Key Takeaways
- Stablecoins were created to address this issue, pegging cryptocurrencies to stable assets like the US dollar
- Early stablecoins like Tether or USDT were centralized, backed by company reserves
- Decentralized stablecoin models like Terra and DAI emerged to create a decentralized financial system
- DAI relies on a unique system called crypto over-collateralization, users lock up various cryptocurrencies like ETH to mint new DAI
Intro
The rise of cryptocurrencies brought exciting possibilities but also the challenge of price volatility. To address this, stablecoins were created – cryptocurrencies pegged to a stable asset like the US dollar. Early stablecoins, like Tether or USDT, were centralized, meaning a company held reserves to back each coin.
However, the desire for a decentralized financial system led to the development of new stablecoin models. One example is the now-defunct stablecoin Terra. Terra differed from traditional stablecoins by using an algorithm, rather than reserves, to maintain a peg to a stable asset.
Another more successful example of a decentralized stablecoin is DAI. In this article, we will discuss the stablecoin DAI, its origins, and how it works.
What is the Cryptocurrency DAI?
DAI's roots trace back to 2014 with the formation of MakerDAO by Rune Christensen. This organization envisioned a decentralized credit system, fostering lending and borrowing without traditional intermediaries. However, a stable, non-volatile digital currency was needed to facilitate loan payouts and transactions. As such, DAI was created in December 2017.
Unlike fiat-backed stablecoins, DAI relies on a unique system called crypto over-collateralization. Users can lock up various cryptocurrencies like ETH in a smart contract on the Ethereum blockchain. This locked crypto acts as collateral, allowing them to mint new DAI. The value of minted DAI depends on the value of the locked collateral and a pre-determined over-collateralization ratio. This means users must lock up more crypto than the DAI they wish to mint, creating a buffer zone to absorb price fluctuations in the underlying collateral.
DAI's decentralized governance is another key aspect. MakerDAO functions as a DAO, meaning it's controlled by its community of token holders. These token holders vote on crucial decisions impacting the protocol, such as adjusting risk parameters and adding new collateral types. This democratic approach fosters transparency and community involvement in maintaining DAI's stability.
How Does DAI Work?
DAI maintains a soft peg to the US dollar through collateralized debt positions or CDPs and a feedback mechanism. Users deposit crypto assets supported by the MakerDAO protocol into a smart contract as collateral, enabling them to mint DAI up to a certain percentage of their collateral value based on the loan-to-value or LTV ratio.
The stability mechanism includes a decentralized Oracle network for real-time price data and a Target Rate Feedback Mechanism or TRFM. If DAI’s price deviates from $1, penalty fees or stability fees are incurred to maintain the peg. Arbitrage traders are incentivized to buy discounted DAI and burn it for its collateral value, adjusting the supply and demand to stabilize the price.
What Gives DAI Value?
As previously mentioned, DAI is over-collateralized by a number of different cryptocurrencies. This means that the assets backing DAI exceed the worth of the number of DAI in circulation. Currently, the value of assets backing DAI is listed as $8.52B, while the value of the supply of DAI is 6.78, meaning that DAI is over-collateralized by roughly 25%. The assets backing DAI, include other stablecoins, such as USDC, and USDP, and other popular cryptocurrencies such as WBTC and ETH.
What are Collateralized Debt Positions?
Collateralized Debt Positions or CDPs are central to the functioning of DAI as they enable the minting and stability of the stablecoin. Users lock up crypto assets as collateral in a CDP smart contract on the Ethereum blockchain, which then determines a safe borrowing limit known as the LTV Ratio. This LTV ratio ensures that users deposit more collateral than the DAI they mint, acting as a buffer against price swings and maintaining stability.
CDPs are essentially individual safety deposit boxes within the DAI system, where users deposit their crypto assets to borrow DAI up to a certain limit based on their collateral's value. This dynamic supply control mechanism ensures that DAI remains pegged to the US dollar and maintains its stability.
The close relationship between CDPs and DAI is what allows for the decentralized minting and stability of the DAI stablecoin. It provides a robust mechanism for users to generate DAI while ensuring that the system remains secure and resistant to price fluctuations.
What is the Stability Fee?
The Stability Fee in DAI is a crucial component that helps maintain the stablecoin's peg to the US dollar within the MakerDAO ecosystem. It is an annualized percentage rate charged on the outstanding DAI debt borrowed through CDPs. This fee continuously accrues on the amount of DAI borrowed and is subject to dynamic adjustments based on market conditions and governance decisions by MKR token holders.
The primary function of the Stability Fee is to incentivize actions that keep DAI's price close to $1. If the price of DAI falls below $1, indicating a deviation from its peg, the Stability Fee increases. This discourages excessive borrowing of DAI and encourages users to convert DAI back to its pegged value. Conversely, if the price of DAI rises above $1, the Stability Fee decreases, making borrowing DAI cheaper and potentially leading to increased borrowing and minting of new DAI to bring the price back down towards $1.
DAI Savings Rate (DSR)
The DSR is a unique feature within the MakerDAO ecosystem designed to incentivize users to hold onto the DAI stablecoin. Here's how it works:
By locking your DAI tokens into a designated contract, you can earn interest on them over time. This interest rate is not fixed but is determined through governance votes by the MakerDAO community. The main goal of the DSR is to influence the supply and demand dynamics of DAI, aiming to maintain its price pegged to $1 USD. By offering an interest rate, the DSR encourages users to retain their DAI instead of selling it, potentially increasing demand and stabilizing the price in the market.
