What is DAI? A simple explanation

By Roberto D. | CryptoFarm | 28 Jun 2019

$0.03 tipped


In December 2017, the Maker company released their long awaited system for a decentralized "stablecoin", called Dai (DAI).

A stablecoin, as the name suggests, is a currency whose value is (relatively) stable, therefore lacking the wide fluctuations that characterize bitcoin, Ether and cryptocurrencies in general.

Decentralized Stablecoin

Dai is an ERC20 token that is pegged at $ 1 USD. Each Dai is worth $ 1 USD, and will always be worth $ 1 USD, regardless of the amount of existing Dai.

There is no centralized authority, like Tether, that guarantees its value, as well as no traditional bank that guarantees each Dai with a real US dollar. Since there is no centralized authority to rely on, no process can ever be blocked.

Dai lives entirely within the Ethereum blockchain, through the use of smart contracts.

The Maker organization is one of Ethereum's precursor development companies, having worked on this project since before Ethereum existed. The team is very well regarded in the environment and is supported by Vitalik Buterin, the creator of Ethereum.

Some may wonder about the need for a stablecoin like Dai. Hasn't Tether already reached the goal of a token tied to the dollar?

The answer is that Tether, or any other centralized stablecoin, can be hacked, blocked, stolen, and still remains at the mercy of the whims of politics and human fallibility.

Not surprisingly, there is a huge amount of speculation that Tether is operating fraudulently (we talked about it in this article).

In order to solve the problems of a centralized system, Dai's operation is rather complex. Some believe that this complication is an obstacle to understanding and, consequently, to dissemination.

This approach is misleading, since Dai's main use case is that of a priced token with a stable value of $ 1 USD. A deeper understanding of its operation is not required.

99.999% of Dai's users will never need to understand how it works.

However, if you really want to know why you can trust Dai, you need to understand all aspects of the Dai system and the economic incentives involved.

Dai is a turning point


Before giving details of Dai and its operation, the following salient features can be established:

  • Each Dai is always worth $ 1 USD.
  • It can be exchanged freely like any other ERC20 token.
  • Anyone with an Ethereum wallet can own it, accept it and transfer it.
  • It can be exchanged without intermediaries.
  • No individual or individual company has control over it.
  • No government or authority can block it.

These peculiarities allow the development of features that were previously impossible.

USD (Dai) can now be transferred instantly, across borders and without fees (in addition to ETH gas fees).

Traders can accept Dai with all the advantages of blockchain technology, but without the enormous risk of volatility.

For example, traders no longer have to worry about the Bitcoin price, which fluctuates by 15%, between the time of receipt of the payment and the time of conversion into fiat currency. If a merchant receives $ 19.99 USD for a T-Shirt, he can trust to have $ 19.99 USD, which he collects his Dai the same day or months later.

Similarly, customers no longer have to worry about spending an asset that constantly increases in value. It is unlikely that a customer buys a product with Ether if he thinks the value will increase. Why spend $ 19.99 USD on Ether today if it is worth $ 24.99 USD tomorrow?

By using Dai, customers will not have to worry about price fluctuations.

Most merchants currently accept cryptocurrencies as payment through intermediaries, such as BitPay. The latter has all the drawbacks associated with traditional payment processors: processing fees, limits and rules of the sector in which they do business.

With intermediaries like BitPay, merchants simply offer another payment method to their customers, but they get no benefits, other than extra sales. Worse still, BitPay may, at its convenience, decide to terminate the relationship, without notice and for no reason.

With Dai, a trader can process payments directly, as if he were receiving cash. If you decide to use a third party, it is only to provide value-added services, such as e-commerce integrations, accounting software and portfolio management.

But it is not necessary for a third party to process payments or temporarily hold funds. The blockchain itself can handle everything.

No one can block the merchant's ability to receive payment.

 

How Dai works


Dai is a masterpiece of game theory, which carefully balances the economic incentives in pursuit of a goal: a token that is continuously close to the value of $ 1 USD.

When Dai is worth more than $ 1 USD, the mechanisms operate on a price reduction basis. When Dai is worth less than $ 1 USD, on the contrary, the mechanisms work to raise the price.

