A Cryptocurrency Dressed in Fiat’s Skin: The Stablecoin DAI

The question “what is DAI?” is rather easy to answer if one is interested only in using DAI as a currency. In order to purchase DAI and to use it, it is enough to know that DAI is a type of digital Dollar, that it runs on the Ethereum Blockchain and that it is a decentralized cryptocurrency like Bitcoin or Ethereum itself.

The key detail that it is “a particular type of Dollar” is also easy to explain: almost at all times, one DAI keeps the same value of one Dollar; therefore, users may understand it and use it as an electronic Dollar. It is very convenient because one can use it from any Ethereum wallet. In case you wish to send Dollars to other countries, for example, DAI might represent an extremely cheap and secure option. In addition, money arrives in a few minutes to its destiny. DAI is more or less like the famous Libra currency developed by Facebook. The difference is that DAI is not controlled by any private or public organization. DAI is relatively similar to Bitcoin and Ethereum in that it is decentralized.

All of the above is enough information to understand the basics of what DAI is and how it can be used. Actually, DAI is something similar to the electronic Dollars that we use through debit cards. A DAI is equal to any electronic Dollar, but DAI does not reside in the databases of computers belonging to public or private banks as it is the case for Dollars backed by the United States Federal Reserve. DAI runs on top of a platform that has no owner or central administrator, the Blockchain. As financial units of account, though, both Dollars and DAIs express the same value. Both are data and both carry equal purchasing power.

I AM CURIOUS AND WANT TO KNOW MORE: WHY IS IT CALLED A “STABLECOIN”?

Yes, here the subject begins to become a little more complex, although not too complex. The concept of “stablecoins” makes more sense within the microcosmos of Crypto than in the fiat world of Dollars or Euros. A normal person who lives and works in the United States or in Europe would earn a salary naturally in Dollars or Euros. For this worker, the idea that the Dollar or the Euro is a “stable currency” may not sound fair, because the purchasing power of these currencies fluctuates highly. The same phenomenon may be observed in almost all other countries. In fact, citizens of all continents nowadays seem to be complaining that money loses value every year. There is no stability in national currencies!

The use of the term “stable” for coins whose market price is artificially pegged to a national currency, has nothing to do with the stability of the official currencies. Actually, people’s feelings associated to fiat appear to be the opposite. General opinions, in most countries of the world, indicate that in this 21st century money falls in value precipitously. Massive loss of faith in Dollars and in Euros might even be an inevitable sentiment. Even so, loyal investors who hold Cryptocurrencies or use them for their transactions, seem to suffer from the elevated price volatility of these decentralized currencies too.

Cryptocurrencies such as Bitcoin or Ethereum change prices every minute. It can happen that, if in the morning 1 Bitcoin was trading at $ 12,000, for example, it would be nothing strange that in the afternoon, the price of the same coin is at $ 10,500 or $ 13,000. One can never be sure what the purchasing power of a cryptocurrency will be even within 60 minutes. Bitcoin and altcoin users are accustomed to this violent degree of instability and, in addition, tend to develop a high level of psychological tolerance to such volatility. For these same people, however, a currency that retains its relative value in reference to the Dollar, such as DAI, feels like an extremely stable thing. That’s why they call cryptocurrencies whose value is somehow pegged to national currencies “stablecoins.”

There are many types of stablecoins, not just DAI. Most stablecoins are backed by some funds in real Dollars, Euros, or any other Fiat currency. The predominant stablecoin is perhaps Tether tokens. Tether is backed – according to the company that issues it – mostly by solid US Dollars. Recently, Tether is using bonds and some other valuable assets to back their stable tokens. Basically, Tether, as a private company, promises that there will always exist one real Dollar deposited in a designated legal bank account for each Tether token. Of course, as we said already, they are starting to back their tokens with other instruments too in these days.

In the market, there are more than 4 billion Dollars in the Tether currency in circulation. One tether token can change hands 4 or 5 times per day generating daily volumes of up to 20 billion dollars in regular days. By the way, some researchers suspect that certain spikes in the price of Bitcoin are related to specific releases of newly minted Tether tokens. In the Bitcoin Blockchain, you can see when new Tether tokens are born. It has been observed that, when many tokens are minted by the company, the price of Bitcoin immediately begins to rise. Could it be a coincidence?

