DAI is a stablecoin cryptocurrency that aims to maintain a value of $1 USD per token. DAI is decentralized and built on the Ethereum blockchain using smart contracts. It differs from other stablecoins in that it does not rely on asset backing or external collateral to maintain its peg. Instead, DAI uses collateral and economic incentives to ensure its stability.
What is DAI?
DAI is an Ethereum-based decentralized stablecoin developed by the MakerDAO project. The DAI token was launched in 2017 and has consistently maintained its 1:1 peg to the US dollar.
DAI is designed to provide price stability amidst the volatility of the cryptocurrency market. Being on a blockchain also gives DAI the advantages of cryptos like decentralization, transparency, and immutability. Unlike other stablecoins that are backed by fiat reserves, DAI maintains its peg through overcollateralization and economic incentives.
How DAI Maintains Its Peg
DAI maintains its stable value of $1 through a system of collateralized debt positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors. The core components that allow DAI to maintain its peg are:
- Collateral – DAI is backed by excess collateral stored in Ethereum smart contracts.
- CDPs – Users lock collateral into a CDP to generate DAI.
- Stability Fee – CDP owners pay a stability fee when paying back their debt to burn DAI.
- Target Price – The Maker system targets a price of $1.
- Arbitrage – Traders arbitrage the DAI price if it strays from $1.
This creates a self-balancing mechanism where changes in supply and demand dynamically adjust DAI’s price. If DAI drops below $1, stability fees decrease, incentivizing CDP creation to increase supply. If DAI is above $1, stability fees increase, incentivizing CDP closures to decrease supply. This brings the price back to $1.
Collateral
DAI generation requires excess collateral stored in Maker smart contracts. Currently, the only accepted collateral type is Ether (ETH). The collateralization ratio is currently 150%, meaning $150 worth of ETH must be locked to create $100 worth of DAI. This overcollateralization provides security and absorbs price volatility in the collateral asset.
CDPs
Users create collateralized debt positions (CDPs) by depositing ETH into Maker smart contracts as collateral. This allows them to generate DAI up to 66% of their collateral’s value. CDPs are overcollateralized individual positions that isolate each user’s collateral. This provides security and decentralization.
To reclaim their locked collateral, users must pay back the generated DAI plus a stability fee. This burns DAI from circulation. The stability fee discourages excessive CDP creation when DAI is below $1. It consists of a variable rate set by Maker governance and a fixed percentage fee.
Stability Fee
The DAI Stability Fee is a charge levied on CDP owners when they want to reclaim their ETH collateral. This fee is used to contract DAI supply by burning DAI. It consists of:
- Variable rate – Set by Maker governance to target $1.
- Fixed 5% fee – Paid when closing a CDP.
For example, if you borrow $100 worth of DAI using a 150% collateral ratio, you’d lock $150 of ETH in a CDP. To reclaim your ETH, you must return the $100 DAI plus pay the stability fee. This DAI is burnt.
If DAI is trading above $1, the variable stability fee increases to make CDPs more expensive. This contracts supply and brings the price down. If DAI is below $1, stability fees decrease to expand supply.
Target Price
The Maker system is programmed to target a DAI price of around $1. The stability fee and feedback mechanisms dynamically adjust to maintain this target. Even with excess collateral, the target price anchor is still necessary to balance supply and demand.
The target price, coupled with overcollateralization, allows DAI to maintain purchasing power without needing reserves. As long as the system can contract and expand DAI supply accordingly, the price remains at $1.
Arbitrage
If the DAI price strays from its $1 peg, arbitrage traders will bring it back into line. Traders can profit from buying undervalued DAI and selling overvalued DAI.
For example, if DAI trades at $0.98, traders can purchase DAI and redeem it for $1 worth of collateral, pocketing the difference. The increased demand raises the price back to $1. The reverse is true if DAI trades above $1.
These arbitrage opportunities balance DAI supply and demand. The combination of overcollateralization, stability fees, and arbitrage create aligned incentives to maintain DAI’s peg to the US dollar.
Creating DAI
Users can create DAI by opening a collateralized debt position (CDP) on the Maker platform. The process involves:
- Send ETH collateral to a CDP smart contract.
- Generate DAI up to 66% of the ETH collateral’s value.
- Withdraw the DAI to a wallet or exchange.
For example, Bob deposits $150 worth of ETH into a CDP and receives 100 DAI (66% of $150). He now has $100 in DAI and a collateralized debt of $100.
DAI is minted when CDPs generate DAI. The Smart contracts lock up the collateral and create new DAI tokens.
Closing CDPs
To reclaim the collateral locked in a CDP, users must:
- Repay the amount of DAI originally drawn plus the accrued stability fee.
