Part 2: A Primer on Dai

This is a three-part series which serves as a primer for understanding the fundamentals surrounding stablecoins and the MakerDAO Ecosystem. Curious about how Dai works? The second post in the series gives a high-level overview on Dai and shares what you should know about the very first decentralized stablecoin. You can read Part One here.

In our last post “Why Stablecoins Matter” we explored the importance of a truly decentralized, stable currency and the critical role stablecoins play in the ecosystem. This fundamentally new type of digital money is a foundational pillar in supporting the rise of a modern financial system on the blockchain.

For the past three years, MakerDAO has been working hard on solving the critical problem of a digital stable currency.

To accomplish this, we carefully researched countless models, reviewed the spread of possible scenarios including extreme black swan events, built an ecosystem to support early adoption, and brought together a team of experts in economics, mathematics and blockchain development. We’ve never wavered in our belief that a truly decentralized, stable currency is what is needed to unlock the massive benefits (and promising future) of blockchain.

Last year, we made a huge stride toward our ultimate goal and released the very first decentralized stablecoin, Dai. In addition to enabling new applications, we’re proud to observe its stability through this year’s bear market as Dai maintained it’s peg to $1.

This post gives a primer on what you need to know about Dai.

What is Dai?

Dai lives completely on the blockchain; unlike other stablecoin options, Dai’s solvency does not rely on any trusted counterparties and it’s stability is unmediated by any locality. No one can alter the core mechanics of Dai, making it a safe and predictable form of money.

Dai is a fully decentralized, asset-backed currency whose value is stable relative to the US Dollar. The price stability is maintained through an autonomous system of smart contracts, which responds to varying market dynamics.

Some important features of Dai:

  • Each Dai is worth $1.
  • All Dai are backed by real assets, a surplus of collateral that has been escrowed into audited, ownerless, and publicly viewable Ethereum smart contracts.
  • It’s solvency doesn’t rely on trusted counterparties.
  • It’s a currency that lives entirely on the blockchain.
  • It’s stability is unmediated by locality.

Once generated, Dai can be used in the same manner as any other currency: it can be freely sent to others, used as payments for goods and services, or held as long term savings.

How does Dai work?

Each Dai is fully backed by a valuable asset held in the secure Maker smart contract platform. Anyone can lock their tokens up as collateral and issue Dai against them.

Everyday users don’t need to understand the internal mechanics in order to use Dai. People can freely use Dai as a traditional currency because price stability is managed through an autonomous system of smart contracts specifically designed to respond to market forces and an ecosystem of economic incentives.

Anyone can create Dai by opening a Collateralized Debt Position (CDP) on the MakerDAO platform. A CDP is a smart contract which gives users Dai in exchange for locking up valuable collateral. The assets are held in escrow until the borrowed Dai is returned by the user. Put another way, Dai is created when users lock up collateral and Dai is removed from circulation when users free up their collateralized assets. This system of exchange is essential in regulating the total supply of Dai in the market and guarantees the value of circulating Dai.

It’s important to note that the amount of collateral in a CDP is always set to be significantly higher than the amount of the debt, so stability seekers who wish to use Dai as a predictable store of value can be confident that 1 Dai is worth 1 USD in underlying assets.

Should the value of the underlying collateral increase, CDP owners are able to mint more Dai from the same amount of staked assets. This influx of additional Dai into the market during bull runs keeps the supply higher during periods of increased demand.

Third party network participants, known as “keepers” help maintain the price of Dai. Keepers are generally automated programs that take advantage of arbitrage opportunities to keep Dai near its peg. They also participate in CDP auctions ensuring the orderly wind-down of liquidated contracts.

What is Dai used for?

Price instability and market speculation has contributed to extreme volatility in the majority of cryptocurrencies, making it challenging for the existing ecosystem to support financial functions. However, Dai is a predictable and stable form of currency, which has low volatility relative to widely accepted currencies like the US Dollar, making it suitable for a wide range of financial activities.

This enables functions like the following:

  • Hedging: During periods of high market instability, Dai offers a safe harbour to store value without having to exit the crypto space.
  • Lending: High volatility creates an uncertain lending environment as borrowers and lenders cannot comfortably plan for the future. Dai’s low volatility makes them a perfect medium for a stable, predictable loan.
  • Decentralized Leverage: In creating CDPs, users can get more capital without spending collateral they are bullish on.
  • Payments / Online Purchases: Users can spend Dai at merchants that accept crypto at point of sale.
  • Decentralized exchanges: Decentralized exchanges are frequently unable to provide fiat-offramps. Dai allows their users to trade their assets for a low volatility currency that is stable relative to other widely accepted currencies like the US Dollar.
  • Exchange pairs: Crypto-to-crypto trading can be a complicated proposition. It is difficult to track earnings when the base trading pair is rising and falling in value as users are making trades. Creating low-volatility pairings with Dai allows for greater price predictability.
  • Supply Chain: As goods and assets exchange hands, middlemen take large fees for ensuring safe transactions, lending stable capital, and brokering cross-border initiatives. Dai and blockchain can reduce the costs of supply chain and international trade.
  • Prediction Markets: Long term betting becomes infeasible if users also have to gamble on the future price of the asset they are wagering. A cryptocurrency with price stability like Dai can be the natural choice for prediction markets and gambling applications.

Dai is a key solution for those who seek stability from a fully decentralized, asset-backed currency. In the short-term, Dai enables people to transact in a practical manner and in the long-term, it enables a wide range of services on the blockchain such as loans, supply chain and prediction markets. With Dai, a robust financial ecosystem on the blockchain is well within reach.

Part 3: Naturally, interest in stablecoins have growth in recent months. New models for stablecoins, such as seigniorage shares and faith-based models, have been introduced and debated. Please stay tuned for the last part of our series which explains these various models and explores each model’s potential for long-term viability.

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We believe in a future that leverages the power of decentralization for trustless transactions.

With Maker, we are carrying out our vision of creating a decentralized stablecoin that will unlock the unique benefits of a complete financial ecosystem on the blockchain. Join us!