As one of the core components of the MakerDAO project, Dai is the first decentralized stablecoin that is not backed by major fiat currencies. Unlike other stablecoins such as Tether’s USDT or Circle’s USDC, which are pegged 1-to-1 with the USD, Dai’s circulating supply is backed by various different assets (including traditional bonds).
According to Andy Milenius, the Team Lead at MakerDAO (an Ethereum-based decentralized autonomous organization), stablecoins are a “more useful” form of digital money. While cryptocurrencies allow users to exchange monetary value in a decentralized manner (without requiring intermediaries), the price of Bitcoin (BTC) and other cryptoassets are highly volatile.
Dai Is An Asset-Backed, “Hard Currency”
Due to extreme fluctuations in their prices, many consumers and merchants consider cryptocurrencies to be an unreliable payment method. Stablecoins such as Dai allow investors to hold value in more price-stable assets.
As explained, Dai is a key part of Maker’s permissionless credit system that has been developed on Ethereum, the world’s largest smart contract platform. Described as an asset-backed “hard currency”, the Dai stablecoin is always backed by some type of “valuable” asset.
Dai Is A Permissionless Credit System
Milenius, a computer science graduate from the University of Michigan, who noted during Devcon Three (an Ethereum Foundation Developers Conference held in late 2017) that Dai is a permissionless credit system. He explained that all new units of the Dai currency are issued after users lock their “valuable” assets into Dai’s credit system.
All Dai is issued against the assets that users lock up and the stability of Dai is maintained through a system of “dynamic autonomous” interest rates. As noted by Milenius, the interest rates automatically react and adjust according to changing market conditions.
Maker’s MKR Coin Is An Integral Part of Dai’s Credit System
Dai’s usage fees and user incentives also change - based on the emerging market conditions. While not directly linked to Dai, Maker’s MKR coin is the administrative component of the stablecoin’s credit system.
A decentralized regulatory entity is formed by MKR holders, who use their stake in the platform to make decisions regarding which types of assets are “truly valuable” as collateral. These assets are then used to back the Dai stablecoin.
As mentioned by Milenius, MKR coins may be considered the “fuel” for Dai’s credit system. He added that when users pay back their borrowed Dai, they are able to reclaim their collateral.
However, the users are charged a fee in MKR, which is then “consumed” by Dai’s permissionless credit allocation system.
“Well-Defined” Reference Implementation Written in Haskell
In order to create the Dai stablecoin system, its developers initially released a “well-defined” reference implementation - which was written in a functional programming language, called Haskell.
As mentioned in the release notes, the reference implementation helped with the “simplification” of Dai’s system design and its also improved the project’s overall efficiency. Moreover, formal verification specialists working in other industries began to take a closer look at how Maker was developed.
Dai Based on Collateralized Debt Position (CDP) Concept
As mentioned in a blog post published by Sharon Manrique, a front-end developer at MyCrypto,
Dai’s price stability is based on the Collateralized Debt Position (CDP) concept - which was introduced by the MakerDAO project in 2014.
Developed as a potential solution to the extreme price volatility of cryptoassets, CDPs allow users to deposit various assets into smart contracts as collateral for loans taken out in Dai. After taking out a loan in Dai, the stablecoin may be used to make payments or it may be traded on crypto exchanges.
Blockchain-based Finance, Betting, Supply Chain Apps May Need Stablecoins
According to MakerDAO’s website, there are many different blockchain-based applications that won’t function “optimally” unless their platforms support transactions with stablecoins. Distributed ledger technology (DLT)-enabled supply chain and finance applications may require stablecoins, in order to settle transactions more reliably.
DLT-powered prediction markets, remittance payments, betting and various merchant services apps may also need stablecoins to function effectively. This, as users who accept payments in a certain currency do not want its value to fluctuate dramatically like Bitcoin (BTC) and other major cryptos.
Dai May Be Traded for Cash in Open Markets
As explained, new Dai is created each time a borrower takes on a collateralized debt position. As part of the CDP process, users may deposit various types of collateral (such as bonds) in an Ethereum-based smart contract. Once a user’s contract has been locked, a portion of the value of their collateral loaned out to the user in the form of Dai stablecoins.
Notably, Dai may be traded for cash in open markets or exchanged for other cryptocurrencies on various trading platforms.
In a manner that is somewhat similar to how banks charge interest on loans, borrowers must pay a “stability fee” when they pay back their Dai. After a user returned the borrowed Dai, their assets locked as collateral are given back to them and the corresponding Dai is destroyed.
Dai Is Backed By Diversified Collateral Portfolio
In addition to receiving loans in Dai, the stablecoin may be directly purchased from exchanges - without having to deal with requirements associated with CDPs or Maker’s complex lending system.
As noted on MakerDAO’s website, Dai’s circulating supply is “secure” because every Dai coin is backed by a valuable asset. By using a diversified collateral portfolio, the stability and the value of Dai is “guaranteed” - as it may be supported by multiple assets.
Dai Is “Resilient”, As Its System Can Shut Down in Emergencies
Dai-based transactions are also transparent because anyone can check how much collateral is being held in order to back the loans that have been issued using the stablecoin. The Dai stablecoin system is also “resilient” - as an “emergency shutdown” may occur in case of a “black swan” event (unexpected and undesirable situation).