- This repaid DAI is burnt from circulation.
- The CDP owner then unlocks their original ETH collateral.
When CDPs are closed, DAI supply decreases. The stability fee also incentivizes closing CDPs when DAI > $1.
DAI Use Cases
DAI provides several key benefits that make it useful for various cryptocurrency applications:
- Stable Store of Value – DAI’s stability makes it ideal for a stable store of value compared to high volatility assets.
- Payments – The stable value also makes DAI useful for blockchain payments and remittances.
- Trading – Traders often use DAI as a stable pairing for trading volatile tokens.
- Lending – DAI is used in decentralized lending markets to provide stable interest rates.
- Financial Applications – Stable value allows DAI to be used for insurance, savings, and prediction markets.
DAI provides the censorship resistance and security of cryptocurrency while maintaining price stability. Some examples of its real-world use:
- Send remittances abroad without volatility or fees.
- Hedge against crypto market volatility without converting to fiat.
- Take out decentralized loans on platforms like Compound, Maker, or Aave.
- Safely earn interest by lending DAI on lending platforms.
DAI vs Other Stablecoins
There are several differences between DAI and reserve-backed stablecoins like USDT, USDC, BUSD, and others:
| DAI | Reserve-backed stablecoins |
|---|---|
| Decentralized | Centralized |
| No reserve backing | Backed 1:1 with fiat reserves |
| Stability from collateral and incentives | Stability directly from reserves |
| Must be overcollateralized | No collateral required |
The key tradeoff is DAI offers decentralization and censorship resistance at the cost of capital inefficiency from overcollateralization. Reserve-based stablecoins are efficient but centralized toward issuers.
Tether (USDT)
Like DAI, Tether aims to be stable around $1. But USDT is backed by reserves of fiat currencies like the US dollar. Tether Ltd. claims to hold sufficient USD reserves to redeem all USDT in circulation. However, there is ongoing controversy around whether Tether’s reserves are sufficient.
USD Coin (USDC)
USDC is an Ethereum-based stablecoin backed by US dollar reserves and audited by Grant Thornton LLP. The Centre consortium, founded by Circle and Coinbase, manages USDC issuance. USDC reserves are held in bank accounts to ensure redemptions.
Binance USD (BUSD)
BUSD is issued by Binance in partnership with Paxos. It is approved and regulated by the New York State Department of Financial Services (NYDFS). BUSD is backed 1:1 by USD reserves audited monthly by Withum, a nationally top ranking auditing firm.
Unlike the centralized stablecoins above, DAI has no central issuer or reserved assets. This provides censorship resistance but introduces the inefficiency of overcollateralization.
Risks of Using DAI
While DAI has successfully maintained its soft peg to the US dollar so far, there are still risks to consider:
- Technical Failure – Bugs in the Ethereum network or Maker smart contracts can disrupt DAI’s stability.
- Poor Governance – Maker governance participants may set parameters that compromise the peg.
- Collateral Volatility – ETH price swings can impact the collateral ratio.
- Low CDP Usage – If few users open CDPs, the circulating DAI supply may be too low.
However, the growing adoption of both Ethereum and DAI over the years has strengthened the system. Still, users should be aware of these risks before relying on DAI for stability.
DAI Governance
The Maker Protocol and DAI are managed and secured by the independent MakerDAO organization. Maker governance is responsible for:
- Setting the DAI Target Price (currently $1)
- Managing the types of collateral accepted
- Setting collateralization ratios
- Adjusting the DAI Stability Fee
Governance is decentralized and run by the community of MKR token holders. Anyone holding MKR in a compatible wallet can participate. MKR holders have voting power proportional to how much MKR they lock into the voting contract.
Major decisions require a formal governance proposal and vote. Smaller parameter changes happen through an Executive Vote that enables rapid adjustment of technical factors like stability fees.
MakerDAO Team
While Maker governance is decentralized, the MakerDAO core team continues to develop the protocol and apps. The non-profit Maker Ecosystem Growth Foundation oversees the development team.
The Maker team communicates with the community through forums, weekly governance calls, and public meetings. Major governance decisions ultimately lie with MKR holders, while the Maker team focuses on technical implementations.
Conclusion
DAI has shown that decentralized stablecoins are viable without asset backing. By using a combination of smart contracts, overcollateralization, and economic incentives, DAI can maintain a soft peg to the US dollar.
However, challenges remain around efficiency, technical risks, and governance. MakerDAO will need to continue evolving DAI to scale adoption while managing risks from collateral volatility and governance attacks.
Overall, DAI represents a significant innovation in decentralized finance. The growing adoption of DAI across lending, payments, and trading indicates that decentralized stablecoins have found product-market fit.