There are more stablecoins backed by fiat assets, such as USD Coin, TrueUSD, PaxosStandard, STASIS EURS and Gemini Dollar, among many. These are all stable cryptocurrencies whose value is equal to that of the Dollar or the Euro. In itself, this type of stablecoins constitute the union between Fiat money and cryptocurrencies. You can also say that they are Fiat money that runs on top of the Blockchains. Using these stablecoins is a form of holding and utilizing Fiat money while enjoying some level of decentralization of traditional money and the advantages of the Blockchain. It is money that exists within the Blockchain, but that does not suffer from the volatility of most cryptocurrencies.

WHAT MAKES DAI STABLE, THEN?

All right, this is already a major-league level question! We have already mentioned that Tether tokens as well as the other stablecoins named here, are backed by reserves of national currencies basically. In contrast, the case is not the same for the stable DAI that is priced at one Dollar without having Dollars or other legal assets to support it. Unlike the other stablecoins, DAI does not have fiat money, nor bonds, stocks or some other official asset, that support its value. DAI is a fully decentralized currency.

There aren’t Dollars in any bank backing DAI tokens. DAI is not even under the control or responsibility of any public or private institution. However, the backup for each DAI token is twice its value. The DAI currency is backed by funds in Ether, the cryptocurrency that ranks second in the world according to market capitalization. For every DAI that is in circulation in the market, there are at least $ 2 worth of Ethereum coins locked in the Blockchain as solid backing for the system that gives support to DAI. The name of this system is “Maker”.

A very quick and easy way to answer the question of “what makes DAI stable?”, is simply to say that Maker’s Smart Contracts are the ones in charge of keeping the price of DAI stable. It is crucial to have clear that a Smart Contract is a computer program that is hosted on the Blockchain. This means that, as a decentralized computer program, it holds the peculiarity of being immutable and unstoppable. Maker is a open computing system that absorbs funds in Ether from the market and, based on fund in Ether, issues the decentralized Dollars called DAI.

Maker is the intelligent system that mints DAI coins. Obviously, most DAI users do not need to know this in order to leverage DAI for regular purposes, except for those users who decide to feed Maker with Ether. If you insert Ethereum coins to Maker’s Smart Contracts, the Blockchain will give you DAI tokens in return. This is how the DAI stable tokens are born. Only users who make transactions directly with the Maker system have the experience of seeing how DAIs are created. Regular DAI users have no experience with the Maker system, since they buy their DAI tokens at Exchanges.

I AM READY FOR THE TECHIE SIDE: TELL ME MORE ABOUT MAKER!

Maker is a Smart Contract platform on top of Ethereum Network. You need to know what Ethereum is and what a Smart Contract is, if you want to understand Maker at some depth. Maker supports and stabilizes the value of DAI through a dynamic loan system called “Collateralized Debt Positions” (CDP), through autonomous oracle-based feedback mechanisms (TRFM), and – perhaps most importantly – through an algorithmic system of incentives aimed at stimulating or inhibiting the behavior of the actors in the system.

The first key to understanding how Maker manages to support the stable price of DAI is, first, to understand how the CDP system works. A CDP is – to put it simply – like a bank account. This account is not to save money, but, rather, to issue debt. Therefore, it is not called “savings account”, but “debt position”. The system is able to create DAI coins and lend them by depositing newly minted DAI in people’s CDPs.

If you want DAI coins from Maker, you have to create a special account, or a debt position. Obviously, like in the case of a common bank, the Blockchain is not going to give away DAI coins to users by depositing in debt positions without anything in exchange. So, a system similar to that of mortgages comes into play. To be precise, one has to understand it this way: if I want the Maker system to give me DAI coins, I have to borrow them. I can’t buy them. Maker mints DAI tokens only if there is some user interested in borrowing them. The funds in Ethereum serve, then, as the mortgage pledge.

Ether is used as collateral in this system. Of course, if you want 100 DAI tokens – or $ 100 in DAI -, you must lock at least $ 200 in Ethereum coins in your debt position, in Maker. Your Ethereum becomes collateral for your loan. If you provide the correct amount of Ethereum coins for the number of DAI tokens that you are requesting from Maker, then, Maker deposits your DAI tokens in your account – in your debt position -. Since this debt position is now backed by some collateral in Ether, it is called a Collateralized Debt Position (or a CDP).

