Direct from the desk of Dane Williams.
The relationship between MakerDAO (MKR) and DAI is a nuanced one, but crucial to the ecosystem’s success.
You’ve no doubt heard about MakerDAO, the DeFi lending platform that lets you take out a loan by locking-up collateral in exchange for DAI.
But do you fully understand the relationship between DAI and MKR?
It’s a complex topic, but let’s see if I can help you out.
On the blog today, I’ll first introduce the two tokens and explain how their relationship ensures that DAI remains pegged 1:1 with the US dollar.
Then go a bit deeper and explore how price changes in MKR can affect not only the stability of DAI, but the entire ecosystem.
Let’s get into it.
What is the MakerDAO (MKR) token?
Before we dive into the relationship between the two, let's take a closer look at MakerDAO's native token - MKR.
First of all, I need to make it clear that I’m talking about the MakerDAO (MKR) token itself,
NOT the lending platform that you access via different front-ends like Oasis.
MKR is an ERC-20 token that serves multiple purposes within the MakerDAO ecosystem.
Firstly, it is used to govern the platform, with MKR holders being able to vote on important decisions such as changes to the stability fee or collateral requirements.
Additionally, MKR is used as a backstop to ensure the stability of DAI.
This means that in times of market volatility or black swan events, MKR can be minted and sold to cover any outstanding debt.
Thus maintaining the peg of DAI to the US dollar.
So as you can see, the MKR token plays a crucial role in the MakerDAO ecosystem, both as a governance token and a safeguard against instability.
What is the DAI stablecoin?
Now that we have a better understanding of MKR, let's take a look at the stablecoin it is designed to support - DAI.
DAI is a decentralised, collateral-backed stablecoin that is pegged 1:1 to the US dollar.
This means that for every 1 DAI in circulation, there is at least $1 worth of collateral backing it up.
Users can mint DAI by locking up collateral such as ETH or USDC in a MakerDAO smart contract.
The amount of collateral required to mint DAI is determined by the collateralisation ratio, which is currently set at 150%.
While this model of collateralisation means it's not entirely free of 3rd party risk, it is at least further down the decentralisation scale than other collateralised stablecoins..
How do price changes in MKR affect DAI stability?
Now that we have a basic understanding of both the MKR and DAI tokens, let's explore the relationship between the two and how changes in MKR price can affect the stability of DAI.
As we mentioned earlier, MKR also serves as a backstop to ensure the stability of DAI.
In times of market volatility, if the value of collateral backing DAI falls below a certain threshold, MKR can be minted and sold to cover the shortfall and maintain the peg of DAI to the US dollar.
This mechanism means that changes in the value of MKR has a direct impact on the stability of DAI.
For example, if the price of MKR drops significantly, it will become more expensive to maintain the stability of DAI.
This is because more MKR tokens will need to be sold to cover any outstanding debt, which will put additional downward pressure on the price of MKR.
On the other hand, if the price of MKR rises, it will also become cheaper to maintain the stability of DAI.
This is because fewer MKR tokens will need to be sold to cover any outstanding debt, which could put upward pressure on the price of MKR.
The whole concept of MKR token holders using their tokens to set a DAI savings rate to contribute to its stability, while being paid interest for doing so, is super interesting.
But not without its own risks.
The key driver of stability is and will always be the collateral behind every issued DAI.
Maintaining DAI stability isn’t always straightforward
While the relationship between MakerDAO and DAI is designed to ensure the stability of the latter, maintaining that stability is not always straightforward.
One major challenge is market volatility.
In times of extreme volatility, the value of the collateral backing DAI can fall rapidly, making it difficult to maintain the 1:1 peg.
This was demonstrated in March 2020 when the COVID-19 pandemic caused a global market crash.
As the value of ETH and other collateral dropped, MakerDAO struggled to maintain the stability of DAI.
In fact, at one point, the price of DAI even dropped as low as $0.88, well below its target price of $1.
Another challenge is the risk of over-collateralisation.
While the collateralisation ratio is currently set at 150%, it could be increased in the future to ensure greater stability.
However, if the ratio is set too high, it could discourage users from minting DAI, as they would need to lock up a greater amount of collateral to do so.
Finally, there is the risk of governance failure.
As we mentioned earlier, MKR token holders play a crucial role in governing the MakerDAO platform and thus the stability of DAI.
Indecision breeds instability in economics and things are no different within the DAI ecosystem.
Final thoughts on the relationship between MakerDAO (MKR) and DAI
As we have seen, the value of the MKR token is closely tied to the stability of DAI.
Looking ahead, MakerDAO will need to continue to navigate the challenges of maintaining DAI stability, including market volatility, over-collateralisation and governance failure.
I just wanted to wrap up by saying that while DAI is a step in the right direction when it comes to stablecoins, it’s still a collateralised stablecoin that relies on an element of 3rd party risk to maintain its stability.
Its true MakerDAO’s model has proven to be an effective mechanism for stabilising DAI so far.
But you can’t say that it is a solution to truly permissionless money.
There will ALWAYS be a risk that in the event of a catastrophic failure of the MakerDAO system, you may not be able to redeem your DAI for the underlying collateral.
While algorithmic stablecoins still have a long way to go, for me they are the only solution if we genuinely want to reach the point of permissionless money.
In the meantime, DAI is certainly the best of the rest.
Best of probabilities to you.