Mechanism Design Case Study: MakerDao

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We will be using MakerDao as a case study to understand mechanism design. Remember that there isn’t a fixed “rule” to mechanism design. Different projects have different policies and protocols in place.

More articles in Mechanism Design series:

  1. ELI5: Mechanism Design
  2. Theory of mechanism design
  3. Application to blockchain (theory)
  4. Case Study: MakerDao
  5. Governance Protocol & Voting
  6. 28 Examples of Mechanism Design in Blockchain

MakerDao 101: Quick Understanding

  • Collateral-backed cryptocurrency
  • Stable compared to USD
  • Smart contract on ETH and stabilizes Dai through
    • CDP
    • autonomous feedback mech
    • incentivized external actors
  • Leverage ETH assets to generate Dai on Maker platform
Mechanism Design Case Study - MakerDao
Mechanism Design Case Study: MakerDao

Monetary Policy

CDP: Collateralised Debt Position Smart Contracts

  • Hold assets deposited by user
  • Permit user to generate Dai + accrues debt
  • Value of collateral is always higher than debt
  • Steps:
    1. Create CDP and depositing collateral
    2. Generate Dai from collateralized CDP
    3. Paying down debt and stability fee (stability fee accrue on debt over time. Paid in MKR)
    4. Withdraw collateral and close CDP

Pooled ETH (Temp mechanism for Single-Collateral Dai)

  • Pooled ETH (PETH) only collateral type accepted on Maker.
  • Deposit ETH into special smart control that pools ETH from all users. Give corresponding PETH in return.
  • If CDP has more debt than value, Maker Platform dilutes PETH to recapitalize system
  • Proportional claim of each PETH goes down (inflation)
  • Maker Platform upgraded to support multiple collateral types, PETH removed and replaced by ETH with other collateral types

Financial Policy: Price stability Mechanism

Target price

  • Calculate collateral-to-debt ration of CDP
  • Determine value of collateral assets Dai holders receive
  • 1:1 USD (soft peg)

Target Rate Feedback Mech

  • Severe market instability, TRFM engaged. Breaks fixed peg of Dai but maintains same denomination (aka remove fixed exchange rate)
  • Dai stablecoin system adjust target rate to cause market forces to main stability around target price
  • Incentive to hold Dai (if target rate positive aka more than 1:1 = deflationary policy)
  • Incentive to borrow Dai (if target rate negative aka cheaper to borrow like expansionary policy or inflationary policy)
  • TRFM engaged: Target Rate + Target Price changes dynamically to balance supply and demand by adjusting user incentives for generating and holding Dai (expansionary or contractionary policy)

Sensitivity parameter

  • Determines magnitude of Target Rate change in response to Dai target/market price deviation
  • MKR voters can set Sensitivity Parater. TRFM engaged, Target is determined by market dynamics, not voting
  • If SP and TR = 0, Dai is pegged to current Target Price.

Global Settlement

  • Last resort to cryptographically guarantee Target Price
  • Shuts down and unwind Maker Platform. Receive net value of assets they are entitled to
  • Fully decentralized and MKR voters govern access to it. Only used in case of serious emergencies. E.g. long term market irrationality, hacking, security breachers, system upgrades:
  1. Global settlement activated (stop CDP. Freeze price feed)
  2. Claims processed (proportional claims of all Dai and CDP holders based on fixed feed value. Able to claim fixed amount of ETH)
  3. Claim collateral with Dai and CDPs

Risk Parameters

Directly controlled by MKR holders through voting. 1 MKR = 1 vote
  • Debt ceiling
  • Liquidity ratio: collateral-to-debt ratio. Low ratio = kid price volatility
  • Stability fee: paid by every CDP. Annual percentage yield calculated on top of existing debt of CDP paid by CDP user. Denominated in Dai, paid using MKR token. When paid, MKR burned and remove it from supply
  • Penalty Ratio: max Dai raised from liquidity auction that is used to buy up and remove MKR from supply. Used to cover inefficiency of liquidation mechanism. Liquidation Penalty buys and burns PETH, benefit PETH:ETH ratio.

Governance Protocols

MKR Token Governance

  • Election of active proposal by MKR voters. Active Proposal is smart contract to gain root access to modify internal gov variables of Maker Platform. 2 proposals: Single Action vs Delegating
  • Single Action: executed once after gaining root access and after execution, applies changes to internal gov variables. After 1 time, deletes itself. Cannot be reused.
  • Delegating: continuously utilize root access through second layer gov logic (insider DPC). E.g. defining protocol for holding weekly vote on updated risk parameters.
  • Any ETH account can deploy proposal smart contact. MKR voters use MKR tokens to vote.

Key External Actors (players) [Important!]

  • Keeper (automated actor incentives by profit opportunity. Keepers participate in Debt Auctions and Collateral Auctions when CDP liquidated)
  • Oracles (MKR voters choose set of trusted oracles to feed info to Maker Platform through ETH transactions)
  • Global Settlers (external actors similar to price feed oracles. Selected by MKR voters, authority to trigger global settlement.)

Risk Management

MKR token allows holders to vote on performing risk management actions:
  • Add new CDP type
  • Modify existing CDP types
  • Modify sensitivity parameter
  • Modify target rate (governance can change target rate. MKR voters want to peg Dai to current Target Price)
  • Choose set of trusted oracles
  • Modify price feed sensitivity (change rules)
  • Choose set of global settles (governance to choose set of global settlers and how many settlers needed to activate global settlement)

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