The rational actors who take part in these mechanisms are encouraged by the gain they get each time Dai does not feed exactly $ 1 USD. This is why Dai always floats slightly above or below $ 1 USD.

It's an infinite wave function that bounces repeatedly in the vicinity of $ 1 USD, without ever reaching it completely. The greater the distance from $ 1 USD, the greater the incentive to bring it back to balance. This is Dai's magic.

Dai is simply a loan guaranteed by Ether. Anyone can create Dai, all you need is Ether and technical know-how to use a decentralized app (dApp).

Most cryptocurrency enthusiasts will not need to create Dai or understand how it was created. They will simply buy on the exchanges, including decentralized exchanges that live entirely on Ethereum.

This will make Dai an essential component of any decentralized exchange.

Incentives for the creation of Dai


Yes, creating Dai is complex in the face of buying shortcuts on an exchange. This is one of the reasons why 99.999% of people will never go through the abstruse process of creating a CDP.

However, there are several reasons why you might want to create Dai, despite the grain:

  • You need a loan and you have an asset (Ether) to use as collateral for a loan.
  • It is believed that Ether will increase in value. You can use your own CDP to buy Ether on the sidelines. One binds one's Ether in a CDP, one borrows Dai, using it to buy other Ether in an exchange. These latter Ether are used to further increase the size of their own CDP. This activity can be performed without a third party or any centralized authority that allows it to do so. Margin trading can be done entirely on the blockchain.
  • Dai's high demand led the price above $ 1 USD. When this occurs, you can create Dai and sell them immediately on an exchange for an amount greater than $ 1 USD. This is essentially free money, and is one of the mechanisms that the Maker system uses to keep Dai fixed for $ 1 USD. Exceeding the $ 1 USD threshold encourages you to create more Dai.
    These three reasons are enough to ensure that Dai is continually created.

Price peg mechanisms at $ 1 USD


It is economic incentives that ensure that value is maintained.

As noted above, when Dai is worth more than $ 1 USD, Ether owners are encouraged to create more Dai and sell them, since it is free money.

When Dai is worth less than $ 1 USD, CDP holders can pay their debt at a cheaper price. This is an extremely intelligent solution, which requires further explanation.

Let's say I open a CDP with $ 1000 USD in Ether. So I borrow 500 Dai. To close this position, I have to repay 500 Dai (payment of the debt destroys the Dai).

If Dai is trading for less than $ 1 USD, for example for $ 0.99 USD, then I can buy Dai for less than $ 1 USD, and then pay my debt at a 1% discount.

It is essentially free money. In fact, if I took a loan of $ 500 USD (500 Dai), then I bought 500 Dai for $ 495 USD (0.99 * 500 = 495, a 1% discount), with which I paid my loan , I earned $ 5 USD of Ether for free.

Of course, my request for Dai increases its price, with Dai appreciating until it comes close to $ 1 USD. If Dai stays below $ 1 USD, CDP holders continue to pay debts and remove Dai from the system. When Dai exceeds $ 1 USD, it is created to meet the demand.

It is this tiremmolla, creation and destruction, offer and demand, that ensures that Dai always corresponds to $ 1 USD.

 

Collateral volatility: Ether price collapse


What happens if the price of Ether collapses?

The short answer is that if Ether has a value, and its price is not extraordinarily volatile (ie losing 60% in 10 seconds), the system is balanced correctly.

The long answer requires further explanation.

The CDPs have various degrees of indebtedness. When you open a CDP, you can borrow up to 60% of the value in Dai. This means that with $ 1000 USD of Ether, you can get up to 600 Dai.

But not all CDP holders take the full amount: the more we borrow, the more risky it is. Some will withdraw 10%, 25%, 30%, etc.

As Ether changes in price against the dollar, the debt ratio of each CDP also changes. With the increase in the price of Ether each CDP becomes more secure, as it is less indebted. Conversely, if Ether falls in price each CDP becomes more risky, because it is more indebted.

Since each CDP has a different debt ratio, they can be classified in order of risk. The riskiest CDPs have higher debt ratios.

With the decrease in the price of Ether, each CDP approaches the 60% debt limit (as already noted, it is possible to borrow up to 60% of the collateral value). If a CDP exceeds this threshold, any holder of Dai can pay the CDP and earn a profit, which destroys Dai from the system, closes the CDP and penalizes the owner of the CDP.

