What is Dai?
Table of Contents
Liquid customers can now trade Dai, an ERC-20 decentralized stablecoin created by Maker.
At the surface, Dai is an collateral-backed decentralized stablecoin pegged to the US dollar.
But Dai is no ordinary stablecoin. In fact, Dai has a number of unique attributes that differentiates it from other similar assets.
Let's take a look.
Since the stablecoin is decentralized, by the very definition there is no central entity controlling the underlying mechanisms of Dai.
Additionally, as Dai exists by utilizing the capability of the decentralized Ethereum network, value can be transferred via Dai without any middleman, which isn’t possible in traditional finance.
The entire network is controlled by preset rules and the relationship between Dai, Ethereum, and the Maker token (MKR).
Economic incentives play a role too - correct actions are financially rewarded, which ensures the network is maintained.
Dai can be sent anywhere in the world with minimal fees. You just have to pay the gas on the Ethereum network. There are also no restrictions. You can send your money whenever you want, to wherever you want.
The records of Dai are immutable and stored on a blockchain. What’s more, Dai utilizes smart contracts to prevent bad actors from exploiting the system.
How it works
Dai is based on the Ethereum network. As it stands, Ethereum (ETH) is used as collateral for Dai. Maker is working on Multi-Collateral Dai that will significantly upgrade the Dai system by increasing collateral options.
How Dai remains stable
The price of Dai remains stable through the creation and destruction of Dai supply in accord with supply and demand levels. However, the supply isn’t managed in a seigniorage share system like other stablecoins.
Dai manages supply and demand through economic incentives. When the price is above 1 USD, anyone can create Dai and sell it for more than it’s worth. This increases the supply and causes price to fall back to 1 USD.
Likewise, when the price of Dai is below 1 USD, users can pay off debt in the system at a cheaper rate, as they can buy Dai for below 1 USD but pay off debt at the fixed rate of 1 USD. The Dai used to pay off debt is burnt, reducing supply and increasing price.
The mechanics behind it all
Dai can be created by anyone. All you have to do is take ETH and use it as collateral. ETH is locked in a smart contract, creating something called WETH (Wrapped ETH), which is then moved into a collateral pool, at which point WETH becomes PETH (Pooled ETH).
Once PETH is created the user can create what’s known as a collateralized debt position (CDP). This locks the PETH in a smart contract and creates Dai.
A user cannot draw out the same dollar amount as they put in. Instead, as Dai is created against the collateral PETH, a risk ratio of debt is created. The less Dai drawn out, the better this risk ratio is.
The network has a risk ratio limit to prevent more than a certain amount being drawn out against the collateralized ETH.
Having a better risk ratio is favorable as users are penalized for having risky debt over a certain limit.
Dai contributors are economically incentivized to settle risky debt. Once the risk-ratio threshold is reached, Dai contributors are allowed to close the debt on behalf of another user and earn a profit.
As such, once risk reaches a certain level it will be closed by other Dai contributors to earn money and maintain the integrity of the system. If your debt is closed, you are penalized.
If the price of ETH falls, the level of risk increases, approaching the risk threshold. As a user with a risky CDP, you are able to add more collateral to avoid the penalty.
There is proof that this system works. The price of ETH fell from $1,400 to $90 but Dai remained stable.
ETH price chart
Dai price chart
The Maker (MKR) token
MKR is the Maker Token. It works in tandem with Dai to help maintain the network and keep the price stable.
MKR holders can vote on various issues in the network. For example, the risk-ratio threshold level is decided by MKR token holders, which controls when an individual is penalized for having a too risky CDP.
MKR holders can also vote on what’s called a ‘global settlement’. In the event that the system faces problems, it can be shut down and Dai holders reimbursed their collateral, in proportion to the net asset value.
Any loan fees are paid in MKR. Loans have a 1% annual fee, paid in MKR. The 1% fee is based on the value of the Dai minted, not the collateral. Once MKR is collected for fees it is burnt, which reduces the supply of MKR.