The Maker Protocol ↗ is one of the largest Dapps on the Ethereum blockchain and was also the first decentralized finance (DeFi) application to gain meaningful adoption. Created in 2014 as an open-source project and a Decentralized Autonomous Organization (DAO), it enables users to borrow against their ETH and other ERC20 token holdings. The loan that users obtain is issued in a currency called DAI ↗ which tracks the value of the US dollar (USD), meaning that 1 DAI is typically worth 1 USD. DAI stands out from traditional stablecoins such as Tether or USD Coin in that is synthetic and not a convertible claim on some underlying reserve asset. The latter use a full-reserve approach where the stablecoin issuer holds liquid reserves with a custodian bank equivalent to 100 percent of the value of the tokens in circulation. Traditional stablecoins are pegged against a sovereign currency such as the USD and offer full convertibility. In contrast, synthetic stable coins like Maker’s DAI actively manage a peg with the help of a smart contract. In the Maker system, algorithmic risk management and a minimum reserve ratio of 150 percent ensures the DAI-USD peg, along with interest rates to manage its supply. In the Maker system, the amount of DAI that users can borrow depends on the value of ETH or any other ERC20 token deposited. For example, if a user locks up ETH as collateral via a so-called collateralized debt position (CDP), DAI is minted and paid out for the loan. ETH acts as the collateral to the loan, in much the same way as a house acts as collateral for a mortgage loan. Once the loan is repaid, the DAI is “burned” or destroyed. Today, more than 400 Dapps and services that have integrated DAI, including wallets, DeFi platforms and games.
Importantly, the Maker Protocol has a second token, called MKR. Its primary purposes are to support the stability of the DAI token and to make governance ↗ decisions on the operations and future of the system. The MakerDAO governs the Maker Protocol by deciding on key parameters (e.g. stability fees, overcollateralization levels, collateral types and rates) through the voting power of MKR holders. For participating, holders gain MKR fees as a reward. When borrowing DAI, fees are also incurred in MKR. The token also acts as a lender of last resort to keep DAI stable. In the event of a sharp drop in the price of ETH during which too many loans are liquidated at once, Maker’s collateral system might not be sufficient to cover the value of underlying DAI. In such a situation, the protocol would create new MKR tokens and sell it on the market to raise additional collateral. In summary, DAI, MKR and the eligible ETH and ERC20 tokens work as an automatic system of checks and balances that creates incentives to keep the system stable and decentralized.
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