What is DAI crypto? This not a perfect explanation but it’s close

What is DAI crypto and how does it work you ask? Are you sitting comfortably? Good, let’s start from beginning.

Picture this: a Danish dude is sipping a warm cup of green tea while he mentally prepares to give his first English lesson to a class of Chinese students in Beijing.

The year is 2009.

Rune Christensen has just graduated from high school and is taking a sabbatical to explore China before going to University.

Portrait shot of Rune Christensen Founder of DAI
Rune Christensen MakerDAO founder

Our friend here doesn’t know it yet but in a few years he is going to be a founding figure of DeFi.

He ends up spending 4 years in Beijing.

During this time he tries to set up a business that will help more Danes teach in China.

Things are going ok-ish but sending and receiving money has become a hassle.

At that point in time Rune hears about Bitcoin and sees its potential.

He starts investing his earnings in bitcoin.

After a while Rune finds that running a business as a foreigner has become super complex especially due to capital controls.

Rune decides he has had enough and heads back to Denmark where he enrolls in business school and doesn’t like it. He drops out to try biochemistry.

But something else distracts him.

The spark that led to DAI crypto

We are now in 2014 and the price of Bitcoin has collapsed. Rune is losing money on his bitcoin investments.

He thinks to himself, “Damn this volatility is annoying. People are not going to get onto the crypto bandwagon unless there is a more stable coin they can use”.

At that point he comes across BitShares, an early decentralized exchange that issues its own token that is pegged to the US dollar: a stablecoin.

Rune is excited and involves himself in the BitShares community online.

Unfortunately, BitShares doesn’t make it. It’s trying to do too much at the same time.

But that year a new type of blockchain emerges.

The Ethereum blockchain (What is Ethereum) and its smart contract functionality present Rune the perfect opportunity to build a stablecoin.

And that’s how MakerDAO and its DAI crypto stablecoin came to be.

DAI and MakerDAO logos. DAI means “lend” in Chinese. You can find out more about how Rune came up with the name on this reddit post.

1/12. What is DAI crypto?

DAI crypto is a decentralized, overcollateralized stablecoin that is softly pegged to the US dollar.

Huh! Come again?

OK, that was a mouthful. Let me break it down.

First, let’s talk about stablecoins.

2/12. What is a stablecoin?

A stablecoin is a crypto token whose price is equal to that of a stable asset, usually the US dollar.

This is not a new concept. Many currencies around the world peg their currency to the US dollar.

The peg can be 1:1 or some other fraction.

For example Cuba, yes Cuba, maintains 1:1 peg against the US dollar despite the two countries’ antagonism.

Here are some countries that maintain a peg to the US dollar:

table of currencies pegged to USD
Source: worldbank.org via investopedia.com

Stablecoins became popular because people wanted to be able to transact on blockchains in a crypto token that is intuitive and not as volatile.

Now, some of you are thinking: but the US dollar is not stable! What about inflation?

True that, but in the short term the dollar is still less volatile than other crypto assets.

I want you to understand something else about stablecoins. To do that we need to understand money better.

For this section, I have based the content on a lecture about stablecoins by UNIC University. If you have an hour and a half to spare I highly recommend it. Otherwise read on.

The functions of money

Over time money has taken many forms: shells, large stones, camels, gold, promissory notes and most recently fiat currencies.

RAI stones used as money
“Rai” stones are used as money on the Yap islands of Micronesia. Source: bbc.com

What makes good money? There are many aspects but here are 3 major ones:

1. Good money acts as a medium of exchange.

This means that people commonly accept it in exchange for goods and services.

I live in Athens, Greece.

If I walk into a coffeeshop to buy a frappé I know I can give euros and receive my frappé in exchange.

Pic of someone holding a frappe
Here I am holding a frappé.
(Ok that’s not me. It’s just some random dude. )

Coffee in hand I go to a farmer’s market next.

Here too I can buy feta cheese and olives in exchange for euros.

So euros are a great medium of exchange in Europe.

A bad medium of exchange would be a goat.

If I tried to exchange a goat for feta cheese I would probably get some weird looks.

Goats are not widely accepted today as a medium of exchange.

There are two ways a money can become a medium of exchange.

The first is to enforce money by law i.e. for it to become legal tender.

For example, when a bunch of governments declared the euro as legal tender all Europeans agreed to use it.

The second and more powerful way is for a money to become the medium of exchange by convention.

For example, the US dollar is not an official currency in Venezuela or Zimbabwe but people in those countries commonly agree to transact in it.

2. Good money is a unit of account.

When I walk into a supermarket I see stuff is priced in euros.

