Breaking Down the Maker Protocol and Explaining its Positive Correlation With Ethereum's Price


13 min read
Breaking Down the Maker Protocol and Explaining its Positive Correlation With Ethereum's Price
Disclaimer (Important Note!): This was originally written back on July 23rd, 2020 ; so the dates / prices will not be accurate to the time of publishing - this is still a helpful breakdown though! Just keep that in mind so you don't get confused below

Given MakerDAO's prominence in several other major DeFi projects as well as its stop at number one among all DeFi projects based on aggregate value of funds locked on the protocol, its imperative that we start chipping away at the veil of complexity that shrouds Maker.

So let's not waste any time here and get to it.

Assessing Maker's Recent Price Increase

Again, please remember that this part of the report was originally curated on July 23rd, 2020 ; but the findings & revelations hold true

Take a look below:

Maker's single-day price appreciation (> 11% / 12% ) today (July 23rd, 2020) is in line with what we also saw from Ethereum over this same span.

So the question we're going to try to answer here is... why?

Breaking Down the Mechanics of MakerDAO

Yes, you may have dreaded this, but this is something that has to be done (honestly, it isn't that bad and we're going to make sure to break this down in a digestible manner so that you leave with a fairly high level understanding of how the protocol actually works).

Beginning With the Introductory Documentation

Let's start from the basics.

We'll start with this link here to their documentation as our reference point: https://docs.makerdao.com/

Introductory Documentation and the Project's Premise

Much of the introduction is 'fluff', but the most important excerpts that readers need to take away is the following:

"Second, there is MKR, a governance token that is used by stakeholders to maintain the system and manage Dai. MKR token holders are the decision-makers of the Maker Protocol, supported by the larger public community and various other external parties. "

Don't Get Intimidated By the Unrelated Things

Check out this diagram below:

Breathe a sigh of relief knowing that you don't have to understand a single thing on there (and that this is actually a lot easier than it seems).

The following diagram, however, may serve some rudimentary use for at least some readers out there that feel that they could benefit from a quick review of $MKR's macro-level ecosystem - illustrated!

Panning Back For a Second

Believe it or not - the general whitepaper for MakerDAO actually breaks everything down in a much simpler fashion.

But before we get there - we're going to provide Librehash guided simplification of the protocol's scheme.

Outlining the Constituent Elements of the MakerDAO Protocol

There are three distinct facets of the MakerDAO protocol (breaking things down to their simplest form).
Those three elements are:

  1. $MKR (the actual token - $MKR)
  2. Dai (the stablecoin - which is not a MCD)
  3. Collateralized Asset (for simplicity sake, we'll leave it at $ETH for the time being)

These three 'prongs' / facets of the MakerDAO protocol work in concert with one another, in one way or another, to establish and sustain the functionality of the MakerDAO protocol.

Touching on the 'Maker' Token

For this part, we're going to start cracking into the MakerDAO whitepaper (which is surprisingly coherent compared to other whitepapers we've had to break down)

In specific, the whitepaper wastes no time in succinctly outlining the purpose of the Maker token, detailing its role within the protocol in the following: https://makerdao.com/en/whitepaper#abstract

"Through a system of scientific governance involving Executive Voting and Governance Polling, MKR holders manage the Maker Protocol and the financial risks of Dai to ensure its stability, transparency, and efficiency. MKR voting weight is proportional to the amount of MKR a voter stakes in the voting contract, DSChief. In other words, the more MKR tokens locked in the contract, the greater the voter’s decision-making power."

Touching on the 'Dai' Stablecoin

"Dai" refers to the assets 'stablecoin'.

This token is minted with collateral provided by a user on the protocol.

Example

  • Joe decides to put up $300 worth of Ethereum on the MakerDAO protocol
  • Joe collateralizes the full $300
  • Joe is now entitled to borrow 300 DAI (in theory)

How Do the Dai Maintain Their Value?

