DAI is a stablecoin pegged to the United States Dollar (USD). That means that every 1 DAI coin is equal in value to $1. Stablecoins are important in the world of cryptocurrency because of the considerable and unpredictable volatility in the market. Whether the market cap is increasing or decreasing, stablecoins like DAI will have a stable value.
Because stablecoins are traded on exchanges, their price is subject to the law of supply and demand. This means that stablecoins pegged to the USD are sometimes slightly above $1, and sometimes slightly below. How a stablecoin manages this price instability is where the real magic happens.
Unlike Tether, which is a centralized stablecoin regulated by the most fallible and corruptible governance system (humans), DAI is a decentralized stablecoin regulated by smart contract algorithms. This means that the system is trustless, and free from human error.
The DAI algorithms, called “keepers,” ensure that the cost of DAI is as close to the USD as possible through various means, like regulating the supply of collateral and taking advantage of arbitrage opportunities.
In the Tether system, for every Tether you buy, the Tether organization supposedly transfers a real USD to its bank account to back the token as collateral. The main issue with this system is that users of Tether are at the mercy of its leadership’s opaque spending practices. As far as we know, the Tether organization may not be even taking money out on a 1:1 basis for every token that is created. Check out this article for a deeper look into the issues of the Tether system.
With DAI, you can see every transaction on the blockchain, meaning that you know where all of the funds are at all times. Unlike Tether, there is never any question about the true value of DAI because all collateral that is staked to create DAI is visible to everyone at all times.
Because the DAI platform is totally decentralized, any changes made in the system will come completely from its users. The MKR token is the governance token that any user can own, which helps the DAI platform stay afloat. With it, threats to the platform can be negated, and updates can be made to the system. However, the core components of the system cannot be altered, which ensures that the currency is secure and stable. Both MKR and DAI are necessary for the creation of a decentralized platform, which allows users to not only own a stablecoin, but also create loans on the blockchain.
DAI users have already used the platform to do some pretty amazing things (including purchase a car!). In the following article, I’ll explain the uses and moving parts of the DAI system.
DAI can be traded on trading platforms like Ethex, and OasisDex. Like the keepers, you can take advantage of the natural (but small) fluctuations in the price of DAI. Additionally, DAI is used as a base currency of exchange on some decentralized trading platforms, where DAI can be used to directly purchase dozens of coins and tokens.
DAI is a stablecoin, and should be treated as such. Because DAI is valued at about 1 USD, by obtaining and holding DAI, you protect your wallet from the effects of volatility. This means that if the price of the entire crypto market goes up or down, the value of your holdings in DAI will stay about the same. This can be great if the market is going down, or not-so-great if the market is going up.
To me, this is the most interesting part of DAI. CDP’s, or Collateralized Debt Positions are the way to create DAI, and effectively take out loans/borrow on the blockchain.
By “locking in” collateral in a CDP, you can get a lower value of DAI back as “debt.” Once the DAI is created, you can do anything with it — it’s your DAI.
But this doesn’t come without risks or limits.
If you borrow too much DAI, you risk your CDP being automatically liquidated. If this happens, your collateral is returned to you, minus a few penalties (which, as of today, would be at least 13% of your collateral).
Currently, PETH (pooled ether) is used as the single form of collateral on the DAI system. It is created by wrapping ETH (ETH to WETH), and then “pooling” it (WETH to PETH) alongside the rest of the collateral in the system. The reason why PETH is used instead of just ETH will be explained later, but let’s look at how you would use PETH to open a CDP.
You could open a CDP with 150 USD worth of PETH, and be able to borrow 100 DAI. Since you don’t want the CDP to be automatically liquidated if there is a slight drop in the price of ETH (and consequently PETH), you take out 80 DAI. Effectively, you own your 150 USD of PETH and 80 USD worth of DAI. You can sell this DAI on a trading platform for more collateral (ETH in this case), and then lock that ETH into your CDP. This is revolutionary because you can indefinitely leverage debt (buy assets with debt) in this way. That is, as long as the price of the collateral continues to increase.