The interest paid out to DAI holders participating in the DSR is funded by the Stability Fees collected from users who create DAI through CDPs. These fees contribute to the interest earnings for DAI holders.
Recently, MakerDAO introduced an Enhanced DAI Savings Rate or EDSR, which is a temporary increase to the base DSR. This enhancement aims to make holding DAI more attractive, particularly during periods of growth. However, the EDSR is expected to gradually decrease over time as part of the protocol's adjustments.
It's important to note that there are no lockup periods for participating in the DSR, meaning users can withdraw their DAI and interest earnings at any time. However, activating the DSR requires users to interact with the Maker Protocol, which may involve gas fees or transaction costs on the Ethereum blockchain.
What is Unique About DAI?
DAI stands out as a decentralized stablecoin due to its unique architecture and successful adoption within the DeFi ecosystem. Unlike many other stablecoins that rely on centralized entities for stability, DAI maintains its peg to the US dollar through a decentralized system of CDPs and the DSR. This approach offers users a stable digital asset while avoiding the need for a central authority to control its value.
Additionally, DAI's integration with DeFi protocols and platforms has made it a cornerstone of the DeFi landscape. It serves as a reliable medium of exchange and store of value within decentralized applications, enabling users to access various financial services like lending, borrowing, and trading without relying on traditional financial institutions.
DAI vs. USDC - Stablecoins Compared
DAI and USDC are both stablecoins but differ significantly in their underlying structures and functionalities. USDC is a centralized stablecoin backed by real-world assets and regulated entities, providing stability but with centralized control. On the other hand, DAI is a decentralized stablecoin over-collateralized by crypto assets within a smart contract system, offering stability through blockchain mechanisms without relying on a central authority.
The key difference lies in their approach to stability and control. USDC's centralized nature ensures direct asset backing and regulatory oversight, making it reliable but subject to regulatory risks and centralization concerns. In contrast, DAI's decentralized design leverages smart contracts and collateralization, enhancing resilience and reducing dependency on external entities but potentially exposing it to crypto market volatility.
Advantages & Disadvantages of DAI
DAI offers several advantages in the realm of stablecoins. Firstly, its decentralized nature eliminates reliance on a single controlling entity, reducing counterparty risk and enhancing the fundamental principles of cryptocurrencies. The transparency provided by blockchain technology ensures that all DAI transactions are publicly verifiable, fostering trust and security within the ecosystem. Despite occasional fluctuations, DAI generally maintains stability around its $1 peg, making it a reliable store of value for users. Additionally, DAI holders can earn interest on their holdings through the DSR, adding an attractive earning potential to the stablecoin. Moreover, DAI's integration with DeFi applications enables users to engage in borrowing, lending, and other actions, contributing to its versatility and utility in the crypto space.
However, DAI also comes with certain disadvantages. One notable risk is the algorithmic risk, as DAI's peg is maintained algorithmically through smart contracts, which could face vulnerabilities under extreme market conditions. The collateral backing DAI, typically other cryptocurrencies, introduces collateral volatility risk—if the value of the collateral drops significantly, it could impact DAI's stability. Furthermore, DAI may have limited liquidity compared to some centralized stablecoins, potentially leading to challenges in buying or selling large amounts swiftly. Lastly, the complexity of understanding and interacting with the MakerDAO system, which governs DAI, may pose a barrier for newcomers to the cryptocurrency space.
DAI and the USDC Depeg Event
During the USDC depeg event in March 2023, DAI faced consequences as a significant portion of its collateral was held in USDC. This led to DAI briefly falling to around $0.88, its lowest recorded value. However, the situation also showed some unexpected behavior. Despite the depegging of USDC, DAI initially experienced a surge in demand, possibly because users viewed it as a "safer" option during the depegging event.
Read more about: Stablecoins Depegging
To address the depegging crisis, the MakerDAO system's automatic mechanisms were activated. These mechanisms included increasing stability fees for creating new DAI and decreasing fees for burning DAI, effectively reducing its circulation.
Following the event, the MakerDAO community took action. In May 2024, they held a vote and decided to retain USDC as a primary reserve asset for DAI, despite the depeg event. This decision reflects the community's ongoing trust and confidence in USDC's long-term stability, even after experiencing a depegging event that affected DAI's peg momentarily.
FAQ
Is DAI Backed by Fiat Currency?
DAI is not directly backed by fiat currency in the traditional sense. Instead, its backing primarily comprises collateral in the form of other cryptocurrencies and assets, including fiat-backed stablecoins like USDC. These stablecoins are pegged to fiat currencies like the US dollar and are held as part of the collateral in the MakerDAO system, which issues DAI.
How Many DAI Tokens Are in Circulation?
As of the current time, the circulating supply of DAI is approximately 4,788,943,855 tokens. It's important to note that the circulating supply of DAI can fluctuate based on various factors, including changes in its reserves and the demand for the stablecoin.
Is DAI Equal to the USD?
DAI is designed to maintain a soft peg to the US dollar (USD), aiming for a value of approximately $1. However, due to market dynamics and the algorithmic mechanisms governing DAI's stability, its value may fluctuate slightly around this target.
Is DAI backed by USDC?
The presence of USDC in the collateral portfolio contributes to the stability and value of DAI, but DAI itself is not directly backed by USDC or any single fiat-backed stablecoin.
Is DAI Safe?
DAI is considered relatively safe within the context of stablecoins due to its decentralized and over-collateralized nature.
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