Cryptocurrency has evolved significantly over the years, gaining more mainstream presence. One challenge that has remained constant, however, is its price volatility. Cryptocurrency prices can fluctuate dramatically in a given day, and while some may enjoy speculating on the massive price swings, this unpredictability has prevented crypto from gaining wider adoption as a reliable exchange of value.
As a response to this problem, ‘stablecoins’ have emerged as a potential solution. A stablecoin is a cryptocurrency whose price is pegged to a stable asset, such as the US dollar, to reduce the erratic fluctuations in price experienced with cryptocurrencies. They can be either centralized or decentralized. Centralized stablecoins are typically backed by fiat or commodities, and are dependant on governments or other third party custodians. Decentralized stablecoins on the other hand, are backed by other cryptocurrencies, giving them a more trustless, secure, and transparent structure.
Dai is a stablecoin, launched by MakerDao, that is pegged to the US dollar. This means that the value of one Dai will always be approximately $1 USD. Dai is built on the Ethereum network and backed by Ether, meaning that it is completely decentralized because its price stability is sustained on through a system of smart contracts, and does not rely on any banks, governments, or other centralized third party.
You may be asking how Dai maintains its price stability when it is backed by cryptocurrency, which can of course be very volatile. Dai price stability is managed through a system of lending on the Ethereum network. To create Dai, someone with Ether would deposit their Ether into what is called a “collateralized debt position,” which is essentially a personal smart vault that holds your ETH. In return for depositing ether as collateral, Dai gets generated to the Ethereum holder.
To unlock their ETH, the Dai holder simply pays back the Dai plus a stability fee. If the value of Dai drops below $1, the stability fee is increased in order to make Dai loans more expensive. If Dai loans are more expensive, less loans will be generated and supply of Dai will retract, driving up the price. Likewise, if the value of Dai surpasses $1 USD, the stability fee is lowered in order to make Dai loans cheaper, leading to increased supply in the market and lower prices.
Rather than being determined and manipulated by a centralized financial institution, company, or government, the stability fee is voted on by the community of people who hold MKR tokens, which is the governance token for the MakerDAO system. Ultimately, it is based on supply and demand within the lending system.
The mechanism behind Dai creation and price stability gets a bit more complex, though we hope the explanation above gives you a basic understanding of Dai conceptually. We will be launching more offerings with Dai in the months to come. In the meantime, we hope this gave you more background so that you can start familiarizing yourself with Dai. Leave a comment below letting us know any thoughts or questions you may have!
