This is the first of a two-part article on the mechanics of MakerDAO, POA Network, and state channels. In it, we aim to explain the fundamental mechanics of Ethereum’s most popular crypto-collateralized stablecoin and the methodology by which POA Network improves the transactability of Ethereum-based assets such as the dai stablecoin.

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Four years after the project was announced, MakerDAO has become the largest dApp on the Ethereum blockchain, outpacing even the most popular decentralized exchanges in weekly volume. As the pace within the cryptocurrency market swings back up and Pink Sky Group looks to the future, we expect a large amount of the Ethereum ecosystem to be designed around the dai stablecoin and, in future, dai-collateralized synthetic assets such as fiat-targeted stablecoins with values derived from currencies other than the U.S. dollar, peer-to-peer loans underwritten by the issuers themselves, and synthetic stock indices. With the coming launch of multi-collateral dai (MCD), these dai-collateralized assets will be better hedged than ever against the market volatility that cryptocurrency users have come to expect.

In light of the market’s growing interest in MakerDAO, Pink Sky Group would like to take the time to explain a few of the organization’s key elements in the context of one of our favorite pastimes: chess.

MakerDAO. A decentralized autonomous organization that exists on the Ethereum blockchain. Currently, the sole purpose of MakerDAO is to create — and maintain the value of — dai: a ether-collateralized and U.S. dollar-targeted stablecoin. This is accomplished through a complex system of data feeds, smart contracts, and autonomous feedback mechanisms that respectively inform the organization of the spot price of ether, maintain the asset’s collateral, and manipulate its demand in order to stabilize its price.

POA Network. An interoperability protocol that allows users to convert Ethereum-based assets to native assets on dedicated Ethereum sidechains, each with a proof-of-authority consensus algorithm. The protocol locks Ethereum-based assets in a smart contract and issues synthetic representations on a sidechain, permitting users to execute fast transactions and pay transaction fees in the asset being exchanged.

Dai. Dai is the U.S. dollar-targeted stablecoin produced by MakerDAO’s “collateralized debt positions” (CDPs): smart contracts collateralized with locked ether which loan dai. Due to the volatile nature of ether, these smart contracts require significant overcollateralization (at least 150 percent by design), and only release their collateral when the debt has been repaid in full. Dai is expected by many to become a powerful piece in the Ethereum ecosystem.

xDai. A synthetic representation of dai and the product of converting dai to a POA Network asset. xDai exists on its own blockchain as a native asset and is used to pay transaction fees.

State channels. An interaction conducted off-chain without significantly increasing counterparty risk to any participant. State channels lock part of the blockchain state so that a specific set of participants must completely agree with each other in order to update it.

Mike Ryan’s xDai chess project. An off-chain game of chess that makes use of state channels on the POA Network. Players stake xDai, each move updates the game’s state hash, and the winner takes all.

To create dai, a user must first lock up ether in a CDP. The CDP smart contract mints dai, loans that dai to the user, and holds the locked ether as collateral. In order to protect MakerDAO against declines in collateral value, the system requires users to collateralize a minimum of 150 percent of the value that they wish to borrow. At the time of publishing, the average collateralization ratio is over 300 percent, which is significantly above the target and ensures the continued stability of the system. However, should the U.S. dollar value of a CDP’s collateralized ether drop below 150 percent of the value of the loan, the CDP is liquidated and its assets auctioned off so as to repay the debt and maintain dai’s soft peg to the U.S. dollar.

The MakerDAO platform — and its CDPs — are managed by a set of autonomous feedback mechanisms with the help of the following external actors within the community:

Oracles. Used to establish the prices of assets used as collateral in CDPs. MakerDAO uses oracles to draw ETH/USD price data from multiple sources to create an externally validated set of internal prices. Currently, MakerDAO uses 32 oracles operated by maker holders. These oracles all obtain data from the same sources and their addresses are publicly known.

Keepers. Keepers are users that are incentivized to manage the risk and price stability of the system. They are generally automated and serve important functions such as triggering the liquidation of undercollateralized CDPs, buying the collateral from liquidated CDPs, and arbitraging dai around its target price to maintain the soft peg.

Global Settlers. A group of representatives who can, in the case of an emergency, vote to enact a failsafe mechanism which shuts down the entire system.

While dai represents the first truly successful departure from centralized and fiat-collateralized stablecoins, it still encounters the same issue that so many other ERC-20 tokens endure: it is a second-class citizen on the Ethereum blockchain and users must pay transaction fees in ether in order to transact it.

Enter POA Network; POA Network creates products that make Ethereum assets and applications fast, cheap to use, and scalable by chain-linking the Ethereum blockchain to an Ethereum fork which hosts the ERC-20 token as the native asset. The fork runs EVM bytecode, making Solidity smart contracts cross-compatible and — more importantly — uses a proof-of-autonomy consensus algorithm (POA, also known as proof of authority) to increase transaction throughput.

Connecting two blockchains. Chain-linking refers to the process of trustlessly connecting one blockchain to another so that assets can be freely transferred between them. In the case of POA Network, this is accomplished with a “TokenBridge”. The POA Network’s TokenBridge consists of two smart contracts — one on the Ethereum blockchain and the other on the xDai blockchain — which work in conjunction with xDai network validators to respectively receive and issue tokens. A user wishing to convert dai to xDai simply sends dai to the Ethereum-side TokenBridge and an equivalent number of xDai are minted by the xDai-side TokenBridge and send back to the user.

Proof-of-authority consensus. The xDai blockchain’s high transaction throughput is a result of its proof-of-authority consensus protocol. Proof-of-authority is designed to replace proof-of-work on private or permissioned blockchains and works similarly to proof-of-stake; however, network validators stake their real-world identities instead of tokens. In this way, network validators are disincentivized from malicious action on POA Network blockchains. Currently, network validators are required to become notary publics before they are permitted to operate a node. This ensures that their identities have been validated by a public, off-chain, and third-party source before they are able to authorize transactions.

Keep an eye out for part two in Pink Sky Group’s MakerDAO series, in which we expand the discussion to Mike Ryan’s xDai chess project and its use of state channels to improve cost efficiency and usability.

NB: This article may contain terms with which you may not be familiar. Pink Sky Group maintains a glossary of blockchain-specific technical terminology for your convenience, which can be found here.