EXPLAINER: Inside DAI – An Algorithmic Crypto-Collateralized Stablecoin

Crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized” - that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins.

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MakerDAO is an over-collateralized stablecoin project running on Ethereum blockchain since 2015.

Its stablecoin, DAI, has risen as the most successful decentralized stablecoin protocol to date growing its total supply by 46x in the last 12 months and generating over $63M in net earnings since the start of 2021.

Stablecoins are generally backed or collateralized, either by fiat or crypto, and usually pegged to the dollar.

Crypto-collateralized stablecoins are backed by other cryptocurrencies. Since the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized” – that is, a larger number of cryptocurrency tokens is maintained as reserve for issuing a lower number of stablecoins.

The Maker Protocol allows users to issue DAI, a stablecoin pegged to the value of the US dollar, by locking collateral assets of a greater value in the system’s vaults. Maker currently supports a variety of collateral types including volatile cryptoassets, stablecoins, liquidity tokens, and Real World Assets (RWA).

The protocol was officially launched in 2017 as the Single-Collateral DAI system (also known as SAI) which allowed users to mint DAI usin only ETH as collateral.

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RECOMMENDED READING: EXPLAINER: All You Need to Know About the $BUSD Stablecoin

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But in 2019, Maker added Multi-Collateral DAI (MCD) system in 2019, accepting an increased variety of collateral types beyond ETH.

As such, unlike most stablecoins, which are collateralized against a single fiat currency or cryptocurrency, DAI can use different cryptocurrencies as collateral:

  • ETH
  • BAT
  • USDC
  • wBTC
  • COMP

and many more. 

DAI combines the advantages of a low volatility currency with the key attributes of cryptocurrencies (permissionless, borderless, transparent, peer-to-peer, etc.).

DAI is generated, backed, and kept stable through collateral assets that are deposited into Maker Vaults on the Maker Protocol (e.g. $1,000 worth of ETH is deposited into a vault as collateral to issue 500 DAI). This, paired with the adjustability of interest rates, ensures that DAI’s value is always equivalent to one US dollar.

DAI is an ERC-20 token that can be purchased from both centralized exchanges and decentralized exchanges (DEXs). DAI can also be borrowed by opening a Maker collateral vault through MakerDAO’s Oasis Borrow dashboard and deposit Ethereum-based assets as collateral.

MKR is the governance token of the Maker protocol. It allows those who hold it to vote on protocol changes such as collateral onboarding, governance parameter changes, budget approvals, etc.

Those who hold MKR set the DAI Savings Rate and act as guarantors for DAI – meaning, their MKR tokens can be liquidated if the system were to crash. This structure incentivizes guarantors to ensure the proper functioning of the DAI system and its collateralized tokens.

The Gemini exchange has listed the following advantages of DAI as a stablecoin:

  • No Account Minimum – Many individuals around the world lack the minimum quantity of assets needed to be eligible to open a bank account, but there is no minimum balance amount required to use DAI
  • Stable Value – DAI can provide an alternative stable currency and means of financial inclusion for citizens living in locations with severe economic instability
  • Decentralized Freedom – DAI is an algorithmic stablecoin thus without the need for an intermediary – creating a permissionless system with transparency and minimal restrictions
  • Income Generation – the MakerDAO system enables owners of DAI tokens to earn returns by depositing DAI into a MakerDAO smart contract. This specialized smart contract system secures the user’s investment which has no minimum and can be withdrawn at any time
  • Fast and Cheap – DAI’s nominal transfer fees and fast processing times, global transactions from one user’s wallet to another become much more transparent and efficient
  • Always On – Through DAI and the Ethereum blockchain, transactions can be completed at any time and on any day of the year in a matter of minutes
  • Highly Secure – Through mathematical analysis, developers formally verify all smart contracts and underlying protocol mechanisms that constitute the internal structure of the system

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RECOMMENDED READING: An Algorithmic Stablecoin ($UST) is Now Among the Largest Stablecoins

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