It is a complex mechanism that requires further reading to understand. But, to sum up, rational actors have an incentive to remove the risky debt from the Dai system through its payment.

CDP holders who make the debt very risky are penalized for doing so. An incentive is generated not to have risky debts.

CDP owners can make their debt more secure by paying as CDP becomes riskier.

The most discerning CDP holders will observe that their CDP becomes more risky, paying Dai in advance to avoid a penalty. Conversely, those who neglect their CDP will be penalized by the system if they exceed the debt threshold.

As the value of Ether decreased from $ 1,400 USD in January 2018 to $ 400 USD in April 2018, the incentive structure of the Dai system kept the value of Dai anchored at $ 1 USD. This is an incredible result, and proof that Dai is also successful in a phase of falling Ether prices.

 

Cognition of the price of Ether


How is the price of Ether known? I thought this system was decentralized!

The value of Ether in USD must also be derived somewhere, and in the Maker system it comes from oracles.

More oracles provide price data, which reduces the risk of some oracle being compromised. Furthermore, the price change of Ether in USD is limited per block, in order to avoid rapid changes caused by an attacker.

But the ultimate fail-safe solution lies in the possibility for Token Maker (MKR) owners to vote for a "global settlement" in the event of a catastrophic failure, like a coordinated attack.

This resolution determines the termination of the system, resolving all the positions to return the Ether to the legitimate holders of CDP.

This is the nuclear option in the system, which shows that MakerDAO is a true "decentralized autonomous organization" (DAO).

The MKR owners themselves vote on what happens.

 

The Token Maker (MKR)


The MKR token has several features.

First of all, owning MKR gives you the right to vote on the system itself. This is why Maker is a "decentralized autonomous organization" (DAO).

MKR owners can vote on various aspects, such as the maximum debt ratio. MKR owners can also cease the entire system in the event of a catastrophic failure, which is an essential security mechanism.

Secondly, for the extinction of the debt in a CDP, the payment of an annual fee of 1% is required, payable only in MKR.

For example, if you get a loan of 500 Dai against $ 1000 USD of Ether, and you keep it for a year, paying off the debt would require 500 Dai, in addition to $ 5 USD of MKR. The MKR used to pay off the loan is then destroyed ("burned").

The destruction of MKR favors the increase in the price of MKR over time.

Since MKR is divisible up to 18 decimal places, as long as there is a single MKR token, up to $ 1 quadrillion USD could be traded without problems. The number of decimals could be increased later, if necessary.

So there is no problem with the fact that MKR will run out. The quantity destroyed will decrease as the value of MKR increases.

 

The guarantee (s) for the loan


Why is the collateral given by Ether and not by another ERC20 token?

Ether is the most important token within the Ethereum blockchain (the native one), so it makes sense to use it as the first CDP guarantee asset.

However, the Maker system will work regardless of the asset, provided that it exists within Ethereum and that oracles can provide a dollar rating.

Maker plans to use Digix as its next asset, which is a token guaranteed by physical gold.

In particular, multiple assets could be used to create a single CDP, including other ERC20 tokens.

The Maker system can work with any other currency or asset. In the future, stablecoin anchored to major currencies, such as Swiss francs, assets like gold, or even shares, can and will be created. All you need are oracle prices.

 

Conclusions


The demonstration of Dai's operation lies in maintaining the price in the vicinity of $ 1 USD. As Dai continues to successfully maintain his $ 1 USD bond, confidence in the system will increase.

99.999 +% of users do not need to understand how Dai works. They just need to put their trust in it, based on the demonstrations given by the history of Dai's operation.

Dai represents a turning point because it allows you to transfer USD in any amount, instantly, across the border, without commissions and without any interference.

The doors are opening to a new era of commerce, existing purely within the blockchain, without the possibility of interruptions.

Maker is a technology that highlights the unique potential of Ethereum, providing a solution to be considered utopian before the advent of blockchain technology.

It is likely that you will hear much more about Maker and Dai. This is just the beginning!

 

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Roberto D.
Roberto D.

Born in Italy, I live in Italy, passionate about cryptocurrencies since I discovered ethereum in 2015


CryptoFarm
CryptoFarm

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