Maker MKR

All You Need to Know About Maker protocol

Maker is one of the largest DeFi protocols built on the Ethereum blockchain. The main interface for the Maker protocol is called the Oasis app. It enables users to enter collateralized debt positions (CDPs) and generate decentralized, crypto-backed stablecoin Dai. The backing is covered by Ethereum-based assets, which Maker DAO approves. 

Collateralized loans

Collateralized loans, as the name suggests, are entirely covered by collateral (deposited value serving as a guarantee for loan repayment). In other words, users cannot take out a loan bigger, than the initial deposit. This mechanism ensures that all borrowed capital created this way has some means of repayment. 

In undercollateralized loans, a leveraged position is created and the collateral itself is not sufficient to repay the loan.

Dai - Collateralized stablecoin

By opening a so-called Vault in the Oasis app, users can deposit collateral and generate a portion of the stablecoin Dai, which is soft-pegged to 1 USD. The vault is a form of loan, meaning the user pays a certain annual interest rate and at some point has to repay back. There is no time limit in which the user has to repay, but the collateral will remain locked until he chooses to do so.

Because of the absence of volatility, Dai can be used as a means of trading, saving, or spending. The value of the collateral is constantly monitored and if it falls below a certain threshold ("liquidation ratio") the position can be liquidated. The collateral coverage required at this time is 170 % but is subject to changes.

Price stability mechanisms

To ensure that the price of Dai remains pegged to USD, Maker protocol utilizes a number of protective measures:

Market conditions - if there is a big demand for Dai, the price increases above 1 USD. Users will arbitrage this difference on exchanges and bring the price down until the arbitrage is no longer profitable. Sell pressure on Dai - price decreases - users will buy Dai on exchanges, rather than generating from the Maker protocol - price increases back to its peg.

Variable interest rate - when the demand for Dai increases, the interest rates also increase, lowering the demand. In the opposite direction interest rates decrease, making Dai essentially cheaper and thus increasing demand.

Liquidations

Usually, liquidation occurs, when the value of the collateral isn't sufficient to cover the debt - the position is immediately sold to prevent under-collateralization. When the CDP is sold this way, the user is charged a liquidation fee.

There are several steps involved in the liquidation process:

1. The position is marked for liquidation, and an "auction timer" is started. This is a countdown timer that gives the owner of the position a chance to add more collateral.
2. If the owner of the position doesn't add more collateral, the position is put up for auction.
3. During the auction, the highest bidder wins the right to purchase the collateral. The winning bidder must pay the value of the position in Dai, and they receive the collateral (usually in the form of Ethereum) in return.
4. If the auction does not produce a winner, the position is sold out to the open market to cover the remaining DAI.

Other features of the Maker protocol

Multiply: Allows users to create a leveraged position on certain assets up to 4x the original amount. In one transaction collateral is deposited, Dai is generated and swapped for more of the original asset. This of course increases the risk of liquidation.

Earn: In this vault, a portion of Dai is swapped for USDC and deposited on Uniswap V3 to the DAI/USDC liquidity pool, where it collects trading fees in a specified price range. It is also possible to multiply this position up to 50x.

Fees and interest rate

Maker protocol charges a variable stability fee in a form of an annual percentage rate. This stability fee is added to the debt and may change depending on the market conditions.

When CDP is liquidated, the user is charged a liquidation penalty, which is subtracted from the collateral. Size of the liquidation fee depends on the type of collateral used and decisions of the Maker DAO, typically 13 %. Further fees are associated with transactions on the Ethereum blockchain (gas fees).

Security

Although being one of the oldest and largest DeFi protocols, one should still consider the risks resulting from the use of the Maker protocol.

Smart contract risk - a lot of trust is being put into code. Security bugs or exploit may occur while using any DeFi protocol. Regular audits and bug bounties help to mitigate this risk.

Liquidation risk - while entering a CDP users are subjected to the risk of liquidation and thus losing a substantial part of their position. It is necessary to maintain a safety margin in cases of swift market movements.

Depegging risk - the price of Dai can deviate from its intended peg. There are mechanisms in place to prevent this from happening but bear in mind that unexpected situations do happen.

Governance

Maker protocol is governed by the Maker DAO, which works through a continuous voting process that allows stakeholders to propose and vote on changes to the Maker protocol. Any stakeholder can submit a proposal, and all stakeholders can vote on the proposal using their Maker DAO governance tokens (MKR). The vote outcome is determined by the number of MKR tokens staked in favor of the proposal.

Key takeaway

• Maker protocol enables users to enter collateralized debt positions (CDPs) to generate Dai
• Dai is a decentralized stablecoin (1 DAI = 1 USD) backed by Ethereum-based assets
• Users may use Ethereum-based assets as collateral to access liquidity without the need to sell those assets
• Anyone using CDPs is subjected to the risk of liquidation and deppeging
• Liquidation occurs when the value of the collateral isn't sufficient to cover the debt
• Maker protocol is governed by Maker DAO - members of the DAO create proposals and vote on changes to the protocol using MKR tokens