Maker is an iconic DeFi project on the Ethereum platform. Founder Rune Christensen began exploring how to achieve stablecoins back in the Bitshares era. Even before Ethereum was launched, Christensen had already designed the prototype for DAI. The protocol was launched in 2017 and can be considered an early lending protocol. After the bull market of 2017-2018, most protocols disappeared, but DAI remains one of the most credible stablecoins, indicating that Maker's infrastructure has stood the test of time.
The most important product of the Maker protocol is DAI, a stablecoin pegged to the US dollar. Its implementation follows the same method as Bitshares, which is overcollateralization to borrow stablecoins. In the early days, the only collateral was Ethereum, and DAI was borrowed by using a certain amount of Ethereum as collateral.
A common misconception about Maker is that DAI is a pre-existing asset and borrowers use Ethereum as collateral to borrow DAI. However, DAI is actually created out of thin air. When borrowing, the system mints DAI and lends it to the borrower, and when the borrower repays the DAI, it is destroyed, and the borrower's collateral is released. This is similar to how fiat currency is created and released in the current monetary system: when a commercial bank issues a loan, dollars are deposited into someone's account as a loan, and the borrower is recorded with a debt. Similarly, DAI holders hold the debt of the borrower: the borrower will eventually buy back DAI with some assets and repay it to the Maker protocol to redeem their collateral. More accurately, DAI is a "synthetic asset," and Maker is more appropriately called a "synthetic asset" protocol.
The initial vision of Maker was to achieve a trustless way of issuing stablecoins on the blockchain, to solve the dilemma of either having the Ethereum ecosystem develop based on volatile tokens (such as ETH) or introducing stablecoins that require trust in a specific entity (such as Tether). The solution was DAI.
In November 2019, Maker introduced the functionality of multiple collateral assets, no longer limiting collateral to just Ethereum. For convenience, the following examples still use Ethereum as collateral.
Borrowers need to establish an independent Vault in the Maker protocol and deposit Ethereum. After depositing, they can borrow a certain amount of DAI based on the collateralization ratio. For example, if 1 ETH is deposited and the current price is 1500 DAI, with a collateralization ratio of 150%, the borrower can borrow up to 1000 DAI. Assuming the borrower borrows 750 DAI and maintains a collateralization ratio of 150% or higher throughout the borrowing period, meaning the Ethereum price never falls below 1125 DAI (750 DAI * 1.5), the borrower only needs to repay 750 DAI plus some interest to redeem 1 ETH.
If the Ethereum price falls below 1125 DAI, it will trigger a forced liquidation. During a forced liquidation, Ethereum will be auctioned at a lower price to attract market makers for arbitrage. Since the debt is denominated in DAI, market makers need to use DAI to purchase the auctioned collateral. The DAI obtained from the auction is first used to repay the debt, and then the protocol collects a liquidation penalty of around 15%, and the remaining Ethereum is returned to the borrower. After this process is completed, the borrower's debt is settled. Due to the discount auction and liquidation penalty mechanism, once a forced liquidation is triggered, the borrower will suffer significant losses, so borrowers are encouraged to maintain sufficient collateral to ensure system stability.
In the event of a significant drop in collateral prices in a short period of time, the value of the collateral may not be sufficient to support the debt. Using the previous example, if the Ethereum price suddenly drops from $1200 to $600, the collateral value would be $600, but the debt would be 750 DAI, meaning the collateral value cannot maintain a 1:1 relationship with DAI and the US dollar.
For this situation, the Maker protocol provides two ways to address it:
First, using the Maker Buffer to compensate for the debt. The Maker Buffer uses the income from the Maker protocol, including borrower interest (referred to as the stability fee rate in the Maker protocol), liquidation penalties, and DEX income, as capital.
Second, when the Maker Buffer is still insufficient to cover the debt, the auction mechanism for the governance token MKR is activated. MKR is auctioned at a slightly lower price than the market price, and the DAI obtained from the auction is used to cover the debt gap. This is similar to a company issuing additional shares to raise funds to repay debt. Usually, in this situation, the governance token price will experience a significant drop, presenting an opportunity for some to buy undervalued assets.
During Black Thursday in March 2020, the sharp drop in Ethereum prices triggered a large number of forced liquidations of Vaults within a short period of time, causing auction prices to temporarily drop to zero and resulting in insufficient collateral for DAI. Maker initiated MKR auctions to compensate for the shortfall and optimized the forced liquidation module.
In addition to overcollateralization, Maker also maintains the peg between DAI and the US dollar through interest rate policies. The borrowing interest rate is called the "stability fee rate" and determines the annualized interest rate for borrowing. The adjustment of interest rates is done through DAO governance. When DAI is priced below the US dollar, for example, 1 DAI = $0.98, it means there is an excess supply of DAI. In this case, the stability fee rate is increased to raise borrowing costs, encouraging Vault borrowers to repay their loans early to reduce the circulation of DAI and increase its price. If DAI is priced above the US dollar, the stability fee rate is lowered to encourage borrowing and increase the circulation of DAI.
Alongside the introduction of multiple collateral assets, Maker also added the feature of depositing DAI, controlling the quantity of circulating DAI through adjustments to the DAI deposit rate. In this way, Maker uses interest rate policies on both the supply and demand sides of DAI to assist in maintaining the peg between DAI and the US dollar.
Based on the above mechanisms, Maker seems to have achieved, to some extent, the issuance and redemption of the US dollar, and also adjusts the circulation of DAI through interest rate policies. In this sense, Maker can be considered a "decentralized" Federal Reserve.
Looking back, in order to achieve decentralized stablecoins, Maker also developed some other foundational features: an oracle module was developed to obtain the price of ETH, and a decentralized exchange called Oasis was created for DAI trading. If these mechanisms were to be redesigned now, there are already existing protocols that can be used. The Maker mechanism can be said to have been carefully designed and can be considered one of the earliest projects to implement stablecoins on Ethereum, making it a benchmark project in DeFi.