I have been working on my understanding of MakerDao system and how it creates decentralized stable coins. I would like to just run through an example in my own words to test my understanding of all the concepts and then take critiques.
Seeing how volatile the crypto market is and realizing it is never going to be adopted as serious currency, someone came up with the idea that crypto needed stable coins. While other stable coins accomplish this by simply hoarding dollars in a bank and backing their coins with dollars on a 1:1 ratio, this approach defeats the purpose of blackchain ethos of decentralization. Having a bank with dollars sitting in it to back coins is a centralized point of failure and not to mention probably more open to accounting fraud also. The crypto market needed a decentralized stablecoin.
The founders of MakerDao accomplish this by attempting to to tame the volatility of the crypto markets. One way to ease the volatility is through overcollateralization in the process minting Dai stable coins. This means that a larger value deposit is required in order to take mint a lesser value of Dai. The minimum required is 150% collateral. This gives some room for markets to fluctuate while Dai remains stable. In the case that the value of the deposit sinks below 150%, the collateral is immediately liquidated and a 13% penalty is applied. Now, I am not sure this is 13% of the collateral or of the minted Dai. I am assuming that it is 13% of the minted Dai for that particular CDP since that remains stable. A penalty on the value of the collateral that fluctuates more in value does not make much sense, but since I have not heard it confirmed from a competent source I am just putting it out there. After the penalty is applied, stability fee paid, and the amount of Dai minted taken out of the collateral, any remaining collateral returns to the original owner. I am not really sure what happens with that 13% penalty after it is paid, so maybe someone can help me with this? In the event that the market of the collateral drops so fast that after the penalty and stability fee it cannot cover the cost of the minted Dao, then MKR tokens are minted an sold on the open market. MKR token holders would seek to avoid this as minting of new MKR tokes increases supply which pulls down the price for token holders. Lastly, once a CDP is repaid the stability must be paid in MKR or Dai (which is converted to MKR) and then everything is burned off. Burning off Dai controls the supply of Dai thus stabilizing the price. Burning off MKR counteracts the minting of new MKR being created and reduces the supply thus increasing MKR’s value for token holders. One of the problems is that this system incentivizes MKR holders to always want to increase stability fees and overcollateralization percentages to both burn off more MKR and mint less; however, if MKR token holders do this too much they shoot themselves in the foot because new Dai will stop being minted and the demand for MKR tokens to pay stability fees will decrease and the overall Dai pools shrinks. Raising stability fees and overcollateralization percentages is short sighted. Keeping them low and growing the Dai pool over the long term is a better strategy that is more inline with Dai becoming a decentralized global currency. I would argue currently that MKR holders are increasing stability rates and overcollateralization percentages too much thus hampering the growth of Dai in the long term.
The other things that keep the price of Dai stable are arbitrage. Minting Dai and selling it when it is above the peg drags the price back down as the supply of Dai is increased. Buying Dai on an exchange when it is below the peg to pay back a CDP decreases the supply of Dai thus resulting in a price increase.
The Dai savings rate (DSR) also plays a role. This control is the one I have studied the least and would appreciate more explanation on how it works to control the price of Dai.
Thank you for reading. Please comment and critique away because I am anxious to learn more.
EDIT: I have no idea why or how oracles fit into all of this? It seems like they are not even needed as the system seems to balances itself. What immediate need there is for oracles I cannot see it.