The CDPs then contain guarantee funds deposited by a user. Thanks to these funds, DAI tokens – also called DAI coins – can be generated. Of course, a normal DAI user might think that this system is a bit inconvenient because the amount of collateral in Ether is at least 200% of the amount of DAI that one can borrow. And even the idea of ​​borrowing itself, might sound very annoying for some investors too. Buying DAI at an exchange at the regular price of 1 DAI = $ 1 would probably sound like a better deal.

Yes, it is true, many people do not use Maker to get DAI. However, it is very convenient for Ether speculators. If you strongly believe that Ethereum coin will rise a lot in price in the future, it would be worth for you using your Ether as collateral and extracting DAI. After you get some DAI, you would not want to save the DAI for the future. Instead of using the DAI, you go to an Exchange and buy more Ether with these DAI coins you just minted.

Now you have some new Ethereum coins. Next, you take these to your CDP again and, with this ETH, you borrow more DAI. Do you realize how you have increased your Ethereum coins with this system? Ethereum believers apply this system to increase their Ether. They repeat the operation many times until they have doubled their Ether. These special investors are not too interested in DAI actually, but, thanks to them, the supply of DAI coins tend to increase. If the price of ETH goes up, they can unlock ETH and take big profits.

The CDP system is the core of the system. But, Maker needs to control more variables in order to keep the price of a coin stable. There is a second system that is based on oracles – in feedback that comes from the market -. This second system is used to adjust the incentives that Maker gives to users and is called “Target Rate Feedback Mechanism” (TRFM). TRFM is activated by Maker when DAI’s market price is not $ 1 or almost $ 1. If DAI is being traded for $ 1 at the open market, as it usually is, then, TRFM is in dormant state.

In other words, when DAI is in its expected stable price of $ 1 in Exchanges and other markets, Maker keeps giving the regular incentives to its users, for example, the right to take loans with only 200% of value in collateral, estimated in US Dollars. Nevertheless, if Maker detects that DAI is becoming expensive in the open market, then, TRFM awakes to keep monitoring the irregular market behavior and Maker starts calculating new rates and adjustments in incentives. For example, if TRFM reports of a fall in price under $ 1, then, Maker will manipulate its variables in order to incentivize a rise in price, and vice versa.

In summary, Maker is the fully autonomous computer system that maintains the stability of the DAI from within the Blockchain. Normally, it is based on a parameter called “Target Rate” – a price that Maker has to incentivize -. This price will usually be $ 1. When the market price of the DAI tends to move away from the Target Rate, then, Maker takes advantage of the TRFM emergency system, which continuously modifies the incentives to generate and maintain DAI stability. The TRFM’s action helps to buffer the temporary volatility of DAI and helps generate liquidity during times of crisis.

WILL DAI STILL BE USED IN THE FUTURE?

Yes, it will! As a matter of fact, a straight “yes” may sound a little pretentious. We all know that, in very volatile markets, like Crypto markets, it is hard to know if an asset will be successful or not in the long term. Granted, we cannot know the future! However, one thing is true too: there in one kind of Blockchains that are practically unstoppable, especially open, public, decentralized and censorship-resistant ones.

Ethereum is one example of a typical unstoppable Blockchain. In theory, then, DAI, as it is a decentralized currency on top of Ethereum, is unstoppable too. DAI does not depend on human action, so, it is highly unlikely that it could disappear completely. It is natural to imagine, consequently, that, there would always be someone wanting to lock Ether in order to get DAIs from Maker. At the time this article is being written, there exist 77,066,865 DAI in circulation.

DAI has many other advantages, as matter of fact. Even if stability is just relative because the purchasing power of national currencies vary, this relativity has proved to be of immense value for many people to the extent that millions of users want to have it in cryptocurrencies too. In the case of DAI, since it not backed by Fiat, it not even some form of Fiat on the Blockchain, but an innovative method to leverage Ether.

DAI can bring surprises. In the future, for example, the community might propose to set the price of DAI to 1 Euro or to 100 Yen through a fairly decentralized process of voting. This is possible. Also, more types of stablecoins could be created on top of Maker. In a world where Fiat money is already very inconvenient for international payments, for remittances, or for global businesses that operate in real time, it seems that, little by little, demand for crypto Dollars, crypto Euros or other types of crypto Fiat, can increase exponentially. Some stablecoins are Fiat wrapped in crypto clothing. But, DAI is a legitimate cryptocurrency dressed in Fiat’s skin. Such are the amazing creations that emerge from the most advanced Fintech development we have in our era, the Blockchain.