Dai is a decentralized stable coin.
Dai is a coin which price is pegged to the dollar, i. e. 1 Dai is worth about 1 USD. It is not an exact match, because Dai is traded on free market, but the system is built that way that any deviation from the initial price of 1 dollar creates forces to counteract the price change.
Unlike Tether, which is also a stable coin and pegged to the dollar, Dai is fully decentralized. There is no single entity that issues new Dai or burns excessive coins. Everyone can issue and burn Dai if he’ll provide a matching collateral. The parameters of Dai generation are regulated by MakerDAO. MakerDAO is a decentralized organization governed by the owners of MKR tokens. Functions of MakerDAO are similar to the reserve bank: it regulates the economics of the Dai currency.
At the heart of the system, there is a Collateralized Debt Position (CDP). CDP is a way of locking a collateral to get right of issuing Dai. At the moment, the collateral can be only Ethereum tokens, but in future, more coins are expected to be accepted.
For each CDP type, there are unique parameters that define the risk potential of a corresponding collateral. These risk parameters are the debt ceiling, liquidation ratio, stability fee, and penalty ratio. Debt ceiling defines the maximum amount of debt that can be created with the CDP. Liquidation ratio is the collateral-to-debt ratio at which CDP becomes vulnerable to liquidation. Stability fee is a fee paid for taking debt. Penalty ratio defines the penalty fee that is used to cover the inefficiency of the liquidation mechanism.
To issue Dai, one first needs to make Pooled Ethereum (PETH). It is done by sending Ethereum to the smart contract. PETH can be converted back to the Ethereum by the same smart contract at any time.
When the user acquires PETH, he then can make a CDP by sending two consecutive transactions to the MakerDAO contract. The first transaction states that user wants to create a CDP. The second transaction sends a specified amount of PETH. Now, the CDP is created and the sent PETH is locked.
With CDP, the user can take a debt in Dai. The maximum amount of debt is defined by the debt ceiling. It is proportional to the amount of locked PETH and can’t exceed it.
Two possible uses of Dai are a stable coin and Ethereum margin trading.
First, Dai can be used as a stable coin, or, in other words, as “dollars on Ethereum”. As the price of Dai is pegged to the dollar, it doesn’t experience severe volatility like other cryptocurrencies. It can be used to buy and sell goods and services, when merchants or consumers don’t want to use volatile cryptocurrencies like Bitcoin, Ethereum, and others. It can also be used as a store of value, as one knows that 1 Dai will worth 1 Dollar in future with a high probability.
It is worth to note that to use Dai as a stable coin, one doesn’t need to go through the procedure of creating a CDP and creating a debt. Instead, he can simply purchase it on an exchange or from his peers. He also doesn’t need to have an in-depth knowledge of how the system works: a general overview and the stable price in past should be enough.
How can users be sure that the price of Dai will be around $1? It’s based on the dynamics of supply and demand.
First, the price can be significantly higher than $1. On one hand, Ethereum holders are incentivized to take a debt and sell expensive Dai on the market, then rebuy it when it’ll become cheaper and take the profit. That way, the supply of Dai increases. On the other hand, the market doesn’t want to buy expensive Dai. It will wait until the price will go back to one dollar. That way, the demand for Dai decreases. With increasing supply and decreasing demand, the price of Dai will decrease.
Second, the price can be lower than $1. Here, the situation is almost the same. On one hand, those who have taken debt in past and sold Dai, are able to buy it back while it’s cheap, close the debt and take a profit. Moreover, no one wants to create more CDPs, because if the price will go up, they will lose. That way, the supply is decreasing. On the other hand, the market wants to buy cheap Dai, to sell it at a higher price and make a profit, increasing the demand. With decreasing supply and increasing demand, the price of Dai will increase.
The second use of Dai is margin trading. If one believes that the price of Ethereum will go up, he can lock his existing Ethereum, take a debt in Dai and buy more Ethereum with this Dai. If the price will really go up, he then can sell this Ethereum and receive more Dai than he had before. Then, he can send part of this Dai to close the debt and unlock his Ethereum. In result, he will gain Ethereum.
How MakerDAO makes sure that it will not lose the money regardless of the price change? If the price of Ethereum goes up, the price of locked collateral would also go up, so no worry for MakerDAO. If the Ethereum price goes down the specific threshold, the collateral locked by the trader is liquidated. This threshold is defined by the risk parameters of CDP. The process of liquidation is assisted by Liquidity Providing Contract. This contract puts collateral on sale, and market participants can buy the collateral with Dai. If there are excesses of Dai after closing the debt, they are used to buy PETH and burn it. If acquired Dai is not enough, the system creates PETH and sells it until there is enough Dai to close the debt.
In case of serious emergencies, such as long-term market irrationality or hacker attack, members of MakerDAO can start the Global Settlement. Global Settlement is the process in which all CDPs are closed and the whole platform is shutting down. When it is initiated, all operations with CPDs are stopped. Every Dai holder can exchange his Dai back to Ethereum at the target price.
- September 10, 2015: The first post in MakerDAO blog which describes the platform. medium.com
- July 5, 2017: Release of Sai, “Simple Dai”, which is a prototype of modern Dai coin. youtube.com
- December 9, 2017: Release of an improved version of Dai white paper. medium.com
- December 19, 2017: The launch of Dai network. medium.com
- December 22, 2017: Global settlement of Sai. medium.com