A Beginner’s Guide to the Dai Stablecoin and How It Works

The inception of cryptocurrency disrupted the entire digital ecosystem, opening newer avenues for business professionals and entrepreneurs to facilitate digital exchange.

Undoubtedly, innovation transformed financial transactions and the wave suddenly hit the industry, attracting leaders, entrepreneurs, and investors. However, in no time did they realize that the technology suffered from significant issues, some so intense that it ravaged the adoption of cryptocurrency.

Of the various issues, the volatility of cryptocurrencies emerged as a significant challenge to mainstream crypto adoption.

Cryptocurrency suffered from price fluctuations, which is fatal for organizations transacting through the same channel. For instance, imagine you had just been out to pay the house rent of $1200, and only a couple of hours later, the price drops down to $800.

A huge loss, right? Would you be comfortable with this kind of fluctuation?

The answer would be negative.

Undoubtedly, volatility was a significant issue with the adoption of cryptocurrency and gave rise to the creation of new methods to mitigate this issue.

Had the currency been less risky, ensured significant returns, and pitched less volatility, investors would have keenly invested in the technology. After years of turmoil and it was in 2017 that a project named Maker DAO went live.

The project aimed at reducing the inherent volatility of cryptocurrency through something that we call Dai, a stablecoin.

What Is Dai?

Ok, we know that Dai can lower the volatility of the cryptocurrency and improve the adoption rate. But what is Dai, and how does it work?

First, let us try to understand what a stablecoin is.

A stablecoin is a digital currency whose value is pegged against a stable fiat currency or asset, which means that the value of the coin would be fixed to any other stable asset. It could be the value of gold or dollar fiat.

For the majority or specifically with Dai, the value of the stablecoin is pegged to the US dollar. Other examples of stablecoins include Tether (USDT), Circle (USDC), and Gemini USD (GUSD)

However, Dai had an advantage over these other stablecoins.

The fact that it was built over the Ethereum network means that it offers greater transparency and opens up the technology to a decentralized system with higher stabilization.

Owing to the above, the adoption is bound to increase as Dai offers more than just the possibility of circumventing the volatility inherent with cryptocurrencies.

Even though there have been many others in the industry offering stable cryptocurrency, Maker DAO’s DAI is different. There has been a steady growth in the number of DAI issued, with 71% users transacting through DAI as soon as they get hold of some.

How Does Dai Work?

One important aspect related to DAI is CDP or the collateralized debt position.

It is a system that ensures that the value of DAI remains consistent with that of the pegged currency, in this case, the US dollar. The Makers draft a smart contract platform on the Ethereum blockchain platform. This platform is responsible for backing and also stabilizing the DAI given an array of feedback mechanisms, which is then named as the CDP.

This works in the manner that users can deposit any form of asset, money, or anything else, which is then held by the CDP. The user can further generate a significant amount of DAI, in value the same as that of USD value, and can use it for initiating transactions.

Whether they want to use to make payments or keep it as their very own savings account, Maker DAO doesn’t impose any restriction on DAI.

Now imagine that you deposited 2ETH (considering the worth of 1 ETH to be 176.22 USD), the total value sums up to USD 352.44. If you borrow, 300 DAI, then you need to return this 300DAI along with specific interest to get your 2ETH back. Simple?

If you still aren’t sure how this system of cryptocurrency works does, keep reading.

How to Use Dai?

  • Start with sending or depositing an Ether to the smart contract of the Maker, which leads to the creation of a Collateralized Debt Position.
  • Take, for example, that you deposit 1 ETH (worth of $100). With this, you can borrow up to DAI (considering the collateralization rate to be 150%, $100/1.50) in opposition to your $100.
  • Now, if the Ether price falls, that is less than $100, the CDP will get forcefully closed. To prevent this, either you add more Ether to the contract or reduce the number of DAI you took in the initial phase.
  • The above makes sure that no matter what is the price of ether, there always remains a significant amount of capital fed against the money you take out.
  • Finally, if you wish to get back your Ether, you will have to pay the total money you took out in addition to a minor fee.

Before investing in this form of cryptocurrency currency, you need to be aware of three essential things.

  1. Stability Fee: The fee borrowed annually
  2. Collateralization Rate: The amount of collateral backed by each CDP.
  3. Emergency Shutdown: Here, the entire protocol shuts down, given there arises an insignificant situation or suddenly the price drops.

These three aspects are part of the MakerDAO ecosystem, and this gives the token holders the right to influence the elements mentioned above of the protocol.

Another thing to note is related to the stability fee. To pay the cost, the MKR dollar equivalent is purchased from the market. One can say that MKR is the deflation currency, and the MakerDAO act as the credit system. They enthuse facilities where a specific loan is given in addition to the interest rate. Now, two cases arise:

  1. For low rates of interest, users can lock more ether.
  2. For higher rates of interest, the CDP would get closed up, and so the borrowed amount reduces.

Dai MCD

Earlier this month, Maker DAO launched a rebranded Dai token that purportedly increases the stability of the token by allowing borrowers to choose whether to use multiple instead of single collateral.

Maker revealed that it would drop support for the old Dai tokens in the next few months after the team has concluded their analysis, but promised to help users convert Single Collateral Dai (SCD) tokens into the new Multi-Collateral Dai (MCD). 

This is all about the DAI stablecoin and its overall functioning process. Though it involves a certain amount of risk, if you are mindful of the activities and the market undertakings, you could find it preferable as a stablecoin rather than those issued without blockchain transparency.

Author Profile

Nikhil Bansal

Nikhil Bansal is the CEO and Founder of Apptunix, a leading cryptocurrency app development company helping businesses in streamlining their processes with powerful and intuitive mobile apps. With extensive experience in iOS app development, he has established himself as a highly-focused Solution Architect and UX expert, the one who is always ready to make efforts in the direction where technology blends with lives.

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