If prices were to be quoted in ounces of gold or fractions of the average value of real estate in Athens then I wouldn’t have an intuitive sense of how much things cost.

3. Good money is a store of value.

This means that good money maintains it value over time. The US dollar, at least in the short run, maintains its value.

Now consider ETH or BTC or any other cryptocurrency you are a fan of. Let’s take ETH.

Is it a good medium of exchange? No, not really.

Yes, some marketplaces quote NFTs in ETH but this is more of a marketing gimmick.

People still look up the value of ETH in their local currency.

screenshot of searches for ETH conversion on Google
Search recommendations on Google. Clearly ETH is not a good unit of account

This means ETH is not a good unit of account. And we know that volatility does not make it a good store of value either (in the short run at least).

Stablecoins come to address all of the above issues.

They mitigate volatility while maintaining the qualities of crypto: being borderless, censorship resistant and offering reasonable fees for international payments and remittances.

There are 3 types of stablecoins you need to know about

  1. The first is stablecoins like USDT and USDC. These are managed by intermediaries and are backed by US dollars. It works like this: You give me a US Dollar, I give you a USDT. Simple as that.
  2. The second are algorithmic stablecoins. These use an algorithm to maintain the peg. I don’t want to fry your brain so I will leave it at that. If you really want to get your head around algorithmic stablecoins check out my explanation of why Terra’s UST crashed.
  3. Collateralized stablecoins. These can be decentralized and work like this. You give me $1.5 worth of ETH and I give you 1 DAI. Oops! I have just explained DAI.

Enough about stablecoins. Let’s dive into the specifics of DAI.

3/12. How does DAI work?

MakerDAO is a protocol, a set of smart contracts that lives on the Ethereum blockchain.

Remember smart contracts are “if… then…” algorithms.

Here is how DAI works:

How DAI crypto works
How DAI works

If I transfer $150 in ETH to MakerDAO, then MakerDAO will allow me to withdraw up to 100 DAI where 1 DAI = 1 US Dollar. When I pay back the DAI plus interest I can get my ETH back.

If I don’t pay back and the value of ETH starts dropping then MakerDAO sells the ETH for DAI. The borrower receives any leftover collateral.

Let’s delve into the mechanics a little and then I will come back to the bigger picture

4/12. How MakerDAO manages collateral

MakeDAO will sell your collateral when you hit your liquidation ratio.

What’s that?

The liquidation ratio is the maximum collateral to debt ratio you can have.

DAI liquidation formula
DAI liquidation formula

In our example before, you could borrow up to 100 DAI if you supplied $150 worth of ETH as collateral.

So you liquidation ratio is 100/150 = 66%

In general you don’t want to borrow the maximum amount because ETH is volatile.

If you borrow 100 DAI today you’ll be in trouble if the price of ETH drops tomorrow.

If that happens then you liquidation ratio will exceed 66% at which point the liquidation process will trigger unless you top up with more ETH.

Let’s understand how this works in more detail.

Here is how the DAI liquidation process works

First, MakerDAO needs a way to figure out that the value of the collateral has dropped.

For example, if I supply ETH then Maker somehow needs to know the price of ETH.

The way it does this is by checking a price feed.

Price feeds are offered by third parties known as Oracles.

To be sure, MakerDAO uses a bunch of Oracles to understand what the price of ETH is.

This way it can check your current ratio.

If it’s below the threshold it triggers the liquidation process.

Once MakerDAO triggers the liquidation process, it starts selling off your assets in an auction.

After it recovers the outstanding debt and charges you a liquidation fee (13%, ouch!) it returns any remainder collateral to you.

The whole process is automated.

The entities that participate in collateral auctions are called Keepers.

Keepers are usually 3rd parties that automate their operations to hoover up the auctioned collateral.

I assume they can achieve some marginal discount this way.

Where does the DAI come from?

Literally out of thin air.

This is the beauty of Ethereum.

Once you supply collateral you can create or “mint” new DAI.

Where does DAI go once you pay it back?

The principal you borrowed vanishes.

In crypto speak we say DAI is burnt. Technically they send it to a smart contract from where it can never move.

So, effectively, it is like it has vanished.

KAPOUSHH! That’s the sound of something vanishing.

The reason they do this is because all DAI needs to be backed by collateral.

The interest you pay in DAI is used in 2 ways:

  1. Some of it is used to build a buffer for emergencies and to pay a savings rate to DAI holders.
  2. Any surplus amount is used to buy back the governance token called MKR. MKR is also subsequently burnt.

