MakerDAO and DAI: Decentralized Lending
MakerDAO and DAI may be in its infancy now but this is a technology that absolutely has the potential to, if not replace, then at least compete with the traditional banking system.
If humans agreed on everything being alive would be boring, the drama is the fuel of life. However, ask cryptocurrencies enthusiasts about MakerDAO and DAI and a surprising number of them will admit that it’s a pretty cool project. MakerDAO and DAI may be in its infancy now but this is a technology that absolutely has the potential to, if not replace, then at least compete with the traditional banking system.
This new decentralized financial system (DeFi) is the future. And while it does possess one serious limitation that the traditional financial system does not, as the ecosystem evolves that problem mays lowly go away. This is the story of DAI, of how people are borrowing money without the approval of third parties and what the future could look like once DeFi achieves mass adoption.
How DAI borrowing works
In most cases, if a person wants to take out a loan, say to buy a house or a car, they have to put some money down upfront. For instance, when a husband and wife wish to purchase a home they may need to put down 20% of the purchase price and then finance the remaining 80%. That’s a typical arrangement.
With DAI, on the other hand, the numbers are heavily skewed in the other direction. In order to borrow just $660, it will be necessary to stake $1,000 worth of Ethereum as collateral. That is also the minimum recommended collateralization rate. In reality, a 300% collateralization rate is preferable. So if a couple wanted to buy a $330,000 house and keep the collateralization rate at 300%, just to be on the safe side, that would require $1,000,000 worth of Ethereum as collateral! Very few people can afford that. Even if they could, someone with that level of wealth would probably be more inclined to seek financing from a traditional institution.
Who could benefit from a DAI loan
The ideal person for a DAI loan is one who already owns a lot of Ethereum and is not currently doing anything with it. They’re just storing it on their Trezor or whichever other wallet they trust. Unfortunately, when someone does this the Ethereum is all but useless. It earns no interest and serves no purpose. But there is another way.
If that investor locked up their Ethereum in a CDP (Collateralized Debt Position) they could create DAI. They could then take that DAI and do one of two things with it. They could purchase more Ethereum and in this way use a CDP as a decentralized margin trading platform. Or, they could use that DAI to generate passive income.
When an investor keeps their money in a bank account the interest rate is often so low as to be negligible. Recently the author received $0.04 of interest on a $1,000 deposit. Astounding, the generosity of the banks. On the other hand, when an investor locks up DAI in a platform like Dharma they can expect to receive an interest rate anywhere from 6% to as high as 14% (although this is unusual).
So whether DAI generated from a CDP is used to buy more Ethereum thus increasing the investor’s exposure to the cryptocurrency, or the DAI is stored with Dharma and used to generate an impressive yearly ROI, the options are much better than what’s available in the traditional financial sector.
Because the DAI stablecoin is collateralized by a volatile asset there must be some controls in place to ensure that it maintains a steady peg against the dollar. These changes are managed by the MakerDAO foundation. The foundation is democratic and anybody who wants to vote on governance changes can purchase the MKR token in order to do so.
In the first place, when too many people are locking up their Ethereum in CDPs it creates a surplus of the coin on the market and the price of DAI begins to fall below $1.00. Recently we saw this when DAI spent several weeks around the $0.95 level. While not horrible, this is not desirable and could be especially undesirable for investors moving hundreds of thousands of dollars at a time.
To discourage investors from putting too much money into CDPs to generate DAI, the Maker Foundation can vote to increase stability fees (interest rates). Recently there have been drastic increases which have set the stability to nearly 20%! In many peoples’ opinions, this is too high but it has had the desired result and now DAI is pegged closer to a dollar.
On the other hand, if DAI is consistently above the dollar the stability fee can be lowered, it becomes more attractive to lock up Ethereum in CDPs and the ensuing selling pressure of DAI drives the price down to its $1 peg.
DAI decentralized balancing
Sadly there has been a lot of infighting amongst the more powerful actors in the MakerDAO foundation and there is an incessant debate about how high is too high for a stability fee (it’s currently just under 20% per annum which does appear too high). However, the hope is that in time a balance is struck and a lasting solution is found. It may be that the stability fee for locking up Ethereum and borrowing DAI ends up being somewhere around 10%. While that would be higher than the nearly 0% rates we saw when DAI was first introduced, it would still probably be a very fair number given that the entire system is decentralized, censorship-resistant and short of Ethereum failing, no transaction can be blocked.
DAI is rapidly proving itself to be a real contender in the stablecoin market and while it lacks the volume of some of the larger coins, with its increased growth there is no telling how popular it may become.