Even if you weren’t interested in trading DAI, if the price of ETH is increasing during this time, you can borrow even more DAI and do cool stuff with it.
Cool stuff like…
…buy a BMW!
That’s right. A DAI user has bought a BMW 335i Sedan Sport with DAI he created on the DAI platform.
He wanted to purchase a car, and he wanted to do it with cryptocurrency. Additionally, there were a couple of other factors which made him decide that a DAI loan was the right choice: 1) He didn’t have a great credit score, meaning if he got a loan from a bank his interest rate would be very high, and 2) he didn’t want to liquidate his ETH in favor of purchasing the car.
So, he used the ETH he had as collateral to create DAI. His process was:
- Create a CDP on the DAI platform
- Lock in PETH to draw DAI
- Convert the DAI into USD, and
- Purchase the BMW!
It was that simple.
Not only do you have to jump through fewer hoops to borrow on the DAI platform, the interest rate is also significantly lower. When this buyer took out DAI, the annual interest rate (stability fee) was only 0.5%.
To compare, if he were to get a loan with his credit score, the interest rate would likely be over 5.0%. That’s 10X as much as the DAI interest rate!
As shown in this real-life example, there are many reasons why the DAI platform is great, including:
- It makes getting loans simpler, more accessible, and faster. As long as you have access to the internet, and some collateral, you can get a loan.
- Interest rates are uniform: For each CDP type, there is a single interest rate. Regardless of your credit score in real life, you can enjoy a lower interest rate than you would have received from a bank.
As mentioned before, if you draw out too much DAI, your CDP can be at risk of being automatically liquidated. This can also happen if the value of ETH (and therefore PETH) drops below a certain level. That’s because there is a set ratio between the locked collateral value and the DAI (debt) that you have drawn, which acts as a threshold of automatic liquidation by the system.
The reasoning behind the automatic liquidation is, if too much debt is drawn out relative to the collateral in the DAI platform, the entire DAI ecosystem is at risk of collapsing due to significant volatility in the value of the locked collateral.
As of this writing, the “liquidation ratio” — the collateral/debt ratio at which a CDP is automatically liquidated — is 150%. This is the reason why in the above scenario where you locked in 150USD worth of PETH, you chose to take out 80 DAI instead of 100 DAI. If you took out 100 DAI, your CDP would be at risk of being immediately liquidated because your collateral/debt ratio would be exactly 150%.
Let’s say that your CDP does get liquidated. What happens?
First, the Dai system immediately buys the collateral in your CDP. You receive the value of the collateral, minus the debt (drawn DAI), stability fee (interest rate), and liquidation penalty fee. The collateral is then put up for sale on the market for keepers and all other wallets.
If enough DAI is sold to cover the value of the PETH, then all is good on the platform. If not enough DAI is sold, then some PETH is created by the keepers, increasing its supply. On the other hand, if there is too much DAI, the DAI is used to purchase some PETH and “burn” it by the keeper. Burning is essentially taking the PETH out of circulation, thereby reducing its supply.
This ability of the DAI system to control the supply of PETH by creating and destroying it is another way that the price of DAI is kept stable. This is the primary reason why PETH is used instead of just ETH currently, which cannot simply be created or destroyed.
Using a CDP
I wanted to see first-hand how CDP’s worked, so I opened a CDP on the DAI dashboard.
The following will be my account of using a CDP. But, before we get into it, here’s a list of definitions related to CDP’s. Consult the list if I use a word that doesn’t make sense.
