What is Maker (MKR)? Crypto’s Unofficial Central Bank Explained
MakerDAO plays an important role in the entire Ethereum ecosystem, and perhaps in the entire crypto realm. Learn more below.
The Maker Protocol, or MakerDAO, is crypto’s unofficial central bank, and this is for a couple of reasons. First, it is a decentralised autonomous organisation (DAO). Second, they are responsible for issuing $5 billion of the DAI stablecoin, which has always had a stable value of roughly $1.00 US per DAI stablecoin.
This article is about MakerDAO’s token, MKR. However, we can’t talk about it without including the DAI stablecoin. Stick around to learn more about MKR and its importance in the crypto realm.
What are MakerDAO and the Maker (MKR) tokens?
MakerDAO, as a decentralised autonomous organisation, issues DAI stablecoins.
MKR tokens also represent partial ownership of the entire DAO, which are essential for community governance and decision-making of the organisation.
Apart from community governance, MKR also has another use, as it has a special relationship with DAI.
It’s important to note that this relationship is not the same as the LUNA-UST algorithmic relationship that caused their instability and eventual collapse in 2022. In fact, MKR will only be useful for DAI in an emergency situation.
To understand this special relationship further, we need to briefly look at how DAI works as a stablecoin.
How MakerDAO issues DAI
While DAI is not the world’s most widely used stablecoins (as of the time of writing, it is still Tether USD a.k.a USDT), it is still one of the most important ones.
In fact, DAI is the first decentralised stablecoin, and currently the biggest one at that. It is therefore completely independent of governmental influence.
Why are stablecoins so important?
Stablecoins are the life-blood of crypto investors. They help them “lock in” the value of their crypto assets at a specific point in time, by converting (or swapping) the assets into stablecoins.
Stablecoins like Tether (USDT) allow crypto investors to keep their crypto assets on the blockchain, and not have to convert their assets to fiat currency through centralised exchanges, at each time they want to lock in their investment value.
By swapping crypto assets with stablecoins through decentralised exchanges like Uniswap, a crypto investor can save time and commission fees, and pay nothing more than the network fees, to hedge against potential downside risks, or to realise any profits they had gained from price movements.
What are stablecoins?
In short, stablecoins are a type of cryptocurrency whose value is pegged to an external refference asset, such as government-issued currency (USD), precious commodities (gold), etc.
DAI is backed by crypto assets
USDT is mostly backed by a reserve of US dollar cash in some custodial bank account in the United States — the same applies to USD Coin (USDC). The two stablecoins are therefore centralised or company-issued stablecoins.
DAI, on the other hand, is backed (or collateralised) by a selection of crypto assets. At the time of writing, MakerDAO accepts the following cryptos as collateral:
- Ethereum (ETH),
- Basic Attention Tokens (BAT),
- ERC-20 Wrapped BTC (WBTC),
- Chainlink (LINK),
- Uniswap tokens (UNI) and a few more.
Because crypto assets are volatile, DAI can only be minted if the value of the collateral is at least 1.5 times the value of DAI to be minted.
For example, if someone were to mint $100 of DAI, they’d have to lock in $150 of ETH inside a Vault, which is secured and operated by smart contracts.
This is why minting DAI is synonymous with “borrowing” from MakerDAO. The borrower’s freshly minted DAI is over-collateralised, to ensure that there is always at least $1 worth of valuable asset backing up each DAI.
What happens to DAI during a crypto market crash?
When borrowers’ crypto collateral loses value, MakerDAO’s smart contracts immediately sell (i.e. liquidate) those collateral for DAI in the open market, before the collateral’s value drops below the value of minted DAI — before MakerDAO becomes under-collateralised, and endangers the integrity of DAI.
When MakerDAO liquidates a borrower’s collateral for DAI, the balance sheets of both the borrower and MakerDAO evens out. Let’s say a borrower had borrowed 10,000 DAI.
Going into a crypto market crash, the borrower discovers that the ETH they had used as collateral is quickly approaching $10,000 in value.
