This post was co-authored with Katie Haun. It pertains to an a16zcrypto investment. The original announcement is here, on our official blog.
Cryptocurrencies are borderless, trustless, and accessible to anyone with an internet connection. As such we believe they’ll increasingly be used for a host of financial services in years to come. This is one of the reasons we’ve established a fund dedicated entirely to crypto. But one challenge with cryptocurrencies to date has been price instability.
Price swings are one of the things hindering the everyday use of crypto for payments. Why pay for a cup of coffee — or famously, two pizzas — using bitcoin when those pizzas could later turn out to have cost millions? The same volatility that is holding back crypto for payments is also limiting its use for a host of other financial services and products. Take lending. Today, it’s not really practical to make a long-term loan in bitcoin because you’d have to consider two independent risks: first that the loan would be repaid, and second, whether the bitcoin would be worth more or less at the time the loan came due.
Why Stablecoins Matter
Price stability is a key feature for the adoption of any currency. By unlocking stability, you unlock many use cases for cryptocurrencies. Payments. Lending and borrowing. Derivatives. Placing bets on future occurrences. And other products and services we likely haven’t yet imagined.
That’s why so many crypto projects — from digital goods marketplaces and lending platforms to decentralized exchanges and prediction markets — are working to integrate stablecoins. With each integration, the overall ecosystem of decentralized applications becomes more accessible. This will also drive strong user network effects around stablecoins as de facto internet money.
As the name implies, stablecoins are cryptocurrencies pegged to a more stable asset, such as the U.S. dollar. But because they’re deployed on top of blockchains that track their supply and movement, they retain the advantages of cryptocurrencies: digital, global, easily transferable, and decentralized.
Broadly, there are three types of stablecoins: (1) those that are fully collateralized with fiat currency, holding reserves equal to the value of the tokens in circulation. This approach requires a central entity to guarantee redemption, so this category of stablecoin can be thought of as a digital IOU; (2) those that are not collateralized by any asset, but instead aim to maintain a stable price peg by algorithmically adjusting the supply of stablecoins in response to price; and (3) those that are collateralized with digital assets. This latter type of stablecoin removes the need for a central entity to custody assets. It instead runs independently within a smart contract. This last category is what Maker is all about. And today, we’re doubling down on stablecoins and furthering our investment in Maker with a $15 million MKR token purchase.
Maker’s Stablecoin
Maker’s stablecoin, Dai, is soft pegged to the U.S. Dollar and backed by ETH custodied on the Ethereum blockchain. There are two sides to the marketplace that allow for the creation and use of Dai.
- Dai is created when asset owners deposit collateral to secure a loan, which is denominated in Dai stablecoin. This loan is called a Collateral Debt Position (CDP). The size of the loan is a function of the USD value of the collateral deposit. This allows owners of illiquid or unstable assets that wish to retain those assets over the long term to gain short-term liquidity, i.e. an ability to spend value otherwise locked in those assets while still retaining those assets.
- Once created, Dai stablecoins can move freely like any other cryptocurrency. People can buy them on exchanges. People can receive them for payment. A secondary holder of Dai need not ever have taken part in — or even understand — the process for creating Dai. Ordinary users can use Dai stablecoins for payments, savings, or as a base currency for more complex financial products (e.g. loans, derivatives, etc). These users benefit from the properties of a price-stable cryptocurrency without having to interact with the complexity of Maker’s collateral-credit system.
A set of autonomous smart contracts coordinates and runs the Maker system, which means that anyone with an internet connection and collateral can create Dai without the need for trusted intermediaries. To ensure the system remains solvent, a network of market makers is incentivized to liquidate loans that risk becoming undercollateralized, thereby removing excess Dai from circulation and keeping the balance of Dai to collateral in check.
Earlier this week, we created 100 DAI and used it to donate to hurricane relief. To do so, we first posted 500 Dai-worth of ETH in Maker’s smart contract credit system. The deposit contract makes use of trusted data feeds (called “oracles”) to obtain the market value of the ETH and mint a commensurate amount of new Dai.
