700, WBTC worth $1750, or stETH worth $1850 to mint DAI, with stability fees of 0.5%, 0.75%, and 0.75%, respectively. The interest generated belongs to the Maker Protocol, not Oasis.app.
How does DAI achieve price stability?
Although DAI is designed to be pegged to the US dollar at a 1:1 ratio, it can still experience price discrepancies due to market behavior. The MakerDAO community uses the DAI Savings Rate (DSR) to allow all DAI users to automatically earn savings yields to balance market supply and demand. Users only need to lock their DAI into the DSR contract of the Maker Protocol, with no minimum deposit requirement. Users can withdraw part or all of their DAI from the DSR contract at any time.
When the market price of DAI deviates from the target price due to market changes, MKR holders can vote to change the DSR to maintain price stability:
If the market price of DAI exceeds $1, MKR holders can choose to gradually lower the DSR to reduce demand, bringing the market price of DAI back down to the target price of $1.
If the market price of DAI falls below $1, MKR holders can choose to gradually increase the DSR to stimulate demand, bringing the market price of DAI back up to the target price of $1.
DAI is not generated out of thin air, so who pays this interest?
The interest on DAI is paid from the revenue of the MakerDAO stability fee. If the revenue from the stability fee cannot cover the total expenditure of the DAI Savings Rate, the deficit is recorded as bad debt, and MKR is over-issued to cover the deficit, making MKR holders the bearers of the risk.
How to leverage using the Maker Protocol?
Once a user establishes a vault, they can borrow DAI in the vault on Oasis.app through the Oasis Multiply feature by paying interest specified by MKR holders to purchase more collateral positions. This allows users to gain more returns as the value of the collateral assets rises, but it also exposes them to higher liquidation risks if the asset value falls.
Users can also choose to put the minted DAI and USDC into Uniswap V3 for liquidity mining and leverage DAI on Oasis.app to achieve higher liquidity mining rewards.
4. How does the DAI liquidation mechanism work?#
After users mint DAI, if they want to retrieve the assets locked in the vault, they need to return the DAI to reclaim the collateral crypto assets from the vault. The returned DAI will be automatically destroyed by the protocol to balance the value of the collateral assets and the value of DAI.
Liquidation Mechanism
When the value of the DAI generated by users remains less than the value of the collateral allowed to generate DAI, everything operates normally. However, if the value of the collateral decreases, causing the value of the DAI generated by users to exceed the value allowed by the collateral, for example, if the collateralization ratio for minting DAI with ETH is 2:1, and a user mints 1000 DAI with ETH worth $4000, the $4000 worth of ETH can mint a maximum of 2000 DAI. If the price of Ethereum drops below $2000, the value of the 1000 DAI minted will exceed the maximum value of DAI allowed to be minted with Ethereum worth less than $2000, triggering the liquidation process. Liquidation means that the user no longer needs to return the DAI, and the user's generated vault will be confiscated for collateral auction to repay the DAI owed to the system. Additionally, the liquidated user must pay a liquidation penalty. MKR holders in the Maker community will set different liquidation penalties for different types of collateral, and the value of the collateral being auctioned will include the amount of the liquidation penalty.
The auction process consists of two stages: Collateral Auction and Reverse Collateral Auction:
Collateral Auction: In the first stage of the collateral auction, bidders start bidding on the auctioned collateral. The highest bidder pays DAI to acquire the collateral at a low price, and the repurchased DAI is used to repay the treasury's outstanding debts and liquidation penalties.
Reverse Collateral Auction: If the DAI obtained from the first stage auction is sufficient to repay the treasury's debts and cover the liquidation penalties, the auction will enter the second stage, where bidders bid for a fixed price of DAI to take away less collateral, aiming to allow the original vault owner to recover as much collateral as possible while ensuring that all DAI debts are repaid.
The auction process is illustrated below:
When the first stage auction is sufficient to repay the debt, the second stage is initiated.
