Kryptolesson #23

What is DAI?

DAI is a stablecoin cryptocurrency ↗ which aims to keep its value close to the US Dollar. As many other cryptocurrencies experience intense price fluctuations, stablecoins were invented for reducing price volatility through being pegged to a fiat currency. In the case of DAI, one unit is ideally constantly worth one US Dollar (1:1). So far, this ratio successfully has been hold quite steady (see here ↗ for a real time chart).

DAI is maintained and regulated by MakerDAO ↗, an open-source project on running the Etherium blockchain that is a decentralized autonomous organization (DAO) ↗created in 2014. MakerDAO is composed of the owners of the governance token Maker (MKR), which are entitled with voting rights to manage certain parameters in its smart contracts in order to ensure the stability of DAI. These voting rights are distributed based on the amount of MKR that a voter stakes in the voting contract, DSChief. Through a minimum reserve ratio of 150 percent plus algorithmic risk management and the voted decisions by the MakerDAO, the Maker protocol and the MakerDAO together ensure the peg to the US Dollar.

Different stablecoins use distinct collateralization strategies to achieve price stability. Most of other publicly known stablecoins (e.g. Tether ↗, TrueUSD ↗, BUSD ↗) are fiat-collateralized, i.e. backed by actual fiat currency. Although fiat-collateralized stablecoins combine low volatility of fiat currency with the advantages of blockchain, they require a centralized entity as a trusted custodian to store the fiat currency - as this must happen outside the blockchain – and give out the stablecoin cryptocurrency in exchange. The collateralization strategy that DAI uses is one of crypto-collateralization, i.e. DAI is backed with reserves of other cryptocurrencies instead of fiat currency. The advantage of such stablecoins is that the entire system is able to live on the blockchain without a central, trusted entity needed. Hence, DAI is a true decentralized finance (DeFi) product, while fiat-collateralized cryptocurrencies are necessarily centralized. The Maker protocol had become the first DeFi protocol that earned significant public adoption.

The advantages of DAI are those of cryptocurrency in general, that are for example transparency, anonymity, transaction speed, versatility as well as non-discriminated availability for everyone. Additionally, as a crypto-collateralized stablecoin, DAI offers low price volatility through its peg to the US Dollar as well as trustlessness by means of decentrality of the MakerDAO. However, its mechanisms might appear somewhat complex and counterintuitive (refer here ↗ for a detailed explanation on the DAI-US Dollar peg and on the minting and liquidation processes of DAI). The over-collateralization of a minimum of 150 percent leads to an inefficient use of capital, what results in a tradeoff for DAI buyers to be made in favor of price stability.

Photo by Luca Gianquitto