I've recently encountered more and more coverage of MakerDAO, so I thought I'd have a look and check out what they're actually doing. If you want to get a good overview instead of reading the entire white paper (which I also did), it's worth listening to Kevin Rose's podcast Block Zero and the [episode with Rune Christensen of MakerDAO). An even shorter view can be seen in a short explanation video:

So I'll just give a quick overview here.

What is MakerDAO?

MakerDAO is an Ethereum-based Decentralized Autonomous Organization (DAO) that organizes a system to provide a stable crypto coin called Dai. Other than e.g. Tether, which is backed by real USD and managed by a central entity (the Tether company), Dai is being backed by collateral in a decentralized way. Users can lock up some ETH and then they're allowed to mint some Dai, basically about half of the USD value of the ETH they've locked up. In order to get their ETH unlocked again, the user will have to buy back the same amount of Dai on the market and put it back into the smart contract. Once that's done, the Dai will be burned and the ETH released. Releasing ETH costs a small fee (depending on the amount and duration of the loan) which is paid in MKR tokens. These MKR tokens are also burned upon the repayment of the Dai, leading to a deflation of the MRK token if everything works nicely.

Disclaimer: There are scenarios where MKR can be inflated heavily, so don't assume there's always deflation and therefore a rise in price.

What's cool about that?

From a scientific point of view, this is brilliant. It is a very secure way of transparently collateralizing a stable coin. No discussions about whether or not the collateral really exists and no difficulties how to prove that.

In addition, MakerDAO want to add more options for collateral. If there's a wide range of Ethereum-based tokens that can be used as collateral, the risk of Dai becoming undercollateralized will drop dramatically.

How that works in practice

If you lock up ETH and mint Dai, you can basically do whatever you want with those Dai tokens. You can buy other tokens on some markets, invest, speculate, stake or whatever you want. That's sounds really easy.

How many Dai exist?

But how is it ensured that there's enough Dai to cover the demand? There is no inherent mechanism to ensure that there's enough Dai liquidity. In addition, the price of Dai is supposed to be pegged against USD. Therefore, if demand for Dai was really high, e.g. because a lot of people are seeking to sell ETH or ERC-20 tokens for Dai, this means that price for Dai compared to ETH will go up, meaning that the price of ETH against Dai would go down. In an ideal world, as ETH is a very liquid asset, this will not be important as those ETH markets will get arbitraged quickly on other USD-pegged markets. This is how the Dai price can always remain stable, despite the fact it's not fixed in value.

Is this the end of Tether?

So far, it sounds like the MakerDAO / Dai system is significantly superior over Tether. After all, it's decentralized, transparent and you can use crypto as collateral rather than USD. So, Tether will be destroyed by that, right?

I'm not so sure about that. To me, there's one big question which I haven't wrapped my head around, yet:

What are the incentives for users to lock up ETH or other assets as collateral on MakerDAO?

At first, this looks like a non-issue as you don't lose your ETH when you do lock it up. The fee is rather low and you get a (hopefully) liquid asset - Dai - which you can work with. But for someone with a lot of ETH there are a lot of different options, an minting Dai doesn't seem the most profitable. Let's see:

• Dai needs to be heavily over-collateralized in order to be able to sustain volatility of ETH an still remain stable. Right now the factor is 2, so for 1000 USD worth of ETH you can get 500 USD worth of Dai
• If you lend ETH on collateralized loan platforms like ETHLend or Bitfinex, you can typically get 3-4% ARR
• If you use ETH as collateral on those platforms, you typically just need 20-25% of the value of the cryptos you want to borrow / margin trade, as compared to 200% for Dai

The fact that Dai needs to overcollateralized to me looks like that will make it really unattractive to users, so I'm not sure what to think. If there's anybody who has an idea about the incentive scheme here, I'd be happy to discuss that.