Centralized stablecoins are riskier than most people think. If you are holding a significant amount of Tether in your portfolio, you probably know what we are talking about. While keeping centralized stablecoins in your wallet, you trust a single entity not to mess with your money. When it comes to Tether, you are trusting Bitfinex. You never know whether they are holding an equivalent amount of US dollars in their bank account. The problem is: nobody can verify it. There is always uncertainty left.
The crypto space has been suspicious of centralized stablecoins for a long time. There are too many things that could potentially go wrong. How will the markets react if they find out that Tether is not 100% backed by FIAT currency? Crypto markets could crash immediately as USDT trading pairs make the most of today's trading volume.
That's why we need decentralized stablecoins. Stablecoins like DAI are an excellent alternative leading in the right direction.
Let's dive deeper into how Maker and DAI work.
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How Maker works
Maker is a way to create decentralized stablecoins. Stablecoins are tokens that replicate the value of 1 US Dollar. In contrast to Bitcoin or Ether, stablecoins are not volatile; you can always count on them to be worth 1 US Dollar.
Maker makes the creation of stablecoins possible through overcollateralized backing. For example, a user can deposit $150 worth of Ether into a smart contract and receives $100
worth of stable coins (called DAI) for it. It is essential to mention that the collateral always has to be worth more than the issued DAI. Because every DAI is backed by more than $1 of assets, users can be sure DAI keeps its value. When the price of Ether drops below the collateralization ratio (150% in the example above), the contract gets liquidated. This concept makes sure DAI will always be worth $1.
Maker (MKR) is the protocol's native governance token. Holders of MKR, therefore, decide on crucial protocol parameters. They take the risk if something goes wrong. They also get rewarded by the platform's usage because protocol fees are being used to burn existing MKR tokens.
Last October, Maker burned over $2 million worth of tokens. In this chart, you can see Maker's fee dip during the Corona crisis in March 2020. During this time, the Maker protocol had to lower the DAI Savings Rate (interest users receive on their DAI) effectively to zero, which is why MKR holders didn't profit from any protocol fees. The DAI savings rate has now been raised again and the protocol is earning as much money as never before.
Maker is a Decentralized Autonomous Organization (DAO). MKR token holders are the leaders of the protocol because they can vote on the most critical metrics. The quality of MKR token holders' decisions ultimately determines whether or not the protocol succeeds in the long run.
The voting rights of the users are proportional to the amount of MKR they own. A user with 1,000 MKR has ten times more power in the network than a user with 100 MKR.
Below, you can see essential parameters MKR holders vote on:
The amount of DAI that can be minted depends on the collateralization ratio. The higher it is, the fewer DAI users can mint.
If the collateralization ratio is 200%, you can mint $100 worth of DAI while locking $200 worth of ETH.
2. Stability Fee
The Stability Fee is the interest rate, which you must pay if you would like to pay back your debt. The stability fee incentivizes/disincentivizes the new creation of DAI. The higher it is, the less likely people are to mint new DAI.
3. DAI Savings Rate (DSR)
The DSR is the interest you receive for holding DAI over a specific period. You can imagine the DSR to be similar to the interest rate on your bank account. Typically, the DSR is marginally lower than the Stability Fee.
The protocol uses the difference between the stability fee and the DSR to burn MKR tokens. When the Stability Fee and DSR are virtually zero, the protocol does not burn any MKR. This happened during March-August 2020.
Maker is one of the earliest DeFi protocols, and it enables many DApps to build on it. It was the "Hello World" of DeFi. That's why DAI is the native stablecoin of the DeFi ecosystem. It is a mechanism to create certainty in an uncertain and volatile environment. You can always count on DAI to be worth $1 (not considering black swan events).
There is almost no DeFi application that doesn't support the usage of DAI. You can deposit your DAI in Aave/Compound, trade it on Uniswap, and so on.
Because MKR was one of the earliest DeFi tokens, it didn't experience much hype during the DeFi bubble in summer 2020. However, it is fundamentally one of the most crucial DeFi tokens.
Maker is the backbone of Decentralized Finance.
All information presented above is meant for informational purposes only and should not be treated as financial, legal, or tax advice. This article's content solely reflects the opinion of the writer, who is not a financial advisor.
Do your own research before you purchase cryptocurrencies. Any cryptocurrency can go down in value. Holding cryptocurrencies is risky.