What is DAI & How it Actually Maintains It’s Price
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Transcript:
DAI is a stable coin, which simply means that it is a coin that should always have a stable value or price, so one DAI should always be worth one dollar. But, from where exactly does it come? Who creates it, and how does it actually maintain its price stable at one dollar? Well, you will know the answers to all these questions in this video.
Welcome to Crypto Bee where we explain cryptocurrencies and DeFi topics in the most simple and beginner-friendly way. In this video, you will know what is DAI, and why would you use it instead of the US dollar for example, we will also explain how the Maker Protocol works to create DAI, and how it actually maintains its price at 1 dollar, and finally, we will talk about some risks of DAI, so let’s get started.
So like what we said, DAI is a stablecoin pegged to the US dollar, which simply means that it has a price always very close to one dollar. It was launched in 2017 by MakerDAO, which is a DeFi lending protocol that is managed by the Maker token holders that is why it is called DAO. We have a full detailed video about DAOs and how they work if you want to know more.
But here, generally, the way other stablecoins get their value is from the assets backing them. So let’s take Tether for example. Tether is a stablecoin issued by the Tether Limited company. To create a new Tether token, you need to give the Tether company $1 so that they can hold it to back the stablecoin with it.
Theoretically, you should be able to go to Tether at any time and redeem any Tether tokens you have for the dollars backing them. So, that is why a Tether token has the value of one dollar, as you can redeem it for one dollar at any time. This type of stablecoins is known as centralized stablecoins, examples of these stablecoins are Tether, USDC, TrueUSD, and the Gemini USD.
Here, it is pretty obvious that you need to trust that tether holds enough dollars to back all the tether tokens circulating in the market but die on the other hand is a decentralized stablecoin which means that you don’t need to trust that a centralized company actually holds the dollars or the assets backing the stablecoin.
That still does not mean that DAI is not backed, actually DAI is backed by crypto assets like Ethereum, Wrapped Bitcoin, USDC, and many other tokens. But the difference here is that these assets are locked in smart contracts that work automatically and not controlled by any company or individual. Before you get confused, we’ll explain all of this very simply when we talk about how DAI works, but now let’s first talk about why would someone use DAI, instead of simply using the US dollar.
If you have ever tried to make an international wire transfer, you will know that it takes a lot of time to be processed, like 5 business days, sometimes even more, and usually you can’t send money on holidays for example or after your bank working hours other than that you’ll also pay high fees from 30 to 50 dollars on average to make the transfer on the other hand with die you can send money to anyone anywhere in the world in minutes and it doesn’t matter when do you want to send the money you can do it anytime you want all of this while paying much lower fees
like from two to five dollars and you’ll also be sure that the value of the tokens you send won’t change overnight like what happens with other cryptos so it is a much better option for sending and receiving money another reason to use die is to lock in your crypto profits for example if you made some good profits on the bitcoin you hold you may want to sell your bitcoin for die to protect your profits and to avoid the risk of bitcoin falling again in price another reason to use die instead of a normal fiat currency
like the dollar is that it is decentralized if you have your money in die and you store your die in a hardware wallet for example then basically no one can take your money away from you or prevent you from using it like what can happen with banks finally some people in small countries use die as a store of value and that is when their country has very high inflation rates and their government is printing a lot of money so their currency is quickly losing its value in this situation holding their money in other currencies may protect them from the very high
inflation so instead of exchanging their money for dollars for example, which may be very hard for them, they can simply buy DAI tokens, which will always have the same value of a dollar. So now, you know what is DAI, and why would you use it, let’s now talk about how it actually works, and how it maintains its price at one dollar.
Let’s start with how the DAI tokens are created at the first place. So, DAI is first created when users use the Maker protocol to take loans. These loans are given in DAI, so the protocol basically mints or creates new DAI tokens and gives them to the users. To take a loan from the Maker protocol, you need to deposit Ethereum or other coins you have to be locked as collateral in what is known as a vault on Maker.
Just like what happens with banks, when you go to a bank to take a loan, you need to offer the bank a collateral, which is an asset that the bank can take if you fail to repay the loan. For example, you may use your car as a collateral for a loan.
Now with maker, you may be wondering if you already have ethereum or other assets, why would you lock them up and take a loan? Well, you may do this to invest in other cryptos. For example, you may have $10,000 worth of Ethereum, and you want to also invest in Chainlink, but you don’t want to sell your Ethereum. So you can simply go to Maker, deposit the Ethereum as collateral, and take a loan in DAI. Then you swap the DAI tokens you got for Chainlink.
And after a while, when you make profits on your Chainlink tokens, you sell them for DAI, repay the loan, returning back the DAI tokens you borrowed plus the fee, then, your collateral assets will be unlocked and returned to you, and the DAI tokens will be burned and removed from circulation.
We will get to this fee in more details in a minute, but a very important point here is that on Maker protocol, the assets you deposit as collateral need to have a much higher value than the value of DAI you want to borrow. This is because Maker requires a collateralization ratio of at least 150%, which simply means that for every one DAI token you want to create or borrow, you need to deposit at least $1.50 worth of crypto assets as collateral.