By virtue of the collateralized asset that backs them - pegging Joe's -$300 debt to the protocol as a "CDP" (collateralized debt position).

That's a Super Simplified Version of Things to Start Off With

There are certain minor differences between how we described Dai and how it is implemented on the MakerDAO protocol in reality, but at the risk of losing you (the reader) entirely stumbling / nitpicking all of the peripheral details, we figured it better for you to get the general gist of how this works.

Up to speed so far?

Good.

Now let's go a bit deeper.

'Dai Savings Rate'

Specifically, information in the whitepaper related to the 'Dai Savings Rate' can be found here: https://community-development.makerdao.com/makerdao-mcd-faqs/faqs/dsr#how-is-the-dsr-being-used-by-mkr-token-holders-as-a-monetary-policy-tool

"What is the 'Dai Savings Rate?'

The whitepaper explains it succinctly:

"The Dai Savings Rate (DSR) is a variable rate of accrual earned by locking Dai in the DSR smart contract. Dai holders can earn savings automatically and natively while retaining control of their Dai. The DSR smart contract has no withdrawal limits, deposit limits, or liquidity constraints. The rate is actively set by MKR token holders through on-chain governance."
"The DSR is also a monetary policy tool used by Maker governance to influence demand for Dai."

Again, we're not going to climb to far into this rabbit hole of how exactly the DSR functions on the MakerDAO protocol.

But here is the accompanying documentation breaking down more information on it: https://docs.makerdao.com/smart-contract-modules/rates-module/pot-detailed-documentation (referred to as 'Pot' within the smart contract context)

DSR is Something Specific and Relegated to DAI

The whitepaper makes this explicitly clear.

How the DSR Can Be Manipulated to Ensure the Peg Remains Consistent

This part is perhaps the most important out of this sectino of documentation, so we have it re-written below for users (in case anything happens to the screenshot for any reason):

"The DSR is a global parameter that can be raised or lowered to influence demand for Dai. Raising the DSR incentivizes users to hold more Dai, leading to higher demand for Dai, whereas lowering the DSR has the opposite effect of reducing demand for Dai. This is reflected in the spot market price of Dai; if Dai is trading below a dollar, then the DSR can be raised to increase demand for Dai which would bring up the price of Dai. Conversely, if Dai is trading above a dollar, then the DSR can be lowered to reduce the demand for holding Dai which may help bring down the price of Dai."

One of the Core Goals of $MKR

Beyond being used for governance decisions on the protocol, the whitepaper, documentation, and other related literature disseminated by MakerDAO (and other experts), make it clear that ensuring a consistent pegged value (with USD, in specific) is the perhaps the most important priority for the protocol.

Back to an ELI5 View of Dai

See below:

Simple enough, right?

Also, per the whitepaper:

"Every Dai in circulation is directly backed by excess collateral, meaning that the value of the collateral is higher than the value of the Dai debt, and all Dai transactions are publicly viewable on the Ethereum blockchain."

Gathering Facts

Before we simply barrel ahead, let's take a second to aggregate what we know:

  1. Dai is a stablecoin (or at least its supposed to be).
  2. There is no limit to the number of Dai that can be created. As long as there are individuals that are willing to provide assets (let's say, Ethereum, in this instance) to be collateralized. The amount of Dai that can be minted at a given time is contingent on the value of the assets at the time that they are being collateralized on the platform.
  3. $MKR's job is to use the various tools / instruments / resources at the disposal of the protocol (and its users), to ensure that the price of Dai remains consistent. There are other purposes for $MKR (within the context of this ecosystem), that we'll get into when we get there.

Breaking Down the Actual Lending Process

Since we don't have all day here - let's fast forward to the part where we look at the hyptothetical requirements / hurdles that one must face if they have some $ETH, but are looking to get their hands on Dai (i.e., interact with various other facets of the ecosystem).

"Maker Vaults"

What are those?