When the first stage auction is insufficient to repay the debt, the second stage is not initiated, and the outstanding debt is paid by the Maker Buffer.
There is a concept called the Maker Buffer, so what is the Maker Buffer?
The Maker Buffer is part of the Maker Protocol, a treasury that does not belong to anyone. The stability fees generated when users use the protocol and the proceeds from auctions (such as liquidation penalties) flow into the buffer. The debts generated by the Maker Protocol (such as under-collateralized auctions) are borne by the buffer. If the buffer does not have enough DAI to repay the Maker Protocol's debts, the Maker Protocol will trigger the Debt Auction mechanism.
Debt Auction Mechanism: When the DAI in the buffer is insufficient to repay Maker's debts, the Maker Protocol will over-issue MKR to initiate the auction process. Bidders can use DAI to bid for MKR, and the DAI obtained from the auction will enter the buffer to repay the debt.
But wouldn't this lead to serious over-issuance of MKR, making it increasingly worthless?
The Maker Protocol actually has another auction mechanism to ensure that MKR is not seriously over-issued, which is the Surplus Auction mechanism.
Surplus Auction Mechanism: When the DAI in the buffer accumulates to a certain amount (a value determined by Maker governance), the excess DAI will be auctioned off in a surplus auction. During the surplus auction, bidders can use MKR to bid for a fixed amount of DAI, with the highest bidder winning. Once the surplus auction ends, all MKR obtained from the auction will be automatically destroyed by the protocol, thereby reducing the total supply of MKR.
Now, you might have a question: How does the Maker Protocol know that my assets are facing liquidation?
The world of blockchain does not communicate with the real world, so a bridge is needed to connect the two worlds. How does the Maker Protocol obtain the prices of these crypto assets in the real world? This requires something called a Price Oracle.
A so-called oracle is not a machine for predicting the future, but a tool used in the blockchain world to obtain off-chain information, as smart contracts cannot actively fetch off-chain data and can only receive data passively.
The Price Oracle is a group of trusted price nodes selected by MKR voters to provide price information to the Maker system. The number of nodes in the group is also controlled by MKR voters. To prevent attackers from controlling most of the price oracles, the Maker Protocol obtains price information through the Oracle Security Module (OSM) instead of directly through the oracles. The Oracle Security Module is a defense layer set up between the price oracle nodes and the Maker Protocol, delaying price updates by 1 hour. During this period, if any price oracle is found to be controlled by an attacker, it can be frozen through emergency information submitters or Maker governance voting. The decision-making power regarding emergency information submission and the delay in price input lies with MKR holders.
Once DAI is minted, the collateral will be locked in the vault, and the Price Oracle will monitor whether the value of the collateral reaches the maximum collateralization value of DAI. When the value of the collateral exceeds the maximum collateralization value of DAI, a liquidation auction will be triggered, and the liquidated party will incur a penalty, while bidders will acquire the collateral at a low price. If the auction is under-collateralized, the debt will be borne by the protocol.
5. Is the Maker Protocol really safe?#
In the online world, there is no absolutely secure protocol or system, and this is also true for a complex design that carries such a large amount of funds in a DeFi protocol, which inevitably has some vulnerabilities.
MakerDAO "zero-dollar purchase"?
In the "312" black swan event, due to a sharp drop in the price of ETH, the value of a large amount of collateral in the Maker Protocol fell below the liquidation threshold, triggering the auction process. However, due to a surge in on-chain transactions in a short period, the gas fees skyrocketed, and the liquidation bots' liquidation transaction requests could not be processed in time due to low gas fee settings. As a result, a certain liquidator won the auction with a bid of 0 DAI without any other auction competitors, leading to MakerDAO's liquidation mechanism failure, with ETH collateral worth up to $8.32 million being auctioned off at zero price, and the Maker Protocol system experiencing $5.67 million in unsecured bad debt, draining the DAI from the buffer. To fill the $5.67 million in unsecured bad debt, MakerDAO initiated the first MKR auction to fill the gap and subsequently improved the protocol mechanism to prevent similar incidents from happening again:
Increasing the maximum auction quantity from 50 ETH to 500 ETH to reduce the number of auctions and concentrate bidders, so that bidders do not need to participate in ten auctions to bid for 500 ETH but only need to participate once.