So for example, if you want to create 1000 DAI tokens, then you would need to deposit at least 1500 dollars worth of Ethereum or other crypto assets as collateral. Now, you may be thinking, why does Maker need all this collateral? Well, the reason behind this is that crypto is very volatile and prices move very fast, and for DAI to have value, there should always be large amounts of assets backing it.
When we say DAI is backed by crypto assets, we mean that these valuable locked crypto assets can be redeemed or unlocked with DAI. So DAI will always have value. So, to maintain the value of DAI, the Maker Protocol makes sure that at any time, the value of the locked crypto assets backing DAI needs to be larger than the value of all DAI tokens on the market.
If, for example, Maker required a 100% collateralization ratio, then the value of the locked crypto assets backing DAI would need to be exactly equal to the value of all DAI tokens in the market. all DAI tokens in the market.
Let’s say that there is a total of 10 million dollars worth of Ethereum locked up as collateral in all vaults and there are 10 million DAI tokens in circulation, each worth 1 dollar. Currently everything is okay and DAI is totally backed, but if for example the price of Ethereum drops by 20%, then the total value of the locked Ethereum collateral would now be 8 million dollars, and the total value of the locked Ethereum collateral would now be $8 million, and the total value of all DAI tokens in circulation is theoretically still $10 million, which means that the DAI tokens are no longer fully backed by the locked Ethereum.
So a collateralization ratio of at least 150% is necessary on Maker, as it allows some room for the price movements of the crypto assets backing DAI, so that DAI stays fully backed at all times. It is important to know here that this required collateralization ratio may change, and the maker token holders are the ones who suggest and vote on these changes.
Before we continue, if you have been enjoying the video so far, hit the like button, as a new channel, it really helps us. Now, remember the fee we mentioned when we talked about repaying your loan this fee is known as the stability fee and it is kind of like the interest you pay on your normal bank loan so on maker the stability fee you need to pay changes based on the asset you lock as collateral it gets higher for riskier assets and lower for relatively stable assets so for example if you borrowed 1 000 die tokens with Ethereum as collateral, and the stability fee at the time was 5%, and then, after 6 months, you want to repay your loan, then
you will need to pay 2.5% fee on the 1000 DAI tokens, which will equal 25 DAI tokens. So now, you may be wondering, what happens if the price of the collateral assets in your vault falls significantly. Well, in this situation, the collateralization ratio may fall below 150%. The moment that happens, your vault will be automatically liquidated, which means that the Ethereum you deposited as collateral will be sold in an auction, and you will also pay a 13% liquidation fee. So, what happens is that there are trading bots constantly monitoring the Maker protocol.
These bots are known as keepers. Whenever they find that a vault is being liquidated and the collateral is up for sale in an auction, they bid to buy the collateral with DAI, and the highest bidder wins the auction and gets the collateral. Sometimes, Maker will not sell all your collateral, it will just sell all your collateral, it will just sell enough to cover the value of the DAI tokens you borrowed plus the liquidation fee.
Let’s see an example so you can better understand how this works. So, let’s say that at first you deposited $1000 worth of Ethereum as a collateral, which was around 1 Ethereum coin. Then, you borrowed 500 DAI tokens, so your collateralization ratio was 200%.
After a while, the price of ethereum drops by 30%, so now, your ethereum coin is worth only 700 dollars, which means that your collateralization ratio is now 140% only. So, your vault will be liquidated, and you will pay a 13% liquidation fee, which will be added to your debt, which means that now you owe maker 565 DAI tokens, which is around 0.8 Ethereum.
Keepers will now bid to buy your collateral, each offering a different price. The keeper who bids the highest price per Ethereum coin will win, but you should know here that usually usually the winning bid is lower than the market price so that keepers can make profits by selling the collateral they win on the market so when taking a loan from maker it is your responsibility to make sure that the collateralization ratio of your vault stays above 150 percent when you think it may start to go down you should deposit more collateral to avoid paying the 13% liquidation fee.
Now, after the auction, any remaining collateral will return to you, which will be around 0.19 Ethereum or slightly less, and you also get to keep the 500 DAI tokens you borrowed. As for the DAI tokens paid by the keeper, 500 of them will be burned to pay off your debt, and the rest will go to something called the maker buffer, which is like a reserve that contains a lot of DAI tokens.
This reserve of DAI tokens is used in emergency situations to keep the price of DAI stable. Remember the stability fees you need to pay on your loan? Well, all the stability fees paid by all users also go to this maker buffer. Now, what do you think happens if no one wants to buy the collateral in your vault, or if the DAI collected from the collateral in your vault, or if the die collected from the auction is not enough to pay your loan? Well, in this case, Maker will take some die tokens from this Maker buffer and burn them.
This amount will be equal to your loan amount. So what if there were no enough die tokens in this Maker buffer? Then the Maker protocol will mint new Maker tokens and sell them for DAI tokens and then burn these DAI tokens. So in all situations, the Maker Protocol will not allow any DAI tokens to be created or remain in circulation without being fully backed by more than enough collateral assets.