Whitepaper, to the rescue:

"All accepted collateral assets can be leveraged to generate Dai in the Maker Protocol through smart contracts called Maker Vaults. Users can access the Maker Protocol and create Vaults through a number of different user interfaces (i.e., network access portals), including Oasis Borrow and various interfaces built by the community. Creating a Vault is not complicated, but generating Dai does create an obligation to repay the Dai, along with a Stability Fee, in order to withdraw the collateral leveraged and locked inside a Vault."

The Big Incentive For Users That Interact With MakerDAO

Read below:

Most important among the breakdown above is step #3, where it states:

"To retrieve a portion or all of the collateral, a Vault owner must pay down or completely pay back the Dai she generated, plus the Stability Fee that continuously accrues on the Dai outstanding. The Stability Fee can only be paid in Dai."

Retrieving One's Collateral

Per the specifications, in order to retrieve one's original principle "lock", that user simply needs to:

  • "Pay down or pay back the Dai generated"

and

  • Pay the, "Stability Fee that continuously accrues on Dai outstanding."

These Two Conditions Are Stagnant Regardless of the Collateralized Asset's Price Action

A) Let's say that Pedro provides 2 Ethereum, worth $250 each to the MakerDAO protocol. Pedro goes through the motions of creating a preliminary account / signing up

B) Pedro decides to mint $500 worth of Dai with those two Ethereum that he had [i.e., he collateralizes those two Ethereum]

C) A short while later, the price of Ethereum...doubles. Now, the value of Pedro's collateralized debt position has increased from $500 to $1,000.

Pedro Decides That He Wants to Redeem Now

The question now is, what must Pedro pay in order to receive his collateral back?

Simple.

He simply, "Must pay down or completely pay back the Dai he generated"

So that means that Pedro only needs to provide $500 worth of Dai (minus the stability fee) in order to receive his full collateral back (even though it is currently worth double that amount).

Given this structure it should be obvious that bullish price action from Ethereum should intuitively result in increased Ethereum deposits on MakerDAO.

This Sentiment is Affirmed By Outside Research As Well

Specifically, readers that are still 'gathering their bearings' in relation to learning about MakerDAO and how it works, should check out this Medium link here: https://medium.com/mycrypto/what-is-dai-and-how-does-it-work-742d09ba25d6

In relation to the payback amounts that users are required to make before receiving their any amount of their collateralized amount again, the referenced Medium post above comes to the same conclusion we do regarding the implicit lucrative "deal" users receive in instances where their collateralized asset appreciates in price:

Confirming Our Hypothesis

Let's head over to 'DefiPulse' and see.

Check out the overall rankings below (for July 23rd, 2020):

Moving from there, let's check out the specific protocol stats for 'MakerDAO' over the past 24 hours:

As expected, in the last 24 hours (since Ethereum has gone crazy), the following has transpired:

90k Ethereum tokens have been moved to the platform

The overall increase in assets locked on MakerDAO increased by >15% (literally, overnight) - pushing it to the first spot among all other DeFi protocols being tracked on "defipulse" (defipulse.com/maker).

Seven Day Chart of Ethereum Locked on the Maker Protocol

DefiPulse was kind enough to provide us with additional metrics such as the one depicted below too:

Collateralization Ratio

We haven't gotten into this concept yet - but it is an important one to note (in general):

"Anyone can use Maker to open a Vault, lock in collateral such as ETH or BAT, and generate Dai as debt against that collateral."

We know this now. Great. Next tidbit.

"Dai debt incurs a stability fee (i.e., continuously accruing interest), which is paid upon repayment of borrowed Dai." (this is true whether the user in question held the Dai entire time or not)"

Important fact here, but the "stability fee" is priced in the $MKR token (although it can be paid with $DAI).

In either case, when users do repay whatever Dai they've borrowed (along with the accompanying 'stability fee'), "That MKR is burned, along with the repaid Dai."

