What is Maker and DAI?
The Maker Protocol is governed by the MakerDAO and is responsible for the creation and management of the DAI stablecoin. DAI is a decentralized stablecoin pegged to the US dollar and is backed by collateral assets that are locked in smart contracts. To gain a better understanding of decentralized stablecoins, see this blog post.
As the most popular decentralized stablecoin on Ethereum, DAI currently holds about 5% of the total stablecoin market and over 50% of the decentralized stablecoin market. See these two dashboards from 21.co and KARTOD for reference.
How is DAI Created?
To mint DAI, depositors must lock tokens like ETH, USDC, wBTC, and others into smart contracts known as collateralized debt positions (CDPs). Each CDP accrues interest over time, representing the cost of borrowing to users.
The cost of borrowing in the Maker ecosystem is referred to as The Stability Fee. It is an annual percentage yield (APY) that is calculated on top of the existing debt within the CDP and has to be paid by the CDP user. The Stability Fee is denominated in DAI, but can only be paid using the MKR token.
From a collateralization perspective, each CDP has its own requirements. For example, a user who deposits $10,000 of ETH is currently required to maintain an overcollateralization ratio of at least 150%. This means that at most, 6,666 DAI can be minted against $10,000 of ETH.
From a depositor’s perspective, creating DAI is meant to generate liquidity which is most often used for leverage. Going back to our example, a user can deposit $10,000 worth of ETH to generate 5,000 DAI. Then, the user can swap their newly-minted DAI for more ETH. As a result, they have set up a trade that captures a leveraged multiple of the ETH/USD price movement since their debt (DAI) accrues in US Dollar terms.
According to this dashboard from Steakhouse, Maker is currently sitting on nearly 4.7B in assets made up of other stablecoins, RWAs, and tokens like ETH, wBTC, and others. On this asset base, Maker earns interest by charging Stability Fees on user deposits.
What is sDAI?
To put it simply, sDAI is a tokenized wrapper around the DAI Savings Rate (DSR). The DSR helps balance the supply and demand of DAI and is one of the monetary policy levers that the Maker DAO can influence in order to maintain the stablecoin’s peg.
The DSR is funded out of the Stability Fees paid by CDPs. For example, if the average Stability Fees collected on CDPs is 3%, it could be used to fund a DSR of 2%. In other words, the Maker protocol will earn interest income for providing users with liquidity in the form of DAI, and then distribute a portion of this income via the DSR. This means that the DSR is a result of “real yield” generated by the Maker protocol and is not artificially boosted in any way.
A person who holds DAI can lock and unlock DAI into a DSR contract at any time. Once locked into the DSR contract, DAI continuously accrues. For example, if the DSR is 2%, a user who locks 100 DAI into the DSR contract and keeps it locked for a full year would earn two additional DAI. They would receive this additional DAI when they unlock their position from the DSR contrct. Thus, sDAI is not a rebasable token like stETH, meaning that the user's balance of sDAI will not change automatically in proportion to their accrued interest from the DSR. That is why the sDAI / USDC trading pair is currently priced at 1.09 sDAI for each unit of USDC on DEXs like Uniswap.
Using the DSR to Maintain DAI’s Peg
So, how exactly is the DSR used to maintain DAI’s peg? If the market price of DAI is above 1.00 USD, the DAI Savings Rate will decrease. This lowers demand for DAI in the sense that some users would unlock their DAI from the sDAI contract and then sell it on the open market for other assets. As a result, this should reduce the market price of DAI down towards the 1.00 USD target price.
Conversely, if the market price of DAI is lower than 1.00 USD, the Maker DAO may choose to raise the DSR. As a result, we would see more demand for DAI and thus, a convergence to its peg of 1.00 USD across trading venues like DEXs and centralized exchanges.
Right now, there is nearly 1.4B DAI earning the DSR in the sDAI contract. On March 8th, the Maker DAO passed a proposal to increase stability fees charged on the protocol’s CDPs in order to align borrow rates with those observed on platforms like Aave and Compound. As a result, the proposal also called for increasing the DSR from 5% to 15%, outlined here. Whereas more recently, the stability fee was lowered to 8%, where it currently stands.
Unpacking Key Risk Factors
Operating since 2017, The Maker Protocol is often referred to as Ethereum’s flagship DeFi project. See here for Maker’s relevance in the history of DeFi.
By depositing USDC into Maker’s sDAI contract, the most significant risk relates to the protocol’s ability to maintain DAI’s peg in the long term. To maintain DAI’s stability, Maker DAO has instituted many risk-mitigation strategies, including their Target Rate Feedback Mechanism (TRFM), Peg Stability Module (PSM), and the DAI Savings Rate (DSR) which can be read about in detail here. Since its creation, DAI has demonstrated relative stability over the past few years.
However, with a significant portion of deposited collateral now in the form of USDC and RWAs, DAI now inherits some of the risk associated with the US banking sector and overall US economic environment.
In March 2023, when USDC lost its peg following concerns that deposits were locked in the recently-bankrupt SVB, both USDC and DAI fell to 0.90 for a short period of time. It is worth noting that DAI has not suffered from any sustained deviation from its peg, and therefore shouldnt be considered a high-risk asset.