MakerDAO’s smart contracts then execute to liquidate the borrower’s $10,000 of collateral for 10,000 DAI. The borrower then is no longer in debt to return the DAI they had minted, and could keep however much DAI they had left.
How MakerDAO copes with a liquidity crisis
The over-collateralized debt position model has historically worked quite well during the few volatile periods in the crypto market. This is why many peer-to-peer lending protocols, such as Compound (COMP) and Aave (AAVE), continue to use this model to this day.
However, such a safeguard doesn’t guarantee the fullest protection against under-collateralisation. During the global financial market crash of March 2020, MakerDAO also struggled to cover the gap in its balance sheet.
Despite having a reliable collateral auction system, when the market panics, nothing could convince people to buy assets that are rapidly falling in price. Because of this, MakerDAO activates a second mechanism to protect DAI’s value — it would mint new MKR tokens out of thin air.
The newly minted MKR tokens theoretically have value, as the existing ones do, even in times of market turmoil. However, having MKR tokens to prop up the collateral value for DAI is just a temporary solution. MKR tokens must be sold off in an auction for other crypto assets, preferably other stablecoins.
MKR as a collateral is only temporary
Keeping MKR in its balance sheet for too long could spell doom for MakerDAO. This is exactly what was being done by FTX in 2023 prior to its collapse — using FTX tokens to back up the exchange’s debt. The UST stablecoin’s over-reliance on its partner crypto pair, LUNA, also drove the asset to the ground.
In principle, when an organisation’s governance token is being used to prop up the value of its stablecoin, instead of an independent asset, a financial shock would cause a negative feedback loop that increasingly drives the value of both the DAO’s token and the stablecoin further and further down.
MKR holders are the guardians of DAI
Eventually, the market panic will subside, and buyers would be willing to buy the newly minted MKR tokens at a bargain.
MakerDAO would no longer be under-collateralised, DAI would maintain its stable price of $1, but at the cost of diluting the supply of MKR and costing MKR investors some money from their invested MKR.
Hence, MKR holders are indirectly the guardians of DAI, and that being part of the MakerDAO governance community is a big responsibility to take.
The reward for assuming the risk of holding MKR comes in the form of the cost to mint DAI — that is, the interest rate that holders agree to set.
MKR holders can also vote to allow or disallow crypto assets as collateral, or even to set the collateral ratio requirement. For example, they could set the collateral ratio of BAT tokens to be, say, 80%. This means anyone wanting to use BAT to mint DAI must deposit $180 of BAT for every $100 of DAI to be minted.
A higher percentage for the collateral ratio gives a wider room for the collateral to lose value, but this makes it more expensive to mint DAI, constricting MKR token holders’ future revenue.
MKR is the governance token for MakerDAO, a self-regulating decentralised organisation that issues the DAI stablecoin.
Unlike the most popular stablecoins, DAI is backed by crypto assets in a reserve that has a much higher value than the DAI being minted, making it an over-collateralized stablecoin.
The over-collateralised minting system allows MakerDAO the flexibility to protect itself against being under-collateralized due to a market panic.
However, in case MakerDAO continues to be under-collateralised despite its best effort to liquidate the collateral, as a last resort, new MKR tokens are produced to temporarily prop up the reserve value represented by minted DAI.
Eventually, MKR tokens must be sold to be sustainable, at the cost of diluting MKR tokens in the market. MKR token holders must then make the best decisions together to decide the interest rate (borrowing cost of minting DAI) as well as other parameters such as the collateral ratio requirement, and also the type of assets allowed to be used as collateral.
How to buy Maker (MKR)?
Now that you know all about Maker (MKR) and its significance in the DeFi and crypto space, what are your thoughts?
If you’re feeling bullish on the role Maker has in DeFi and want to consider adding MKR tokens to your crypto portolio, you can do so with us here at Easy Crypto.
Invest in Maker (MKR): Buy MKR with Easy Crypto.
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Disclaimer: Information is current as at the date of publication. This is general information only and is not intended to be advice. Crypto is volatile, carries risk and the value can go up and down. Past performance is not an indicator of future returns. Please do your own research.
Last updated May 15, 2023