So if there were 500 DAI tokens you borrowed for example, and then your collateral drops in value, then then maker will always find a way to burn 500 die tokens as they will not be fully backed by enough assets now you know that all the die tokens in circulation are backed by enough crypto assets but still how does it actually keep its price very close or equal to one dollar at all times well you may know that the price of any token on the market is based on the supply and demand.
The demand for DAI changes according to market conditions and how much investors trust DAI and the mechanism it works with. The supply on the other hand depends on how many new DAI tokens are minted. So DAI maintains its price at one dollar, through trying to influence the supply and demand for DAI on the market, and this can be done through two ways.
The first way is through adjusting the stability fee charged on the DAI loans, and the second way is through arbitrage opportunities. Let’s start with adjusting the stability fee, so, let’s say the price of DAI falls to 95 cents on the market. Now, to raise the price of DAI back to one dollar, we need to reduce its supply. So to do this, the maker token holders will decide on raising the stability fees paid on DAI loans.
When that happens, more people are now encouraged to pay back their loans as the fees are high, and they can now buy DAI for cheap on the market. When a lot of people pay back their loans, the demand for DAI on the market increases and a lot of DAI tokens get burned, which reduces the supply of DAI on the market, which should raise the price back to one dollar.
So what happens if the price of DAI is higher than one dollar? Well, the opposite of all of this will happen. So, the maker token holders will decide on lowering the stability fees, which will encourage a lot of people to create and borrow new DAI tokens as they won’t pay much on these loans. When many people do this, it will increase the borrow new DAI tokens as they won’t pay much on these loans.
When many people do this, it will increase the supply of DAI on the market. This increase in supply should lower the price of DAI back to one dollar. Let’s now get to the second way of influencing the supply of DAI, which is through arbitrage. So currently, there is a smart contract on maker that allows you to create new DAI tokens from USDC and to swap any DAI tokens you have for USDC. This smart contract is known as the PEG Stability Module.
When the price of DAI is lower than $1, you can actually make profits by buying cheap DAI tokens from the market for less than $1. So, let’s say you bought 1,000 DAI tokens for $950. Then you need to swap them for 1000 USDC tokens from the stability module and then you can sell these USDC tokens on the market for $1 each, making an easy profit of $50.
When a lot of people do like what you did, the demand for DAI increases and its supply on the market decreases, which raises its price back to $1. and its supply on the market decreases, which raises its price back to $1. So, what if the price of DAI is higher than $1, let’s say at $1.05? Well, you can also make profits in this situation by buying 1,000 USDC tokens from the market for $1,000.
Then, you can give these USDC tokens to the stability module on Maker to get 1000 new DAI tokens, which you can then go and sell on the market for $1050, making $50 in profit. Here, when a lot of people do this, the supply of DAI in the market will increase, which will help lower its price back to $1.
So, now you know how DAI works, but the question remains, is DAI actually safe? Well, like with anything in crypto, you can’t be 100% sure. But the good remains is DAI actually safe? Well, like with anything in crypto, you can’t be 100% sure, but the good things about DAI is that it is decentralized, so you don’t need to trust the claims of any company.
With DAI, all the information about the assets backing the coin is available for anyone to check. Other than that, it seems that DAI has held up quite good in the past few years and actually managed to maintain its peg to the US dollar most of the time. As for the risks of DAI, one thing is that DAI is based entirely on smart contracts, and like any code, there is always the risk of bugs or vulnerabilities that can be exploited by hackers to attack the protocol.
One event that is definitely worth mentioning here is the Black Thursday, which was on the 12th of March 2020. On that day, the stock markets and the crypto markets crashed. Bitcoin and Ethereum were even down on that day by 50%, which caused a lot of vaults on Maker to be liquidated, but the problem here is that on that day, the Ethereum blockchain was congested, so, many keepers were not able to send their bids to buy the collateral assets.
But this actually allowed one keeper to bid 0 DAI tokens for the Ethereum collaterals that was being sold, and he managed to send his bid by paying very high gas fees. So on that day, he claimed approximately 4 million dollars worth of Ethereum for free, and many people lost 100% of their collaterals.
After the event, the maker token holders decided on some changes to the protocol to make sure that an event like this won’t happen again. Another point you should know here is that currently, around 50% of all DAI tokens are backed by USDC and, as you may know, Circle, the company issuing USDC, can actually blacklist some addresses, preventing them from sending or using their USDC tokens actually blacklist some addresses, preventing them from sending or using their USDC tokens.
So at the moment, DAI is relying heavily on USDC and nobody knows what may happen if the US government decides to sanction DAI for example, as this may cause Circle to comply with the regulations and blacklist some of Maker’s smart contracts, just like what happened with Tornado Cash. Before we end the video, we just want to tell you that you should not put all of your money into one token or asset, and always do your own research before taking any decision, and like all of our other videos, this video is not financial advice.
