Stablecoins are awesome, aren’t they? It’s nice to know that you can hold tokens without risking their price collapsing overnight. Normally you can do this because an entity promises to buy back every token you have for a fixed dollar amount. For example, you give them ten dollars and they give you ten tokens in exchange. If you return them, you get your money back.It is practically a fiat currency transposed on a blockchain. If we wanted to have this same system with no middleman we have to trust, we could use DAI. To issue it yourself, you lock your own cryptocurrency in a smart contract. To recover it, simply return the DAI with interest. Of course, if you don’t want to worry about the issue, you can just buy DAI on a Binance marketplace, for example using the USDT / DAI pair .
Want to know more ? Read on.
Introduction
The stablecoins emerged as a kind of intermediary between the traditional financial market and the emerging market of digital assets. By mimicking the value of the underlying fiat currency and while operating like cryptocurrencies , these blockchain-based tokens were initially attractive to traders in order to ‘lock in’ their earnings.
The most popular types of stablecoin to date are backed by fiat. Usually, these tokens are backed by USD. They keep their value because there is a large vault (located somewhere) filled with a dollar bill for each token issued. In other words, each token is worth $ 1 and must be able to be exchanged for fiat at any time. Some of the most popular stablecoins include USDT, USDC, BUSD, and PAX.
In this article, we’ll take a look at a protocol called Maker (or MakerDAO). This innovative stablecoin system focuses on what we call crypto-collateral. It eliminates the need for the vault we just described.
What is MakerDAO?
Maker is an Ethereum-based system that allows users to issue the DAI, a token that closely tracks the price of the US dollar. No central entity has power over this system. Instead, participants hold the governance token ( MKR ), which grants them voting rights on changes to the protocol. This is where the decentralized autonomous organization (DAO ) part of the protocol name comes from. Indeed, the latter is effectively governed by a distributed network of stakeholders who hold MKR tokens.In this decentralized ecosystem, smart contracts and game theory allow DAI to maintain a relatively stable value. Other than that, they are functionally identical to their fiat backed cousins. You can send them to friends and family, use them to buy goods and services, or staker them for yield farming .
Why is DAI “backed by cryptos”?
When you provide collateral , you are locking in something of value in exchange for a loan. When you have paid off the loan (plus fees), you will get your collateral back. Think of a pawnshop, where you can deposit your jewelry (collateral) in exchange for cash. You have a period during which you can redeem the jewelry by returning the money (plus interest).
If you don’t return the money, the pawnshop may just sell your jewelry to get their funds back. In this way, the collateral gives them security. The same principle is applied by banks: you can choose to put a car or a house as collateral in exchange for a loan, for example.
Likewise, a stablecoin backed by fiat is also guaranteed by fiat. A user deposits their money (the guarantee) and receives tokens in return. He can return these tokens to the issuer if he wishes, but if he does not, the issuer still has the money.
A crypto-guaranteed stablecoin (like DAI) works similarly, except that you use crypto assets as collateral, and the issuer is a smart contract. The contract defines something like “issue X tokens for a collateral Y amount in ETH”. Return the Z amount of ETH when the tokens are returned.
Things are a bit more nuanced than that with Maker.
Supercollaterization and CDP
You’ve probably noticed that the cryptocurrency markets are quite volatile. The price of BTC, ETH and other cryptocurrencies changes often and abruptly. Your holdings could be worth $ 4,000 when you go to bed and $ 3,000 when you wake up the next day. For a lender, this is rather risky. At least with gold jewelry, they can be expected to remain relatively stable in value. If you don’t pay back your loan, the lender may just sell your jewelry to get their money back.
If you’ve taken out a loan for $ 400 (locking in 1 ETH worth $ 400 as collateral) and the price of ETH drops to $ 300, the lender won’t have that chance. He can either ask you to give him more ETH as collateral or liquidate them and cash the loss of $ 100.
That’s why Maker uses the concept of over-collateralisation. It’s an important word, but a simple idea: when a borrower wants to issue DAI, he provides more collateral than the amount he is going to borrow. So even if the price goes down, the position remains hedged.
In practice, users lock their Ethers (or other supported assets) into what is known as a Asset Backed Position (CDP). At the time of writing, they must provide a guarantee of at least 150% of the value of the DAI they borrow. In other words, if you want to issue 400 DAI (remember that each DAI is worth $ 1), you will need to provide 1.5 times that value as collateral, or $ 600 in ETH, in this case.
A user can provide more than that if they wish. In fact, this is what most people do to stay safe. However, if the collateral amount drops below 150%, they incur high penalty charges. Ultimately, the user risks liquidation if they do not repay the DAIs with interest (known as a stability fee).
How does the value of DAI remain stable?
1 DAI = 1 USD (more or less). But why ?
Well, it comes down to incentives and smart contracts. When the DAI drops below the price of the underlying, the system allows users to close their CDPs by paying off their debts, especially because interest rates rise. This reduces the total DAI supply, as the refunded amount is destroyed. If the price exceeds a dollar, the reverse happens: users are incentivized to open CDPs because interest rates fall. This creates more DAI and increases the total supply.
DAI use case
As mentioned before, you can use DAI like any stablecoin, trade it for other cryptocurrencies, use it to pay for things, or even destroy some for fun. If CDP doesn’t appeal to you, don’t worry. Like other cryptocurrencies, DAI can be purchased on a cryptocurrency exchange like Binance .MakerDAO was arguably one of the first decentralized finance (or DeFi) protocols. After all, DAI is a decentralized stablecoin and DeFi is all about creating a ‘financial system, but on the blockchain’. That sums up DeFi perfectly.There is a growing list of products and services that support DAI. You may have noticed some DeFi oriented decentralized applications where it can be used. Examples include PoolTogether and SushiSwap , as well as the myriad of yield farming systems.
To conclude
As a dominant crypto-backed stablecoin, DAI has proven to be a successful experiment in creating a token that closely tracks the price of the US dollar. The system mitigates the volatility of traditional digital currencies (without collateral in fiat currency!), Thus moving away from the traditional financial system towards a native digital system.
Still have questions about MKR, DAI or stablecoins? Go to Ask Academy, for the community to respond.