Maker DAO – a Decentralized way of solving the volatility problem in cryptoeconomics

Maker DAO bring stability for the blockchain and solving the volatility problem in cryptoeconomics. 

Hard problems in cryptocurrency

One of the many hard problems   in cryptocurrency ecosystems is the price instability of  most direct to trade crypto-assets.  The lifecycles of these cryptoassets begin with the mining function, and the network effects that accompany the blockchain.

These network effects often accentuate the ability of different stakeholders such as market makers/takers/traders/miners/app-developers, etc. to strategize in order to maximize their own rent making ability in these markets. Due to multiple sides of the markets continuously contributing in the face of entries and exits, the underlying asset faces significant volatility. 

In such circumstances, despite the promise of decentralized-fungible equivalent cryptocurrency that can be transferred without an intermediary, these cryptocurrencies often become risky for trade which expects some amount of stability vis-a-vis the current stable fiat (USD or Euro).

A solution in the form of stablecoins has often been sought wherein each cryptocurrency has collaterlized to some asset (either money in the bank or something else). Nevertheless, each such stablecoin is controlled by a trust or a consortium which is responsible for auditing the assets and ensuring that the right supply-demand-balances exist in these markets.

DAI and the Collateralized Debt Position

DAI is a type of collateralized cryptocurrency that is pegged to 1 USD and  operates purely on the Ethereum smart contract platform. The decentralized governance makes this a unique stable coin which any user can  exchange to fiat currency. 

How is DAI generated?

The way DAI is generated is through CDPs where users deposit a certain quantity of Ethereum (usually more than the number of DAI needed), into a smart contract. The ratio of the value of the collateral to the DAI generated is known as the liquidity ratio, and this liquidity ratio is pre-set by the Maker Platform voters through a governance mechanism considering several factors.

Once the  collateral (i.e., a certain quantity of ethereum that is accepted) is  locked into the smart contract DAI is generated. The DAI is generated and the user is now free to use this DAI to do anything he wants to. Once the DAI is paid back to the smart contract, with the interest (labeled as the stability fee) into the Maker account, the collateral is released to the user.

Governance

The governance of the DAI token exchange values and several intervening conditions such as a flash crash in collateral prices, or an emergency price variation,etc.  are handled through a transparent and collateral system overall.

Why go through the trouble of creating  DAI?

Firstly, DAI is accepted on many crypto-fiat exchanges as a mechanism to trade on various markets due to its price stability of 1USD. This is almost equivalent to borrowing money against cryptocurrencies at the rate of the stability fee (i.e., approximately 5% per annum with the risk of liquidation).

Secondly, DAI due to its decentralized nature enables users to participate on several decentralized  finance platforms such as dydx or celsius.network. These platforms offer an interest rate on DAI between 5.5 % and 9%. This gives people the ability to use their cryptocurrencies as a means of earning interest directly. 

How to create and use DAI

Step 1.

You own 10 Ethereum. You create a smart contract on the Maker Platform and send your 10 ETH to it. This is the website to make this https://cdp.makerdao.com/

You now have a CDP created.

Step 2.

You send another small transaction to the smart contract, which then locks up the CDP, making the 10 ETH temporarily inaccessible, and generates Dai. The CDP must be 150% overcollateralized, so depending on the price of Ether, the amount of Dai received will change. If ETH = $300, then 10 ETH = $3000. Then, the CDP would generate 2,000 Dai.

Step 3.

You could then do whatever you wanted with the Dai. Many people use it to trade other crypto, while still being able to hold on their ETH. So, say you then use Dai to purchase another cryptocurrency, such as Bitcoin. After a period of time, which could be days or even years, you sell you your Bitcoin for a profit back into Dai. You now have 3000 Dai after BTC goes up 50%.

Step 4.

You then now send the original 2000 Dai plus the 5% Stability fee (50Dai) and unlock the CDP, receiving back your ETH. Now, you have $950 in profit and the original 10 ETH.

Risks

The whitepaper lists several risks.

  1. Mkr governance can choose to liquidate the collateral if the risk is too high at any point in time, holding 13% as a penalty.

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