What is DAI?

What

Despite the fact that cryptocurrencies have changed a lot since its inception, they still have problems that make their use as real money extremely inconvenient. The main problem is volatility. No, if we consider coins and tokens from the point of view of risky investments, then everything is fine - the ability to play on price fluctuations and earn several thousand dollars in an hour is fine. However, in a situation requiring stable payments, for example, paying rent, everything immediately becomes not so convenient. It becomes impossible to imagine - how much money you have to take - another 900 or already 1,500? What if the cost increases even more?

In addition, the legendary bull run associated with the cost of Bitcoin, which began in mid-late 2017, immediately comes to mind. The price went up, and unhealthy excitement arose among investors, associated with the fear of losing potential profits, the market was rapidly growing. However, this could not go on ad infinitum - such are the laws of a market economy. And in the first months of 2018, the cryptocurrency market plummeted. Stable investors, acquiring cryptocurrency precisely because of its basic properties, could not resist those who invested their finances purely out of investment hype. From that moment, many people had the idea - is it possible to make cryptocurrency stable and minimize such price fluctuations? If so, this could change the whole financial world. Several promising ideas arose immediately. For example, a secured debt position.

In 2014, the concept of CDP, a secured debt position, was first introduced. The idea was to create a binding for the coin to some stable currency. This is what made it possible to create the first stablecoins - the DAI cryptocurrency. In this case, the coins were tied to the simplest and most predictable thing - the US dollar. That is, it turned out to both reduce volatility and preserve most of the advantages of cryptocurrency - transparency, decentralization, stability against external influences. This became possible due to the fact that the MakerDAO project was built on the basis of the Ethereum blockchain.

What is DAI?

But back to the CDP. There are many mechanisms that provide a stable DAI price against the US dollar. At a basic level, it is a system of interconnected smart contracts that stabilize the situation through automated feedback. It also allowed the creation of the first effective decentralized platform for margin trading.

Each user places his assets as collateral for a loan by creating a CDP smart contract. As soon as the funds are withheld, the user receives the amount in DAI equivalent to the current market value in US dollars. And with these coins, you can do the same thing as with another cryptocurrency - use it for payments, invest, and use it as a personal savings account, and much more.

Since DAI is clearly pegged to the US dollar, you will be able to return (after all, it’s kind of like taking a cryptocurrency on credit) only the base amount spent plus accrued interest. Simply put, if you originally contributed 2 ETH (at the time of writing - about $ 105) to the CDP, you get 100 Dai. When the return time comes, you have to return the same 100 DAI plus accrued interest - only then you can use your ETH again.

There are, however, other systems that allow you to work with unstable coins, but with their level of volatility, you may need to pay almost 2 times more than the down payment. Let's pretend you contributed 10 AssetCoins, whereby you received the right to dispose of 100 NonStableCoin (NSC) at the current market price of $ 2. If the price drops to $ 1, then to repay the loan you will have to pay 200 NSC and accrued interest. For investors, as you can see, this can be quite profitable.

Another example. Pretend you want to invest your savings in the risky project AmazingICO (AICO), but do not want to invest through ETH, because you are afraid to lose them. In this situation, you convert ETH to CDP (at the time of writing - $ 1050), get the equivalent amount of DAI, and then invest these 1050 coins into AICO.

Let's say the project did not live up to expectations and the price fell. You sell AICO assets and get already 800 DAI. And if you somewhere find this difference of $ 250 plus interest, you can get back your 10 ETH. At the same time, if the cost of airtime increased (and it really could have done it), then you did not lose anything, but, on the contrary, you won due to an increase in the price of ETH, while your assets seemed to be lying in a "depository". It might even be enough to cover the losses from working with AmazingICO's assets (AICO).

And if you invested exactly ETH, then you could have completely lost them. So using DAI stablecoin as an investment method, which implies doubling both losses and profits, is a pretty good idea. However, some risk still remains.

In any case, assets deposited in the form of CDP can be returned if you deposit to the account the same amount in the DAI cryptocurrency that you originally worked on. Plus interest. At the same time, active CDPs always have a higher collateral value than the cost of the user's debt. Otherwise, the chance of liquidation “for debts” is seriously increased.

Initially, DAI only supported the possibility of taking one pledge tied to the ether. The so-called PETH. In order to get this cryptocurrency, you first need to add a certain amount of ETH to the CDP smart contract. The point was that with a sharp drop in the ether market, a secured debt position maintained a higher value than the user's debt. At a minimum, more than collateral. In this case, the manufacturer, in order to recapitalize the market, limits the supply of PETH, which increases the demand and, accordingly, the price of Dai. This has a positive effect on the state of CDP.

Regulatory mechanisms

The main mechanism that turned DAI into a stablecoin is the Target Rate Feedback Mechanism (TRFM). The mechanism is automated. Here is the point. Yes, 1 Dai is equivalent to $ 1, but when the cryptocurrency market fluctuates, this ratio changes. For example, if the price of a cryptocurrency falls, the TRFM mechanism shifts the equilibrium so as to push the growth of its value. Prices are rising, and Dai production through CDP is becoming more expensive. At the same time, cryptocurrency owners receive additional profit, which leads to an increase in demand for it. Higher demand is a decrease in supply and a further gradual decrease in the target rate to a base level of $ 1.

So yes, TRFM and the target rate are determined based on the dynamics of supply and demand in the market. At the same time, the manufacturer’s regulators can determine the “sensitivity” of the target feedback mechanism — how sharp the reaction to the course change should be. Suppose, with the “10 percent in 15 minutes” parameter set, you get a situation in which the target rate cannot change the current market price by more than 10 percent in 15 minutes. That is - 40 percent for an hour. This is necessary so that there is enough time to begin a global settlement with the targeted influence of someone who has gained control of most positions. This could happen both in normal market situations and with a trivial hacking of users. In any case, it takes time to return the situation to normal and low sensitivity gives this time.

However, this requires users to interact with the platform continuously and in real-time. Only this guarantees the effective operation of automatic mechanisms and the preservation of collateral in the CDP above the level of accumulated debt. If the assets secured in the CDP begin to be considered risky, the regulator may announce their liquidation.

Another regulatory mechanism is Global Settlement, or “global solutions.” When this process starts, the entire system shuts down. DAI owners and CDP users automatically receive the net worth of the assets to which they are entitled. This process is decentralized and is launched through the global consensus of regulators.

Yes, some users of the system have extended rights, so they are called Global Settlers. Their distinguishing feature is independence from the situation within the Dai protocol, and the ability to interact with it “from the outside” and observe the situation “from the outside”. This allows you to more effectively control security. Another category of “Key External Actor” is the so-called “guardians”. These are automated and independent entities that benefit from maintaining a stable system. Most often, these are active speculators working like the TRFM mechanism. They begin to actively buy DAI if its price falls below $ 1, which reduces supply, increases demand and triggers price increases.

Conclusion

MakerDAO, like any company, strives to ensure that its work is as safe and predictable as possible. However, there are potential risks. On the other hand, the stablecoin system is constantly evolving, improving the sustainability of the Ethereum ecosystem. However, it is still too early to talk about its use as an everyday currency.