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Dai: The Crypto-Backed Stablecoin Powering DeFi

September 6, 2021

8 min

Dai: The Crypto-Backed Stablecoin Powering DeFi

Dai is the most important decentralised stablecoin, and is backed by cryptocurrencies. Dai is pegged to the dollar price and is governed by MakerDAO, a decentralised autonomous organisation.

DAI: The Crypto-Backed Stablecoin Powering DeFi

What is DAI

DAI is one of the two currencies of MakerDAO, a project based on the Ethereum blockchain. The project’s other cryptocurrency is MKR, the governance token.

DAI is a stablecoin. This means that its value is not as volatile as that of other cryptocurrencies, e.g. Bitcoin.

Like most stablecoins, its price replicates that of the US dollar.

Compared to cryptocurrencies backed by fiat reserves, however, DAI is based on a rather complex collateralisation system.

The collateralisation of DAI is:

  • Based on more than one cryptocurrency (mainly ETH, USDC, WBTC)
  • Technically based on smart contracts
  • Over-collateralisation, as the assets on which it is based are always worth slightly more than DAI’s total capitalisation.

So Dai is not collateralised by fiat currency reserves or traditional financial instruments, but by other cryptocurrencies, thus being very decentralised as it does not need regulation, is not controlled by banks or companies, but is completely blockchain-based and governed by its community.

Its peg to the dollar is called a “soft peg“, meaning it can deviate from the dollar price by a few percentage points.

DAI: The Crypto-Backed Stablecoin Powering DeFi

Information on the price of the dollar is provided to Dai’s smart contracts via oracles native to its protocol.

Thus, for this type of stablecoin, price pegging and collateralisation are two separate things. The anchor is the reference price to be “imitated”, while the collateralisation is the set of assets that supports the value of the stablecoin and makes it always convertible, like a sort of crypto reserve.

Beware of online information

The way DAI works has changed significantly since 18 November 2019, which is why you may find conflicting information online.

Before this date, DAI was only collateralised by Ether (ETH), and was therefore referred to as Single-collateral Dai, now called SAI.

In addition, with regard to the generation of new Dai, it was often referred to as CDP (Collateralised Debt Position), whereas today this feature is called Vaults.

Another misconception is that Dai is an algorithmic stablecoin. This cannot be true because algorithmic coins have no collateral or guarantees, but their value is based solely on algorithms.

How Vaults work

We mentioned that DAI tokens are guaranteed by a larger reserve of cryptocurrencies. The great thing is that any user can nurture this reserve and consequently generate new DAIs. In fact, the larger the cryptocurrency reserve, the more DAIs will be in circulation as they are always maintained in a proportional ratio.

These reserves are called “Vaults” and the assets with which you can feed them are called “collaterals”.

The cryptocurrencies that are accepted as collateral in Vaults are many and growing.

On the technical side, Vaults are smart contracts of the Maker protocol.

The Maker protocol is a system of smart contracts that enabled the use and operation of a number of elements: the DAI stablecoin, native oracles, the DAO voting system, and Vaults.

How to borrow DAI using Vaults

DAIs that are generated if you deposit collateral are a loan.

There are a number of platforms that make it easy to obtain DAIs, most notably Oasis.app.

As DAI is over-collateralised, consider that you will have to deposit more collateral than the DAI you can generate.

Of course, the number of DAIs you can generate is limited, so as to avoid excessive inflation of the currency. There is a limit, called the Debt Ceiling, both for the DAIs that can be generated throughout the system and for each individual Vault.

In addition to that, you should take into account the liquidation risk, i.e. if the value of the deposited collateral drops below the value of the DAIs obtained, it can be sold by the protocol in order to keep the reserves stable and eliminate your debt.

Therefore, it is always necessary to stay above the Liquidation Ratio required for the individual Vault, where:

Liquidation Ratio = (Collateral Amount x Collateral Price) ÷ Dai generated × 100

For example, a Vault with a liquidation ratio of 150% will require a minimum of $1.50 worth of collateral for every $1 of Dai generated.

If the value of the collateral falls to ≤ $1.49 it will be liquidated to cover the Dai generated, in addition to a fee called the Liquidation Penalty.

How to earn Dai with the Dai Savings Rate

The Dai Savings Rate (DSR) is a variable rate earned by locking Dai into the DSR smart contract.

Dai holders can thus earn a rate equal to the DSR by depositing them in the Dai Wallet of Oasis.app.

The DSR smart contract has no withdrawal limits, deposit limits or liquidity constraints and the rate is actively set by MKR token holders through on-chain governance.

In this way, MakerDAO can influence the demand for Dai by changing the DSR.

Other use cases

In addition to the native use cases of the Maker protocol, DAI can be used in all major DeFi lending protocols.

Like other stablecoins, it is also an excellent store of value and a decentralised alternative to more popular stablecoins such as Tether and USD Coin.

Dai also has an excellent commercial network, and is accepted by many ecommerce and charity projects or Dapps.

These include Unicef for charities and Opensea for NFTs.

There are also apps and sites for everyday services such as generating gift cards, paying bills in countries such as Australia and Texas, and managing shared expenses via Dai.

As in the whole DeFi sector, gaming has its own special place. You can use DAI in Decentraland, win it on CelerX or on PoolTogether, a kind of lottery that allows the winner to receive all the interest earned by the other participants through yield farming or liquidity provision.

Fun Fact: Where the name Dai comes from

Rune Christensen, the founder of MakerDAO, wrote on the project’s Reddit page the story of how Dai’s name and symbol were chosen. From what he recounts, the name is closely tied to the concept and mission that Dai embodies, and it was a carefully considered choice for him. You can’t expect less from someone called Rune.

Rune reveals that originally, Dai was called eDollar. However, he did not want this currency to be dependent on the dollar or its monetary policy. He envisioned an independent currency, with a name that would stand out from any other English word, thus recognisable and as short as a code (e.g. BTC or DASH).

Having identified the Chinese market as his initial target, Rune sought inspiration in this language.

Finally a Chinese friend suggested the perfect name for him, 貸 – lend, provide capital for a loan, which is transliterated as “Dài”. To hear the pronunciation you can click on the audio icon on this site.

An interesting coincidence is that Dai also appears in the name of Wei Dai, the very inventor of the cryptocurrency concept, who in turn named Ethereum’s smallest unit ‘wei’.

A second coincidence pointed out by Rune is that “dai” is related to the verb “give” in many Slavic languages. He does not know, however, that it is also the case in Italian.

What instead inspired the original Dai logo is the concept of “diamond standard” (pronounced /daɪmənd/).

Rune initially chose this Unicode symbol ⬙ because it resembled a diamond, but in many fonts it was distorted and consisted of two triangles that seemed to indicate directions.

Another valuable suggestion was made, namely to use the symbol ◈, which he said evokes the “diamond’s hardness” – and thus the stability and resilience of the coin.