Changing the time for the last bid until the auction ends from the original ten minutes to six hours to prevent other bidders from being unable to participate during on-chain congestion.
From this incident, it can be seen that MakerDAO's losses did not stem from flaws in the protocol itself but rather from defects in the auction mechanism design.
What is MakerDAO's "nuclear button" - the emergency shutdown mechanism?
For Maker, which carries the largest amount of funds, it is particularly important to be prepared for various extreme situations with emergency measures. In extreme situations such as malicious governance actions, illegal intrusions, security vulnerabilities, and prolonged market irrationality, the emergency shutdown mechanism serves as the last line of defense for MakerDAO. When the emergency shutdown mechanism is activated, the normal functions of the Maker Protocol will cease, and users will no longer be able to deposit collateral or generate DAI from the Maker Protocol. The settlement system will ensure that any DAI holders can redeem the corresponding value of collateral from the system, and to facilitate smooth liquidation, MKR holders will decide on a waiting period before collateral can be redeemed. Once the emergency shutdown is initiated, the prices of all collateral types' price oracles in the system will be immediately frozen, and it will be calculated whether the collateral is sufficient to cover the unpaid DAI.
There are two methods to initiate the emergency shutdown mechanism:
Emergency Oracle: An emergency oracle is an emergency oracle selected by MKR holders that can freeze individual price oracles (for example, the price oracles for ETH and BTC) and has the unilateral authority to trigger the emergency shutdown mechanism. When extreme situations occur, MKR holders can authorize the emergency oracle to initiate the emergency shutdown mechanism.
Emergency Shutdown Module (ESM): The Emergency Shutdown Module is a decentralized emergency initiation process that requires MKR holders to lock MKR in the module to initiate. The emergency shutdown will only be triggered when the locked MKR reaches a specified amount, which is determined by MKR holders' voting, with the initial proposal being 50,000 MKR.
Once the emergency shutdown mechanism is activated, it will go through three stages:
Stage 1: Maker Protocol Shutdown
After the shutdown mechanism is activated, users cannot create new vaults to mint DAI or operate existing vaults. The price oracle mechanism will also be frozen, and asset prices will stop updating. Freezing the price oracle mechanism ensures that all users can retrieve their entitled asset values, and vault owners can immediately reclaim collateral exceeding the debt collateral required.
Stage 2: Auction Mechanism Activation After Emergency Shutdown
After the shutdown mechanism is activated, collateral auctions will commence, and the auctions will be completed within a specified time frame, which will be longer than the original auction time limit. The auction duration is determined by MKR holders' governance to ensure that all auctions can be successfully completed after the auction ends.
Stage 3: DAI Holders Redeem Remaining Collateral
After the auction ends, DAI holders can redeem collateral at a fixed exchange rate using DAI, and MKR holders will begin to decide on restarting the system.
From the current perspective, MakerDAO has experienced a black swan event and learned lessons to improve the auction mechanism. The existence of the emergency shutdown mechanism gives MakerDAO the ability to withstand systemic risks in extreme situations, making it relatively safe overall.
6. What is MKR? What can MKR be used for?#
MKR is the governance token and source of capital restructuring for the Maker Protocol. At the beginning of the Maker Protocol, there was a total of 1,000,000 MKR, and the total supply of MKR fluctuates with the operation of the protocol system.
As a governance token, MKR holders can use MKR to vote on governance matters related to MakerDAO. Voting typically involves modifying internal parameters of the Maker Protocol, such as the collateral value and the DAI generation/liquidation ratio, liquidation penalty ratio, DSR deposit rate, auction mechanism parameters (bid amounts, bidding duration, bidding intervals, etc.), which crypto assets can be used as collateral, and the selection of oracle nodes.
