MakerDAO is an innovative open financial system that mints the DAI stablecoin, which is backed by crypto collateral. Today, DAI decentralized stablecoins are used across DeFi platforms like Awe, Compound, and Uniswap. To understand DAI and how MakerDAO works, let's begin by looking at the differences between centralized and decentralized stablecoins.
Centralized vs. Decentralized Stablecoins
Stablecoins are essentially digital dollars—they offer a relatively stable value that doesn't fluctuate drastically day by day. Crypto investors favor stablecoins because, unlike volatile cryptocurrencies, they offer a safe place to park cash at a 1:1 value. For instance, you can typically exchange $1,000 for 1,000 dollar-pegged stablecoins.
For crypto traders and investors, stablecoins offer numerous benefits:
- You don’t have to leave the crypto ecosystem to access cash-like stability.
- Sending stablecoins between exchanges is easy, fast, and inexpensive.
- Stablecoins generate significant interest on DeFi protocols like Compound and Curve.
- You can borrow stablecoins or other cryptocurrencies using stablecoins as collateral on platforms like Awe.
The list of use cases continues. Now, here’s where it gets interesting—and why Maker’s DAI stablecoin stands out.
Earlier, we referred to stablecoins as "digital dollars" for a reason. The vast majority of stablecoins—including USDT, USDC, GUSD, and PAX—are not only pegged to the USD but are also backed by actual dollars held in reserve. That means there’s a vault somewhere holding physical dollars and assets to guarantee each USDT, USDC, GUSD, and so on.
You can think of these stablecoins as the AOL of digital currency. All they’re really doing is taking dollars and making them digital. But dollars are a centralized currency, and so are dollar-backed stablecoins.
Behind USDT, USDC, and other major dollar-backed stablecoins are centralized entities that mint them like central banks. A significant amount of third-party oversight goes into auditing, accounting, and regulating stablecoins like Tether.
If you care about decentralization, these digital dollar stablecoins are not what you want. So what do you want?
A decentralized stablecoin system, of course—and that’s exactly what MakerDAO has built.
What Is MakerDAO?
MakerDAO is a decentralized bank of the future that issues stablecoins backed by other cryptocurrencies. The entire system runs on the Ethereum blockchain, is decentralized, and operates via smart contracts.
Note this key difference: while other stablecoins are backed by dollars, DAI stablecoins issued by Maker are pegged to the dollar. "Pegged" means the Maker protocol uses an oracle to track and link DAI’s value to the USD in real time.
To help you understand dollar pegging, here’s a TL;DR version of how Maker works:
- Deposit supported cryptocurrencies into the Maker protocol.
- The deposit opens a Vault position.
- You can withdraw DAI based on the amount of your collateral.
- To retrieve your crypto collateral, repay the withdrawn DAI.
Simple enough, right? The reason this system works is that Maker uses overcollateralized loans. Essentially, you deposit more than the loan amount to drastically reduce risk for Maker.
So, if you want to borrow 500 DAI, you might deposit 1.5 times that amount in ETH or another cryptocurrency. The collateral amount must be high because cryptocurrencies are volatile and often experience significant overnight value drops. Overcollateralizing your vault protects the loan from drastic price swings and helps avoid liquidation.
Maker Vaults
The secret sauce of Maker lies in its Vault system. In short, a Maker Vault is where DAI is created against your deposited collateral. Everything happens on the Ethereum blockchain, meaning transactions are decentralized and fully auditable by anyone.
When you deposit collateral into Maker, you simultaneously open a Vault position. This gives you the option to withdraw DAI stablecoins against your collateral. Once you withdraw, DAI tokens are minted and enter the general circulating supply. When you repay your Vault position, the DAI attached to it is destroyed and removed from supply.
Because Maker Vaults create and destroy DAI tokens, the supply is elastic. Just as a rubber band expands and contracts, so does the DAI token supply. This elasticity helps maintain the token’s dollar parity—more on that in the next section.
