MakerDAO in <7 Minutes
What is MakerDAO?
MakerDAO is a platform like Amazon or Ebay that connects buyers and sellers. Unlike ecommerce platforms, however, MakerDAO is a platform for the buying and selling of credit.
The supply side are people who lend the DAI stablecoin to MakerDAO using the DSR (“DAI savings rate”) smart contract1 in exchange for interest.
The demand side are people looking to take DAI denominated loans using BTC and Ether as collateral. Typically, they will either sell the loaned DAI and offramp to fiat and invest in businesses or purchase goods and services, or use the loan to gain leverage and participate in speculative economic activity like yield farming. Borrowing against collateral in the US does not trigger capital gains, which provides additional incentives to borrow against ether or BTC.
MakerDAO profits off the spread between the interest returned to depositers and interest paid by borrowers. For example, lenders might supply 10,000,000 DAI to the DSR for 1% annual interest while borrowers are loaned 6,000,000 DAI at an annual rate of 2%. The MakerDAO protocol would then earn a spread equal to (6,000,000 * .02) - (10,000,000* .01) = $20,000.
Interpreting MakerDAO:
At the moment, there's actually more money being supplied into MakerDAO than there is demand for DAI as leverage- we can see this because a low DSR means that the supply of DAI is relatively large compared to demand for leverage whereas a high DSR means the opposite. Today the DSR is near 0%.
Advantages over traditional banks:
MakerDAO is easily composable with other DeFi protocols such as AAVE, and it’s components like DAI and the DSR can be used by other protocols as “money legos” to form more complex/leveraged economic activity.
Because MakerDAO uses smart contracts that do not have reocurring costs once developed, it's cost structure is much lower than banks that have to hire many employees, especially if L1 settlement layer fees end up being a race to the bottom over time.
Due to the transparent and open nature of DeFi, everyone can see borrowers liquidation points, which is good for suppliers because they can monitor their counterparty risk in real time.
Disadvantages of MakerDAO:
DeFi is new and gets hacked all the time.
Because the DAI stablecoin is something like 50% backed by Crypto collateral, volatility can produce bad debt for the protocol during events like Black Thursday. Bad debt is when MakerDAO is unable to liquidate collateralized positions on the open market fast enough to pay off all of the protocols debt.
Due to the transparent and open nature of DeFi, everyone can see borrowers liquidation points, which is bad for borrowers because well capitalized market participants can use this information to purposefully provoke unnecesary liquidations.
DAI is currently completely dependant on centralized stablecoins like USDC to hold it’s peg and current market capitalization.
Where does the DSR yield come from?
The DSR is equivalent to smart contract risk (basically the risk of being hacked) and the aforementioned bad debt risk.
Should the MakerDAO governance token be worth anything?
It’s highly likely that spreads on collateralized loans will go to zero in the coming years as DeFi matures, although this may also mean that the cost of capital in DeFi will end up being lower than tradfi, which would drive a lot of activity in the ecosystem. Generally, I do not believe the MakerDAO token should have any value if you are using DCF models, but it may if you believe that MakerDAO stakeholders will hold governance tokens to prevent bad actors voting in an uncompetitive spread between the DSR and borrowing rates or other value destructive measures that would result in market share being stolen by an incentivized fork.
I.e., if governance tokens end up in the wrong hands they can be value destructive for stakeholders, which forces them to buy the token.
Bonus
Depositing ether to MakerDAO has a payoff kind of like selling a covered put.
A smart contract is code that can create and transform data and tokens on top of the blockchain to which it belongs and allows the user to encode rules for any type of transaction. For example, the most basic type of smart contract imaginable are NFT mint contracts: in exchange for supplying a specified amount of ether, depositers are transfered an NFT according to the code of the specific smart contract.