Dai loans backed by ETH require a minimum 150% collateral-to-debt ratio, which means we’ll need to ensure that our CDP always has $150 worth of ETH behind our 100 Dai loan. If the price of ETH drops below this 150% threshold, our collateral will be automatically liquidated by the CDP smart contract in order to pay back our loan. This ensures that all Dai minted is always backed by an appropriate amount of collateral.
There are a number of levers that can be pulled by the Maker community to influence the creation and stability of Dai. For example, CDP creators must pay a “stability fee” in order to retrieve their collateral — you can think of this like an interest rate for Dai loans. The stability fee can be dynamically adjusted to incentivize the creation or destruction of Dai. For example, when the demand for Dai outpaces the available supply and drives price above a dollar, the community can adjust the “stability fee,” thereby catalyzing demand for CDPs and increasing the amount of Dai in circulation (reducing price). Conversely, when the price of Dai falls below a dollar, the stability fee can be increased, incentivizing CDP holders to cover their debts by destroying Dai, deflating supply and putting upward pressure on price.
The Near Future: Multicollateral DAI
Today, Dai is solely backed by ETH. In spite of ETH’s volatility, the peg has managed to remain stable over the course of the last year by requiring all CDPs to be safely overcollateralized. With the upcoming launch of “multicollateral Dai” Maker will enable CDPs to be created from a diverse basket of collateral types. Some examples may include derivatives such as dYdXmargin tokens for market-neutral CDPs, tokenized equities, or even other fiat-backed stablecoins. Although beta software can be a bumpy ride with ups and downs, adding new forms of digital collateral should make Dai even more flexible and resilient to exogenous shocks. It will also help Maker benefit from the broader adoption of crypto that Dai can help catalyze.
As crypto adoption grows, more asset classes will find their way to global markets by way of tokenization. For example, today a coffee grower in Colombia may have no choice but to engage a loan shark to fund day-to-day operations. Through Maker’s partnership with TradeShift, that same grower will soon be able to tokenize Starbucks account receivables and sell them into a global market for instant liquidity. In this way, Dai could simultaneously help alleviate the well-known pains of international remittance, while the tokenized invoice makes for a new and dependable collateral-type for the Maker credit system.
In spite of Dai’s early traction, the leadership at the Maker Foundation has described the launch of multi-collateral Dai as the true starting line for the project. Introducing new collateral types will require robust and scientific risk management, and also demand participation from a broad base of network partners, including traditional asset issuers, investment risk managers, market makers for collateral liquidity, and exchanges for Dai liquidity.
Governance and Team
In order to coordinate all these stakeholders, the Maker network has two tokens. The first is the Dai stablecoin we’ve described. The second is MKR, a token that allows its holders to actively participate in the governance of critical network parameters, such as the total amount of Dai that can be issued, accepted collateral types, the collateral to debt ratio, and the price of stability fees for loans against those assets.
The incentives of MKR holders are well-aligned with the interests of Dai holders, because the economics of the MKR token are such that those who hold it are financially rewarded for commensurate with the growth of Dai. In essence, MKR holders are the “miners” of the Maker network — they do the work of providing a stable and secure service, and make decisions to manage its growth.
Within this group are some of the most impressive technologists we’ve met in crypto: Rune Christensen founded the Maker Foundation in 2014, growing it to a group of 50+ employees with operations in San Francisco, Copenhagen and New York. CTO Andy Milenius is a former Amazon engineer and an evangelist for secure smart contract engineering practices. We have been consistently impressed with Maker’s technical ingenuity, execution, community building, not to mention their thoughtful approach to regulation.
Through our purchase of MKR tokens, we’re excited to partner with the Maker Foundation leadership and the broader community of Maker token holders in building a more accessible, inclusive, and stable global financial system.
Onward.
Please note that the a16z crypto fund is a separate legal entity managed by CNK Capital Management, L.L.C. (“CNK”), a registered investor advisor with the Securities and Exchange Commission. a16z crypto is legally independent and operationally separate from the Andreessen Horowitz family of fund and AH Capital Management, L.L.C. (“AHCM”).
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