Stablecoins are tokens that maintain a value approximately equal, or “pegged,” to another asset. Different types of stablecoins exist, including fiat-collateralized (like Tether’s USDT), commodity-collateralized (like Paxos’ PAXG) and algorithmic (like Ampleforth’s AMPL) stablecoins.
DAI is considered to be a fourth type of stablecoin, called a crypto-collateralized stablecoin.
Each token is backed by cryptocurrency and is overcollateralized by crypto deposits through Maker Protocol’s smart contracts, called Maker Vaults. This means that every token requires a token holder to lock cryptocurrencies worth more than the amount they mint in a Vault to ensure the stability of its $1 peg, even with fluctuations in the crypto market.
The open-source Maker Protocol software is built on Ethereum, and its stablecoin can use a variety of ERC-20 tokens as collateral, including Ether (ETH), Basic Attention Token (BAT), wrapped Bitcoin (wBTC), Compound (COMP), and more.
- DAI is a crypto-backed stablecoin that is pegged 1:1 to the US dollar.
- All tokens are generated by loans that require excess collateral of Ethereum-based assets to absorb market volatility.
- Maker Protocol, overseen by the MakerDAO community, is responsible for assuring DAI’s stability, relying on arbitrageurs and controlling supply and demand of the token to maintain its peg.
How was DAI developed?
The Maker Foundation, the company who coordinates development of the Maker Protocol, was co-founded in 2014 by Rune Christensen and Wouter Kampmann.
The formal whitepaper describing the stablecoin was written and published in 2017. The single-collateral token (backed only by ETH) was released in 2017, with multi-collateral functionality introduced in 2019. This means that anyone wishing to borrow the stablecoin can do so with any ERC-20 cryptocurrency.
In July 2021, the Maker Foundation gave up control of the software to MakerDAO, a decentralized autonomous organization (DAO), providing the protocol with a fully decentralized governance model.
The DAI Foundation is a Denmark-based non-profit organization whose role is to maintain the components of Maker that cannot be decentralized such as legal copyrights.
How does the DAI stablecoin work?
Unlike other stablecoin systems that require a centralized company to issue tokens and assure the backing of its tokens, Maker’s lending platform to mint DAI allows for decentralized, community participation.
In order to generate new tokens, a user deposits their cryptocurrency (like ETH) into a Maker Vault. Their tokens are locked in the Vault’s smart contract as collateral against which they can withdraw—or more accurately, borrow—DAI. The user’s deposits are referred to as a Collateralized Debt Position (CDP), and they must pay a small stability fee for using the service.
Maker uses oracles to determine the dollar-based value of the deposited cryptocurrency, and users generate a specified amount of tokens based on that value. This collateralization is never 1:1 because of the volatility of the cryptocurrency market. Therefore, Maker requires overcollateralization of each CDP in which users must deposit more value than they are taking out. If the dollar value of a user’s cryptocurrency decreases, then they must return the tokens they have borrowed, deposit more value into the Vault, or risk being liquidated.
Maintaining the peg
Maker’s smart contracts employ a number of mechanisms to stabilize the cryptocurrency’s value around its peg to the US dollar. One of these is a reliance on Keepers, which are third-party participants (usually automated) that buy DAI when it is below its $1 target and sell it when it is above its $1 target. This process of arbitrage keeps a constant pressure on the price of the stablecoin to remain in a tight band.
There are also four types of auctions that Maker uses to stabilize the stablecoin’s market price:
- Collateral auctions – The protocol offers assets from liquidated accounts for sale to the broader users of the platform, minus a penalty.
- Reverse collateral auctions – When more tokens are bid on in collateral auctions than is needed to cover the debts of a liquidated Vault owner, some is returned to the original owner.
- Debt auctions – If there are not enough buyers in a collateral auction, the protocol sells newly-minted MKR (Maker’s cryptocurrency) to platform users
- Surplus auctions – When the stability fees collected by the system reaches a certain limit, the extra token are sold to users in exchange for MKR which is then burned.
More information about how the Maker Protocol enables the generation and maintenance of the stablecoin can be found in our "What is Maker? (MKR)" guide.
DAI as money
The purpose of the stablecoin is to operate similarly to traditional money, but in the cryptocurrency space. Its peg seeks to accomplish digital equivalency with the US dollar for use in trading pairs on crypto exchanges like Bitstamp, on decentralized exchanges like SushiSwap, and in DeFi protocols.
DAI is also used as a medium of exchange thanks to its stable value and its ability to be transferred 24/7 quickly, cheaply, and efficiently.
How is the DAI token used?
Like other stablecoins pegged to the US dollar, DAI is used primarily as a representation of a constant-value, easily exchangeable asset in digital transactions.
Crypto users who don’t wish to buy/sell other tokens with USD on exchanges instead may opt to swap the stablecoin for other crypto due to the ease of use.
The stablecoin can similarly be used as collateral for loans on decentralized lending protocols like Aave or deposited in liquidity pools in protocols like Balancer. Within Maker’s ecosystem, the token is also used to repay loans, pay the stability fee, and take part in debt auctions.
The supply of DAI fluctuates over time according to the demand for stablecoins in the broader cryptocurrency market. In February 2022, nearly $10 billion tokens were in circulation, making it the fifth most used stablecoin.
How to buy DAI
You can buy the DAI coin on Bitstamp. Sign up for a Bitstamp account and start trading the stablecoin today!
Disclosure: Bitstamp is licensed to engage in virtual currency business activity by the New York State Department of Financial Services.