Moving forward, the most important thing we've uncovered here is that:

"Users can borrow Dai up to 66% of their collateral’s value (150% collateralization ratio). Vaults that fall below that rate are subject to a 13% penalty and liquidation (by anyone) to bring the Vault out of default. Liquidated collateral is sold on an open market at a 3% discount."

"TVL Change"

Staying with 'defipulse', we can see that the total 'TVL Change', day over day for Ethereum increased by over sevenfold in just 24 hours (see below):

Panning Back: 'Pooled Ether'

Now that we have a more comprehensive understanding of MakerDAO, we can introduce the idea of "Pooled Ether".

"How does that work?"

See below (from the same article we referenced above):

Most Important Takeaways From the Above Excerpt

The conversion of Ethereum into PETH (pooled $ETH) is a necessary intermediate process the protocol forces users to undergo before being able to collateralize assets to avoid risking direct exposure (i.e., there is no loss in price depreciation of a synthetic derivative).

"If ETH crashed, the debt in a CDP, would be worth more than the collateral held." ; this is exactly what we saw happen on the MakerDAO protocol back in March...when the price of $ETH crashed (this is virtually 'game over' territory for the protocol). But we'll expound upon that later. The next point is much more important.

"Maker would then have the ability to recapitalize the maker by automatically decreasing the supply of PETH, which would increase demand and, in turn, in crease the price of Dai."

Based on #3, we know a few things to be true.

A Higher $ETH Price = Higher Demand For $DAI

Let's work out the "math" on this here.

Per the protocol's own specifications, if the price of $ETH were to "crash", the first step that the protocol would take to 'recapitalize' the markets would be to decrease the supply of PETH.

The logic here (in the protocol's rationale) is that decreasing the supply of PETH would increase the demand and, in turn, increase the price of Dai.

Going Back to the DeFi Market Metrics

We've already deduced that $ETH appreciating in price creates an opportunity on the MakerDAO protocol (for holders of $ETH).

This was validated by the metrics that were shown in the aforementioned section (i.e., there was >80k+ more $ETH locked up in TVL contracts today vs. yesterday).

In a literal sense - that means that the demand for PETH went up.

And, according to what we now know - when the demand of PETH goes up, the price of Dai does as well.

Double Checking Our Logic

JUST IN CASE WE'RE WRONG! (and we could be), its worth seeing if we can find the floating price of Dai (it should be north of $1.03 since we've concluded that the market conditions dictate that there must be an increase in the demand for Dai - which inherently leads to an increase in its price).

Deferring to 'CoinCheckup' For This One

If you haven't heard of 'CoinCheckup' before, thank us later (link = https://coincheckup.com)

In the screenshot above, we can see that the floating price for Dai (at the time of writing) has increased to $1.03 (well north of $1.00, remember that this is supposed to be a stablecoin).

Accompanying Market Overview Chart Corroborates Our Assumption of Correlation Too

As one can see in the chart above, there is a clear spike in the floating exchange rate for Dai that appears to coincide with $ETH's increase in price today.

Target Rate Feedback Mechanism (TRFM)

Let's defer back to the Medium report for this one:

Intuitive Attachment Between Ethereum's Price Increase and $MKR Appreciation

Remember the 'stability fee' that we mentioned before?
It must be paid before the 'close out' of every CDP (collateralized debt position) on the protocol.

Specifically, the way this goes is:

The amount (in DAI) that users must re-pay is always static.

However, the amount (in $MKR) is always floating (meaning it will vary).

Also, since the stability fee is essentially an interest rate attached to the total number of funds being collateralized on the protocol at any given point in time - logic tells us that an increase in the total number of funds being locked up / collateralized on the protocol = an increase in stability fees that are being paid (as these positions are closed out at some point in time).

And since these CDPs must be paid out in $MKR (not Dai), the end result is an increase in demand for $MKR itself.

GO TOP