Maker Vaults require you to overcollateralize your position by at least 150% to protect both the protocol and yourself. For example, if you use ETH as collateral and ETH is trading at $2,000, to take out a 3,000 DAI loan, you would need to deposit 2.25 ETH.
The goal of overcollateralization is to avoid liquidation risk. If the value of your collateral risks falling below the loan value, lenders liquidate your collateral to repay themselves. Because Maker uses volatile cryptocurrencies as collateral, it needs a significant cushion to keep DAI solvent.
After creating a Maker Vault position, you can use your DAI stablecoin like regular cash. DAI is widely accepted on crypto exchanges, making it easy to buy more cryptocurrencies with your existing liquidity.
How the DAI Stablecoin Maintains Its Value
We’ve talked a lot about how the MakerDAO protocol works, but the system would be useless if DAI stablecoins didn’t hold value. After years of operation, DAI has maintained its value at or around $1 without major issues.
So how does DAI stay pegged to the dollar without being physically backed by dollars? There are a few mechanisms:
- The collateral in Maker Vaults is worth more than the global DAI debt.
- When DAI is below $1, traders repay their vaults, reducing the DAI supply.
- When DAI is above $1, traders open vaults, increasing the DAI supply.
Arbitrage traders opening and closing Vault positions directly affect the elasticity of the DAI token supply. If more traders repay vaults than open them, DAI is removed from supply, pushing the price back to its $1 parity. When the opposite happens, newly minted DAI floods the supply to bring prices down to $1.
Using the Maker Oasis App
If you want to use Maker to borrow DAI, the process might seem confusing since there isn’t a clear explanation on Maker’s homepage. But don’t worry—we’ve got you covered.
To use Maker, you need to access Oasis, the application for creating a Maker Vault and generating DAI. Oasis is user-friendly and sleek. Like most DeFi platforms, you’ll need a MetaMask wallet handy because you can’t access the app without one.
Once inside, you’ll see a list of different cryptocurrencies that Maker officially accepts as collateral. Next to each, metrics detail the minimum collateral ratio along with an "Open Vault" button.
However, if you want DAI but don’t wish to open a vault or collateralize your crypto, you can easily buy DAI on exchanges like Coinbase, Binance, or Uniswap.
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Understanding the Maker Token (MKR)
The Maker token, or MKR, is a governance token used for voting on MakerDAO governance matters. Anyone holding MKR tokens is an equal stakeholder in the MakerDAO system—but it also helps to understand what a DAO is.
Short for Decentralized Autonomous Organization, a DAO enables democratic governance among stakeholders without intermediaries, central authorities, or owners.
Some key issues for MKR holders include protocol security, maintaining the DAI peg, and enacting emergency shutdowns in case of an attack.
Frequently Asked Questions
What is the main purpose of MakerDAO?
MakerDAO is designed to create a decentralized stablecoin (DAI) that is pegged to the US dollar and backed by cryptocurrency collateral. It operates without central intermediaries, using smart contracts and community governance.
How is DAI different from other stablecoins?
Unlike centralized stablecoins like USDT or USDC, which are backed by real-world assets held in reserves, DAI is backed by crypto collateral locked in Maker Vaults. This makes DAI decentralized and trust-minimized.
What cryptocurrencies can I use as collateral in Maker Vaults?
Maker accepts multiple cryptocurrencies as collateral, including Ethereum (ETH), Wrapped Bitcoin (WBTC), and several ERC-20 tokens. The list is updated periodically through community governance proposals.
What happens if my collateral value drops too low?
If the value of your collateral falls close to your debt level, your position may be liquidated to protect the system. It’s crucial to monitor your collateralization ratio and add more collateral if needed.
Can I earn interest on DAI?
Yes, you can lend DAI on various DeFi platforms like Compound, Awe, or Curve to earn interest. Some platforms also offer yield farming opportunities with DAI pairs.
Is MakerDAO completely decentralized?
MakerDAO is highly decentralized thanks to its DAO structure and use of blockchain technology. However, it does rely on price oracles for real-world data, which introduces a minor element of external dependency.