If you list some of the problems cryptocurrency faces to see a widespread and mainstream use, one that will come up is how many of the world's industries will function using an asset that's value is not stable. For example, take the retail sector: you are making a payment to the business for a product, the business is making a payment to their supplier, the supplier may be buying raw goods from another party and so forth. Imagine this was being done with Bitcoin, and there was a flash crash - it could essentially cause one of the parties in that chain of payments to go out of business.
It is a chicken and an egg problem, because, you can argue that once all these businesses enter the cryptocurrency space then the market will be much less volatile by default simply due to stability brought by increased volume. However, we cannot reach that point as it is currently too risky for many traditional businesses to embrace crypto. This is why we have seen the emergence of a concept called Stablecoins.
Table of Contents
- What is a Stablecoin?
- Why do we need Stablecoins?
- What is Dai (DAI) Stablecoin?
- What is Maker (MKR)?
- How does Dai keep its $1 value?
- What are the risks?
What is a Stablecoin?
The general idea of a Stablecoin is to create a cryptocurrency asset whose value is not prone to extreme volatility, with one of the ideas being this will allow more industries and businesses to adopt blockchain technology. We see projects trying to achieve this by pegging their coin's value to an asset that is less volatile such as fiat currencies, generally using the U.S. Dollar. Notable examples of such implementations are USD Coin (USDC), Tether (USDT) or, TrueUSD (TUSD).
These are tokens that have been issued while being backed with dollars in a bank account. In my eyes, fiat backed stablecoins are projects that have left the realm of cryptocurrency and operate in the space of digital payments (like Paypal or Venmo) as they no longer hold any claim to being decentralized.
Fiat-collateralized stablecoins hold several security problems:
- They all rely on a centralized institution and are centralized, their bank accounts could be frozen or their accountants could defraud token holders.
- We can't truly know if the token is backed 1:1 with a fiat currency.
- Even if the project subjects their fiat accounting to regular audits from an institution acting honestly, nothing is stopping them from using traditional financial tools to take out massive loans (using the backed fiat as collateral). In fact, you could say they would be fools to NOT leverage their position.
This is where Maker's Dai comes into the equation, a stablecoin pegged to $1, but lives entirely on chain thus removing many of the security problems outlined above.
Why do we need Stablecoins?
Stablecoins open up a whole world of possibilities for blockchain technology to be used by applications that require a low threshold of volatility. Imagine trying to calculate and issue a consumer loan in an asset that can move 10-20% daily - I doubt that would work, which is why we see most crypto lending products have resulted in working with stablecoins. Or for other types of dApps, it can allow decentralized exchanges such as Saturn Network to provide trading pairs in U.S. dollars instead of Ether or a stable asset may make more sense for a bet on Augur that is going to last months.
They also allow things such as hedging to happen in crypto trading, providing an option of a safe harbour for our cryptocurrency assets during times of high volatility without needing to exit the space entirely.
What is Dai Stablecoin?
So what is Dai (DAI)? In short, Dai is the first decentralized stablecoin on Ethereum created by MakerDAO (MKR). It is a way to use the benefits of having stablecoins in the crypto ecosystem without introducing the risks of trusting centralized institutions.
One Dai equals one US dollar (1:1 ratio), though we see that at many times it is worth a little less than $1 and sometimes is worth a little more - but overall it achieves its goal of being stable. Dai does this by being backed by an excess of collateral at all times, in this case ETH, which is locked up in smart contracts. For new DAI to be minted, you have to lock up ETH in a smart contract. This is a process which is referred to as opening a CDP, you use ETH to open collateralized debt positions.
The amount of Dai you can create is relative to how much Ether you have put in your CDP with the ratio being fixed by what Maker governance considers safe (currently 150%). This is called the collateralization ratio or the safe ratio (important to remember for later!), and locked collateral can be retrieved at any time by paying back the borrowed amount of DAI plus a stability fee.
Or alternatively, another way you can get your hands on DAI is to simply trade it on an exchange. Luckily for us, as it is an ERC20 token deployed on Ethereum, you can find it listed on numerous DEXes also.
This is a mainstream token that we see receiving a much higher trading activity and volume once we implement Atomic Arbitrage trading on our platform.
What is Maker (MKR)?
Don't forget the project is called MakerDAO, there are many puzzles needed in the equation to truly free oneself from traditional centralized financial institutions. One of them is that Maker is not simply a cryptocurrency and a governance token, it is a DAO in charge of two tokens Maker (MKR) and Dai (DAI).
Maker (MKR) holders have governance rights over the Maker smart contract, which is what is used to collateralize ETH and create DAI. For example, holders vote to decide the safe ratio for collateralization or to decide which price oracles can be used to generate the platform's ETHUSD rate. In return, for regulating the system MKR holders are rewarded in fees.
There is also another strong incentive for MKR holders to responsibly regulate the parameters of CDPs and Dai creation: they essentially are the buyers of last resort. If the locked collateral is ever not enough to cover the total amount of Dai in existence, then MKR is created and sold on the open market for additional collateral. Many mechanics go into the role of MKR but, to look at it very simply, if the system should fail then ultimately it is their money on the line.
How does Dai keep its $1 value?
Now as we all know the price of Ether varies, which means the USD value of the locked up collateral will always change over time. Dai carefully balances economic incentives to keep the value of $1, when the USD value of collateral increases then borrowers can create new DAI. When the USD value of collateral decreases then the borrowers have an option to repay DAI or deposit more collateral. Borrowers who do not manage their position and fall below the safe ratio risk forced liquidation.
Forced liquidation is how Maker ensures the whole system does not collapse, by liquidating CDPs and auctioning off the ETH inside before the value of the ETH is less than the amount of DAI it is backing. Remember that this is possible and keeps the system stable because DAI is always over collateralized when minted.
What are the risks?
Let's take a quick moment to think about the risks of Maker ecosystem as a whole. The main concern for the platform could have is security: is the locked up collateral safe? Currently we have over $410M worth of ETH locked up in Lending products, and over 64% of that is via MakerDAO.
Now imagine a scenario where a bug is discovered in any of the Maker's smart contracts, or an update to the underlying Ethereum blockchain code causes something to go wrong? That is potentially a worrying amount of ETH to be at risk, we would assume the smart contracts have been sufficiently audited - but with the industry being still so new as a whole it is very hard to tell.
The really amazing part is that all these mechanisms we have discussed above are built in, it is all happening automatically enforced via smart contracts: there is no centralized institution deciding interest rates or deciding who is being liquidated - it is all algorithmic and lives entirely on the Blockchain.
- No government can or centralized authority can shut it down.
- No individual can control it.
- It can be traded freely much like any token, you just need an Ethereum wallet.
So all the things we love about crypto? This is what makes MakerDAO one of the most interesting projects being built on Ethereum, showing us how decentralized finance is evolving, being innovated, and of course, how smart contracts are being developed to be ever more complicated.
Future is bright!
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