Welcome to PYMNTS’ series on decentralized finance, or DeFi.
In these articles, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution. At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.
See Part 1: What is DeFi?
See Part 2: What Are the Top DeFi Platforms?
See Part 3: What Is a Smart Contract?
See Part 4: What is Yield Farming and Liquidity Mining?
See Part 5: What Is Staking?
See Part 6: What Are DeFi’s Top 10 Uses?
See Part 7: Unpacking DeFi and DAO
See Part 8: DeFi’s Very Real Risks
See Part 9: What Are the Top DeFi Blockchains?
See Part 10: What’s Real, What’s Hype, What Matters
See Part 11: How to Buy an NFT in 19 Easy Steps
So, what’s an algorithmic stablecoin?
Well, what’s a stablecoin? It’s a pretty simple concept to grasp. Take a buck, put it in a bank account, and mint a cryptocurrency token. Offer to redeem that token for $1 at any time. Now you’ve got a one-to-one dollar peg, and that token has price stability because it is never worth more or less than that $1.
As long as crypto buyers are satisfied that the dollar really exists and can be redeemed, the stablecoin will retain its value. That dynamic is at the core of one of the U.S. and other governments’ problem with stablecoins: If that confidence erodes, it will create a run just like a bank run, but faster.
Now, let’s discuss the algorithmic stablecoin, which maintains that one-to-one dollar peg without that cache of fiat currency supporting it.
MakerDAO’s DAI stablecoin isn’t the only one — four of the 10 largest stablecoins, with a combined market capitalization of $26.6 billion, are algorithmic. But, launched in 2015, DAI was the first one to break out. And it has gone full DAO, dissolving the Maker Foundation that was the DeFi project’s centralized training wheels.
So, how does MakerDAO do it? Pure capitalism. Algorithmic stablecoins use artificially controlled supply and demand to maintain their price. To do this, they require a partner.
MakerDAO, the decentralized autonomous organization controlling the project, uses two tokens — DAI and MKR — as well as a DeFi lending/borrowing platform.
Chicken or Egg?
Depending on your perspective, MakerDAO is either a DeFi borrowing platform that uses an algorithmic stablecoin, or a stablecoin backed by the funds locked in a DeFi borrowing platform. Then there’s a second token, MKR, that acts as a governance token for the whole shooting match and also backstops Dai’s dollar peg.
Let’s start with the borrowing platform. MakerDAO lets crypto owners borrow against cryptocurrencies like ether (ETH), Compound (COMP), and even stablecoins tether (USDT), USD Coin (USDC) and the Pax Dollar (PAX).
The point being to unlock the value of your crypto without actually selling any of it, as you believe its price will rise long-term. The amount of collateral is as much as 175% of the amount you can borrow, with the rate dependent on the volatility of the cryptocurrency used as collateral.
In exchange, you are loaned dollar-pegged Dai stablecoins (DAI on exchanges), which can be used for anything from investing in DeFi projects like yield farming and liquidity mining to trading other cryptocurrencies — which is cheaper and easier when using a stablecoin rather the trading one token for another — or just as a currency usable on crypto-backed Visa and Mastercard debit cards, or on other crypto projects like the NFT-based Axie Infinity game.
See also: PYMNTS DeFi Series: What is Yield Farming and Liquidity Mining?
The risk is that if the value of your collateral drops too low — easy enough in the volatile crypto market — MakerDAO’s smart contract-controlled borrowing platform will liquidate your collateral, selling at the bottom of the market, to ensure the loan can be repaid.
So, a lot like any other DeFi lending platform.
The Dai stablecoin is where MakerDAO gets creative. For one thing, there is no set amount of Dai. Instead of being backed by a cache of fiat currency like top stablecoins USDT and USDC, Dai is backed by that cryptocurrency collateral. When you lock crypto collateral into MakerDAO, new Dai stablecoins are minted. When you pay back the loan — plus a fee — they are burned.
OK, so how does that keep the price of Dai stable? That’s where the platform’s second token, MKR, comes in.
First off, MKR is a governance token, giving users a vote in how the MakerDAO platform is run — like setting interest rates and borrowing transaction fees, the latter payable only in MKR.
But it has another role. MKR is used to stabilize the price of Dai. If Dai starts to fall below its $1 peg, MKR is created and sold for Dai to boost its value. If Dai starts heating up above $1, MKR is bought back on the market and burned, knocking it back down.
Why? Supply and demand. If Dai’s price starts falling below $1, arbitrage traders will borrow Dai at $1 and then buy Dai on the market at, say, $0.99 to repay their Dai-denominated debt for less than they borrowed — which has the effect of reducing the supply of Dai on the market and thus raising its price.
Similarly, if Dai’s price rises above $1, those traders will deposit collateral and borrow Dai at the standard $1 price and then sell it on the open market for a profit (presumably enough to cover the fee), increasing the supply and causing its price to drop.
If that sounds like a lot of weight to put on supply and demand, there is a backstop. If Dai’s price rises too far, MKR tokens are minted and sold for Dai, increasing its supply. If Dai falls too far, MKR is bought for Dai and burned, decreasing the Dai supply.