FUEGO!🔥

Schema showing what happens to DAI repayments
What happens to DAI repayments. As of August the buffer is about 80Mn DAI

The key thing you want to understand is that because MakerDAO has more collateral than debt it will always be able to redeem DAI for US dollars.

This is a major game theoretical feature of the protocol.

Everyone understands that if worse comes to worst, MakerDAO will alway be able to give DAI holders the equivalent value in assets.

For example, if you have 100 DAI you can always claim $100 worth of, say, ETH.

Bu.. buttt…but what if DAI crypto collateral crashes too quickly

There are four things that address this

i. Diversification

Firstly, yes it could happen that prices crash quickly.

Actually it has happened and when MakerDAO only had ETH as collateral it was a problem.

But today, a basket of assets back DAI. ETH only makes up 10% of holdings.

More than half of the collateral, 61%, is stablecoins the majority of which is USDC. Liquidity pool tokens make up 23%.

You can read some concerns about USDC making up such a large proportion of collateral here.

MakerDAO collateral by type
Collateral by asset type as of August 2022 sourced from Dune analytics.

Maker currently supports a variety of collateral types including volatile crypto assets, stablecoins, liquidity tokens and even real world assets (RWA) such as real estate

Wait what? How is MakerDAO able to accept Real estate as collateral?

Yes this is weird but possible.

There are a bunch of ways to tokenize real estate, bank loans and other real world assets.

Once tokenized in the form of an NFT you can used them as collateral if the MKR token holders vote to approve it.

MakerDAO currently has about $80Mn collateral in assets most of which is a batch of loans from a bank.

ii. Emergency shutdown

Secondly, MakerDAO can do an emergency shutdown.

This initiates liquidations and means that people can claim their assets if they have no debt.

And if they hold DAI they can redeem it for the equivalent value in collateral assets.

Any occasion can trigger an emergency shutdown.

For example, if an Oracle is compromised and is feeding the wrong prices then emergency shutdown can kick in.

The emergency shutdown is the nuclear deterrent that makes everyone feel safe.

iii. Use the Maker Buffer

Thirdly, MakerDAO can use the Maker Buffer where it has collected DAI from liquidation fees and interest payments.

iv. Mint and sell MKR

Fourth, MakerDAO can mint more of its governance token called MKR.

If the value of the outstanding debt is higher than the collateral then MakerDAO starts minting and selling MKR tokens.

This point is important.

Who will want crappy tokens of an imploding protocol you may ask?

Probably no one which in turn will lead to a drop in MKR’s price.

But this is a problem for MKR holders.

MKR holders are the ones who decide on all the parameters: what is the interest rate, when do we liquidate etc.

This mechanism gives them an incentive to act judiciously.

If they manage the process well then new MKR tokens won’t get minted.

In fact, once the buffer is full, any remaining DAI proceeds are used to purchase MKR tokens which are subsequently removed from circulation.

This means there is deflationary pressure on the MKR token.

And for some reason as soon as you make something less available the market values it more.

Even if its the governance token of some protocol which you don’t really understand.

As discussed earlier, if anything can act as money then so too can a governance token.

I’ve actually seen a valuation models of MakerDAO floating around that compares MKR tokens to shares.

I am a but skeptical about that. Anyways.

5/12. How does the value of 1 DAI stay at 1 dollar?

There are a few mechanisms in place.

The first is the market.

People know that each DAI is overcollateralized.

They understand that each DAI is backed by more than a dollar’s worth of crypto assets and they know there is a mechanism, the emergency shutdown thingie, that ensures each DAI holder will be made whole.

The biggest market participants with the most liquidity are the Keepers.

They understand that one DAI will always hold its value and will trade on the minutest of divergences.

In finance they call them market makers because they make the market exist.

As a result, if DAI trades above $1 they sell it and if it trades below $1 they buy it bringing everything to equilibrium.

But say many people get spooked at the same time.

Say there’s uncertainty in the markets, someone influential tweets something negative about DAI yada yada yada.

In that case MakerDAO has a second tool at its disposal: the DAI savings rate

6/12. What’s the DAI savings rate ?

If you like you can take your DAI and place it into a smart contract on MakerDAO that earns you a return.

MakerDAO funds this through the interest that it earns on its DAI loans.

MakerDAO can change the interest rate to make holding DAI more or less attractive.

If DAI is trading for less than $1 yanking up the rate will make buying and holding DAI more attractive.

And vice versa.

MakerDAO will adjust interest rates until the market comes to equilibrium.

For more on savings and earning a return on you DAI check out my article Is DAI crypto a good investment.

Let’s talk about loans.