As a source of capital restructuring for the Maker Protocol, when there is a debt deficit in the Maker Buffer, the system will over-issue MKR to raise funds for debt repayment. When the funds in the Maker Buffer exceed a certain amount (determined by MKR holders), DAI will be auctioned to buy back MKR and destroy it.
7. Decentralized governance or oligarchic governance of MakerDAO?#
As of July 26, 2022, the total supply of MKR is 977,631.04, with a total of 86,785 addresses holding MKR.
From the MKR token distribution chart, an interesting phenomenon can be observed: although there are a total of 86,785 addresses holding MKR, the top 100 addresses collectively control 83.41% of the MKR. This phenomenon of wealth centralization is not uncommon, even in the real world, where a few individuals hold a large amount of wealth. According to a 2018 BBC News report: 'World's richest 1% get 82% of the wealth' - the richest 1% of people in the world hold 82% of the world's wealth.
What risks does the high concentration of MKR pose to MakerDAO?
The high concentration of MKR can lead to "oligarchic" governance of MakerDAO, where a small number of individuals can control the governance of MakerDAO.
First, let's understand the governance proposal process of MakerDAO.
The Maker governance process is roughly divided into two stages: proposal voting and execution voting.
(1) The purpose of proposal voting is to ensure that governance decisions are carefully considered and reached a consensus before entering the voting process. Before execution voting, a rough consensus will be formed within the community before entering the execution voting stage.
(2) The purpose of execution voting is for MKR holders to collectively decide to approve or reject changes to system parameters, such as voting to determine the stability fee rate of collateral.
From a technical perspective, changes to the internal parameters of the Maker Protocol are implemented through proposal contracts. Each contract is designed for one or more governance actions, and all voting is managed by the contract. Once execution voting is approved, the proposal contract will begin to execute changes to the internal parameters of the Maker Protocol. Since the proposal contract is one-time use, it cannot be reused once executed; a new smart contract must be created for the next proposal.
Changes to governance variables of the Maker Protocol do not necessarily take effect immediately after being approved by execution voting. If voters choose to activate the Governance Security Module (GSM), these changes will be delayed in activation (the time is determined collectively by MKR holders). This delay gives MKR holders the opportunity to take action; if necessary, they can trigger the emergency shutdown mechanism to oppose malicious governance proposals (for example, proposals that modify collateral parameters in contradiction to current monetary policy or proposals to disable security mechanisms).
In simple terms, the governance process of MakerDAO involves forming a certain consensus within the community before initiating execution voting and creating a proposal contract. Voters can choose to activate the Governance Security Module (GSM) to delay the activation of changes after voting approval, allowing more MKR holders to engage in further discussions or actions, such as raising objections to the voting results or triggering the emergency shutdown mechanism.
After understanding the governance process of MakerDAO, we can observe the actual situation of MakerDAO governance. As of July 26, 2022, the latest MakerDAO governance proposal shows:
From this proposal, we can find some interesting phenomena: the number of people who actually participate in governance voting and can have an impact does not exceed 20, and the total voting share of the top four individuals already exceeds 50%, allowing them to decide the proposal's passage and modify the internal parameters of the Maker Protocol. In some votes, a single individual can even play a decisive role.
To some extent, MakerDAO can be said to belong to so-called "oligarchic" governance rather than true decentralized governance. This situation is not uncommon, and the reasons for this can be said to be people's general lack of interest in participating in governance or the price of MKR making the threshold for participating in MakerDAO governance too high. Although for holders of a large amount of MKR, uniting with other MKR "whales" can achieve "complete control" over the Maker Protocol, even the top MKR holders have enough MKR to unilaterally initiate the emergency shutdown mechanism, using it for malicious purposes would not benefit the MKR holders themselves. The development of MakerDAO is the common interest of MKR holders.