The Dai Stablecoin & how it will change Ethereum and the Entire Cryptocurrency Ecosystem - Part 2

Author: James Seibel
Source: https://medium.com/@james_3093/the-dai-stablecoin-is-a-game-changer-for-ethereum-and-the-entire-cryptocurrency-ecosystem-13fb412d1e75

How does Dai ensure that the value is always $1 USD?
Economic incentives ensure that the value is maintained.

As I said in the last section, when Dai is worth over $1 USD, ETH holders are incentivized to create more Dai and sell it, as it’s free money.

When Dai is worth less than $1 USD, CDP owners can pay down their debt at a cheaper price! This is an extremely clever solution that requires further explanation.

Let’s say I open a CDP with $1000 in ETH. I then draw out 500 Dai. In order to close this position, I must pay back 500 Dai (paying down debt destroys the Dai).

If Dai is trading for less than $1 USD, say for $0.99, then I can buy Dai for less than $1 USD and then pay off my debt with a 1% discount. This is essentially free money —if I took out a $500 loan (500 Dai), then bought 500 Dai for $495 (0.99 * 500 = 495, a 1% discount), then paid off my loan, I earned a free $5 of ETH.

Of course, my demand for Dai increases its price, and eventually Dai increases in value until it approaches $1 USD. If Dai stays below $1, CDP owners continue to pay down debt and remove Dai from the system. When Dai goes above $1 USD, Dai is created to feed the demand. It is this push and pull, creation and destruction, supply and demand which ensures that Dai always matches the $1 USD peg.

What if the ETH price crashes? Won’t the whole system fail?
The short answer is that provided ETH is worth something, and the value of ETH isn’t extraordinarily volatile (i.e. dropping 60% of value in 10 seconds), the system successfully balances.

The long answer requires more explanation.

CDP’s have varying degrees of debt. When you open a CDP, you can draw up to 60% of the value in Dai. This means that with $1000 of ETH, you can take out 600 Dai. But not every CDP takes the full amount — the more you draw, the riskier it is. Some CDP owners will withdraw 10%, 25%, 30%, etc.

As ETH changes in price relative to USD, the debt ratio of each CDP also changes. As ETH rises in price, every CDP becomes safer as they are less indebted. As ETH falls in price, every CDP becomes riskier and more indebted.

As each CDP has a different debt ratio, each CDP can be ranked in order of riskiness. More risky CDP’s have higher debt ratios.

As ETH falls in value, each CDP gets closer to the 60% debt threshold. If a CDP crosses this threshold, any Dai holder can pay off the CDP and earn a profit, which destroys Dai from the system, closes the CDP, and penalizes the owner of the CDP.

This is complex and requires further reading to understand, but to summarize, rational actors are incentivized to remove risky debt from the Dai system by paying it off. CDP owners who let the debt get so risky are penalized for doing so, which incentivizes them not to have risky debt.

CDP owners can make their debt safer by paying down debt as the CDP gets more risky. Astute CDP owners will observe their CDP getting more risky, then pay down Dai early to prevent a penalty. But those who neglect their CDP will get penalized by the system if they cross the debt threshold.

As the value of ETH fell from $1,400 USD in January 2018 to $400 in April 2018, the Dai system’s incentive structure successfully kept the value of Dai pegged to $1 USD, which is an incredible accomplishment and proof that Dai succeeds even in a falling ETH environment.

How is the price of ETH known? I thought this system was decentralized?
Extremely good question, and this is actually the riskiest part of the entire Maker system.

The value of ETH to USD has to come from somewhere, and in the Maker system it comes from oracles. Multiple oracles provide pricing data, which reduces the risk that any one oracle is compromised. Additionally, the amount that the ETH to USD price can change per block is capped to prevent rapid changes caused by an attacker.

But the final fail-safe is that Maker (MKR) token owners can vote a “global settlement” in the case of catastrophic failure, such as a coordinated attack. This shuts the system down and gracefully unwinds all positions to return ETH to the rightful CDP owners. This is the nuclear option in the system, and shows that MakerDAO is a true “Decentralized Autonomous Organization” (DAO). The owners of MKR itself are the ones who vote on what happens.

What is the purpose of the Maker token? It doesn’t seem like you need it to create or spend Dai…
The Maker (MKR) token has two distinct uses.

The first is that owning MKR gives you the right to vote on the system itself. This is why Maker is a “Decentralized Autonomous Organization” (DAO) — MKR holders can vote on various things like maximum debt ratios. MKR holders can also shut down the whole system in the case of catastrophic failure, which is an essential fail-safe mechanism.

The second is that paying down debt in a CDP requires the owner to pay a 1% annual fee for taking out the loan, payable only in MKR. For example, if you took a 500 Dai loan against $1000 of ETH and held it for a year, paying off the loan would take 500 Dai and $5 USD worth of MKR. The MKR used to pay off the loan is then destroyed (“burned”).

The burning of MKR encourages the value of MKR to increase over time. As MKR is divisible up to 18 decimal places, as long as a single MKR token exists, up to $1 quadrillion USD could safely be traded without issue, and the number of decimals could be increased later if needed. So there is no issue that MKR will run out, and the amount destroyed will will decrease as the MKR value increases.

Why is ETH the collateral? Why not another ERC20 token?
ETH is the most important asset within the Ethereum blockchain, and it makes sense to use it as the first asset that backs CDP’s.

However, the Maker system will work regardless of the asset, provided it exists within Ethereum and oracles can provide a USD valuation. Maker has plans to use Digix as its next asset, which is a token backed by physical gold. Eventually multiple assets could be used to create a single CDP, including other ERC20 tokens.

Why is Dai pegged to USD? Why not the Euro or Swiss Franc?
The Maker system can work with any other currency or asset peg. In the future, similar stablecoins pegged to major currencies such as Swiss Francs, assets like gold, or even equity stocks can and will be created. All that’s needed are pricing oracles.

Conclusion
The proof that Dai works is that each Dai has been consistently worth $1 USD. As Dai continues to successfully maintain its USD peg, faith in Dai will increase.

99.999+% of users do not need to understand how Dai works, they only need to trust it, and the history of Dai provides the trust needed. If you need to understand Dai deeper to feel comfortable using it, then you should carefully read and understand how it works, and plenty of additional information is easily accessible via Google.

Dai is a game changer because it allows USD to be transferred in any amount, instantly, across borders, without fees, without any interference. This enables a new era of commerce that exists purely within the blockchain and cannot be shutdown.

Maker is truly a technology that shows off the unique capabilities of Ethereum and provides a solution that was 100% impossible before blockchain technology.

You will hearing much more about Maker and Dai — this is only the beginning.

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