7/12. Why are people even taking out DAI crypto loans?

For a few reasons.

  1. The most basic use case is for leverage. You give ETH to borrow DAI to buy more ETH etc. You can automatically do this on most exchanges but there is counter-party risk. What if someone hacks the exchange and absconds with your crypto? With MakerDAO there is no counter-party. It’s just the smart contract. Also interest rates are likely more attractive than what you pay at a centralized exchange.
  2. Another common use case is to take out a loan to buy something. You don’t want to sell your crypto because you expect its price to increase but you need some cash. You then use your monthly paycheck to pay your loan down. Anyone in the world can do this.
  3. Centralized providers such as BlockFi, Nexo etc can also use Maker to borrow. They can take your cash and then do the whole process on the backend to give you a loan in cash again. Similarly, traditional finance is able to tokenize off-chain assets and use them to borrow at attractive rates.

8/12. Ok so what is so special about DAI crypto?

In terms of market cap DAI is not the largest stablecoin.

Today there are about 68Bn USDT, 53Bn USDC and 18Bn BUSD.

But all of those involve a central intermediary.

Bar chart comparing DAI market cap
DAI is the 4th largest stablecoin in circulation

With 7Bn DAI, MakerDAO is the largest decentralized stablecoin protocol out there.

For crypto and DeFi enthusiasts this is a big thing.

You have this permissionless platform where everything happens on the blockchain without a central authority.

It is trust-less, censorship resistant and anyone can use it as a platform to build dapps on top of.

I want to focus on the decentralized aspect a little more.

It is a term you keep hearing about in crypto but MakerDAO does a good job here.

Let’s dive in.

9/12. How MakerDAO governance stands out

MakerDAO is one of the most decentralized protocols out there.

In June 2021, the Maker Foundation which steered the project announced that it would dissolve itself thus handing over all operations to MakerDAO.

If you have been sleeping under a rock, DAO stands for Decentralized Autonomous Organization and means that MKR token holders vote on all decisions.

MKR holders can vote on anything from what the liquidity ratio will be to what interest rates to set for loans and savings.

They can choose wether to trigger emergency shutdown and wether to vote in new collateral and Oracles.

This means that they have full autonomous control of the system.

The community of people tends to be mostly academic.

They have guidelines and processes in place to help decide on what to add as collateral.

Stuff that has been voted on launches every quarter.

MakerDAO is a large organization. Currently there are 115 people working for it. These core teams are funded by the DAO itself.

To get a flavor of all of this you can visit the MakerDAO forum.

Pie chart showing MKR token allocation
In total there were 1,000,000 MKR originally issued. The top 10 holders hold approximately 50% of the total allocation according to @SebVentures. Source: dune.com

I’d like to close some with remarks about how you use MakerDAO in practice and some terminology

10/12. MakerDAO Oasis app

Maker mostly targets developers.

Anyone can build any kind of dapp they want on top of MakerDAO.

We have seen how some centralized players like BlockFi use it.

However there is a user interface that you can use called oasis.app.

There are many others as well but Oasis is developed in-house.

screenshot of the Oasis app
The Oasis app

I will write a separate post on how to use this but this is the place where you can get your hands dirty if you want to try MakerDAO.

If you simply wants to use DAI to transact then you can easily find it on major centralized and decentralized exchanges.

11/12. DAI crypto and Maker DAO Terminology

Every crypto project creates its own terminology. I’ve tried to avoid using it as much as possible but here are some terms you may come across when reading about DAI and MakerDAO

  • The interest you pay on your DAI loan is called a Stability Fee.
  • The smart contract where you deposit collateral is called a Vault.
  • The savings rate is called the DAI Savings Rate (DSR).
  • The initial version of MakerDAO only accepted ETH as collateral. The DAI issued at that time is now referred to as SAI (Single collateral DAI).
  • The smart contract or vault where you deposit collateral to take out a loan has a technical name called Collateralized Debt Position or CDP.

12/12. Wrapping up: what is DAI crypto

DAI crypto is the largest decentralized stablecoin by circulation.

You can deposit crypto and non crypto assets and take out a proportion of that as a loan.

You don’t need to trust an intermediary because everything is encoded in smart contracts.

The game theoretical deterrent that is the emergency shutdown ensures that DAI always trades at $1.

With a diversified portfolio and active community DAI is a fascinating project.

The way that MakerDAO operates serves as inspiration for all other DAOs.

I’m excited to see what they will do next.

If you learnt something new by reading this article this article to the moon and back. You can also sign up to my newsletter and follow me on twitter @lementalcrypto

Hasta Luego!

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