- CDP ID: The numeric ID of the CPD
- Stability Debt (DAI): Amount of outstanding DAI debt in a CDP
- Governance Debt (MKR): Amount of outstanding MKR debt in a CDP
- Locked (PETH): Amount of PETH collateral in a CDP
- %Ratio: Collateral ratio of the CDP (Locked PETH / Stability Debt)
- Avail. DAI (to draw): Max DAI that can currently be drawn from a CDP
- Avail. PETH (to free): Max PETH that can currently be released from a CDP
- Liquidation Price: ETH price at which a CDP will become unsafe and at risk of liquidation
- Status: Whether a CDP is Safe, Unsafe (vulnerable to liquidation) or Closed
- Liquidation Ratio: The collateral/debt ratio at which a CDP is automatically liquidated
- Lock: Add collateral to a CDP
- Free: Remove collateral from a CDP
- Draw: Create DAI against a CDP
- Wipe: Use DAI to cancel CDP debt
- Shut: Close a CDP — Wipe all debt, free all collateral, and delete the CDP
- Give: Transfer CDP ownership
- Bite: Initiate liquidation of an undercollateralized CDP
After I wrapped and pooled my ETH, I created a CDP and locked the PETH into it. My goal was to use a CDP to create DAI, trade it, lock the proceeds back into the CDP, and then hold it.
Step 1: Use CDP to create DAI
I locked 0.114 PETH into the CDP. Then I drew out 10 DAI from it. At an ETH value of $432.48, I could’ve drawn up to 33.561 DAI (the remaining 23.561 that I didn’t draw is under Avail. DAI), but I chose not to.
Because this is a pretty safe debt position, the %Ratio was high (503.42%). The liquidation ratio is 150% — far away from 500%.
If the percentages don’t appeal to you, you can just monitor the liquidation price to see at what point your CDP would be liquidated at. ETH would have to plummet to 128.862 for my CDP to be liquidated. Not likely.
I decided to draw 5 more DAI out of the CDP to see how things would change.
The %Ratio of the CDP went down(503.42% to 335.613%), and the liquidation price went up (128.862 to 193.293). According to the system, the price of ETH was the same at $432.48, meaning that these changes were purely caused by drawing DAI.
Now it was time to use the DAI I created. My goal was to sell it on a trading platform, and then lock more PETH into my CDP.
Step 2: Transfer to wallet
The DAI I created only exists on the DAI platform until I send it to a wallet. I just sent it to the same wallet I was using to do all the transactions on the platform.
Voila! The 11 DAI I sent was available in my wallet within one minute.
Step 3: Sell on a trading platform
Since the Dai was in my wallet, now it was time to sell it on a trading platform. I chose to use Ethex (who I incidentally work with).
I made an order to sell all the DAI at .00232 ETH per coin, which was slightly above market price.
A couple hours later, my offer was taken, and I received the total of .02552 ETH into my wallet. I had officially made a trade with the DAI I borrowed! And I even made a bit of a profit.
The next part of the plan was to put this ETH back into the CDP.
Step 4: Lock the ETH proceeds
I went back to the Dai dashboard and wrapped my ETH:
Pooled the wrapped ETH (WETH to PETH) and finally locked the PETH into the CDP.
Because I locked more PETH in, the %Ratio, Avail. DAI (to draw), Avail. PETH (to free), and obviously Locked (PETH) all increased. The liquidation price went down.
I took 5 more DAI out, just to see what the CDP would look like.
Step 5: Hodl
The last stage of my plan was to hold onto the DAI I had drawn, and not touch the CDP for a day.
When I checked the next day, the price of ETH had dropped to $419.02.
My %Ratio dropped, as did my Avail. DAI (to draw) and Avail. PETH (to free). However, the liquidation price stayed the same. Having completed everything I set out to do, I concluded my experiment.
Finals thoughts and the future of DAI
My experience with CDP’s was an eye opening in many ways. By doing it, I gained a stronger grasp over the DAI system and feel like I can use it more confidently.
In the next few months, DAI is planning on changing its system from a single-collateral system, which only uses PETH, to a multi-collateral system, which uses several different types of collateral, such as regular ETH. Among other things, this will allow the platform to become more versatile, and require fewer steps to get started on the dashboard. Perhaps the most exciting thing about multi-collateral dai is that CDP’s will be able to have diversified collateral, and can be much safer. The future of DAI is looking very promising.
My CDP is still open, and I plan on expanding it in the future. If you follow what I’ve done above, you can easily open your own CDP and receive your first loan on the blockchain.
Maybe you’ll use it to buy a car.