What is MakerDAO and how does it work?

What is MakerDAO and how does it work?  

MakerDAO is a lending platform that started on the Ethereum blockchain in 2017. It is the driving force behind DAI, a decentralized stablecoin. DAI is pegged to the US dollar, which is beneficial when crypto investors want to exchange more volatile cryptocurrencies for a coin with a more stable value. 

The protocol operates by enabling anyone to loan DAI and use other cryptocurrencies as collateral. Notably, these loans are overcollateralized, which means you will have to deposit more cryptocurrency than you initially put in. The minimum collateralization rate for an ETH "vault" as of August 2022 is 170%. Therefore, you would need to put up $170,000 in ETH as collateral to get $100,000 in DAI. 

Overcollateralization is used to safeguard against crashes of ETH or the other coins that support DAI, which include wrapped bitcoin (wBTC) and the centralized US dollar stablecoins USDC and USDP.

DAI is backed by $10.6 billion in crypto assets and a sprinkling of real-world assets, including $100 million from Huntington Valley Bank, as of this writing in August 2022. According to the data, it is 141% overcollateralized. 

The higher the collateral, the greater the drop in value of these cryptocurrencies before DAI loses parity with the US dollar. 

What encourages users to lock up more than they borrow?

MakerDAO seems to benefit from the lender-borrower system, but why would someone want to borrow less than they start locking up? The main reason behind this is that by borrowing DAI rather than purchasing it, an investor can gain access to a US dollar stablecoin without having to sell his or her ETH. This is beneficial because many yield farms and lending platforms provide higher returns for US dollar stablecoins than for ETH. Anytime you want, you can convert DAI back to ETH. 

In the MakerDAO network, there is another token called MakerDAO's governance token (MKR). The token is mostly used to vote on platform protocol upgrades. MKR had a market capitalization of around $1.1 billion as of August 2022. 

The Dai Savings Rate (DSR) is a savings protocol that pays out returns to users who deposit DAI in the DSR's smart contract. This allows people within Maker's governance module to impact DAI demand by modifying the protocol's monetary policy levers, similar to a centralized bank. 

DAI has performed admirably thus far, growing from a market cap of $100 million in early 2020 to a peak of $10 billion in February 2022 before dropping to $6.4 billion in May 2022 with the collapse of the crypto market. DAI had a market capitalization of $7.5 billion as of August 2022.

Governance of MakerDAO

MakerDAO's success is due to its decentralized governance, not its algorithmic design. After the pandemic rattled the token back to its base, those possessing a lot of MKR all but saved DAI from collapse in March 2020.

The decentralized autonomous organization decided to back the stablecoin with USDC, a centralized stablecoin maintained by Centre, a group led by payment company Circle and crypto exchange Coinbase, in order to stop it from going below $1. DAI has since added the USDP to the mix. These stablecoins are evidently centralized because they are managed by companies and backed by USD and equivalents kept in banks. 

In a wider sense, the governance protocol uses a series of time-based polls to keep the protocol current and up-to-date. MKR tokens serve as the medium of exchange for these votes, which are conducted directly on the blockchain. If a resolution is approved, it becomes binding.

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