Author: James Seibel
Source: https://medium.com/@james_3093/the-dai-stablecoin-is-a-game-changer-for-ethereum-and-the-entire-cryptocurrency-ecosystem-13fb412d1e75
In late December, 2017, the company Maker released their system for a decentralized stablecoin named “Dai”. Dai is an Ethereum ERC20 token that is pegged to $1 USD — this means that every Dai is worth $1, and will always be worth $1. With other coins the price has been volatile and linked to supply therefor put people off, whereas with Dai the price stays the same, regardless of how much Dai is in existence. There is no centralized authority like Tether that backs its value, and no traditional bank that backs each Dai with a real US dollar. There is nothing that can be shut down, and no centralized authority that needs to be trusted. Dai lives entirely within the Ethereum blockchain using smart contracts.
The way Dai accomplishes this without centralized trust is incredibly clever and interesting, and in this post I will try my best to explain why Dai can be trusted and why it’s a game changer for cryptocurrencies.
Why Dai is a Game Changer
Before I explain the details of Dai and how it works, assume the following is true:
Dai is always worth $1 USD each
It can be freely traded like any other ERC20 token
Anyone with an Ethereum wallet can own, accept, and transfer it
It can be exchanged without any middleman
No individual person or company has control over it
No government or authority can shut it down
This enables several features that were previously impossible.
USD (Dai) can now be transferred instantly, across borders, and without fees (other than ETH gas fees).
Merchants can accept Dai with all the benefits of blockchain technology without the enormous risk of volatility. For example, merchants no longer need to worry about the price of Bitcoin fluctuating 15% between when they receive payment and convert into fiat currency. If a merchant charges $19.99 USD for a T-Shirt and receives 19.99 Dai, they can be confident that they have $19.99 USD whether they cash out their Dai that same day or in 2 months.
Similarly, customers no longer have to worry about spending an asset that consistently goes up in value. A customer is unlikely to purchase a product with ETH if they think the value is going up — why spend $19.99 USD of ETH today when it will be worth $24.99 tomorrow? — but customers don’t need to worry about price fluctuations when using Dai.
The way most merchants currently accept cryptocurrencies as payment is to use a middleman like BitPay, which has all of the negatives associated with traditional payment processors. These include processing fees, limits, and rules on what industries they do business with. With middlemen like BitPay, merchants are simply offering another method of payment for their customers, but see no upside other than extra sales. Even worse, if BitPay decides they don’t like you, they can shut you off without any warning for any reason.
With Dai, a merchant can process payments directly, as if they were receiving cash. If they choose to use a third-party, it’s only to provide value-added services like e-commerce integrations, accounting software, and wallet management. But there is no need for a third-party to process payments or temporarily hold funds — the blockchain itself can handle everything. No one can shut off the merchant’s ability to receive payment.
Finally, some may ask why you need something like Dai at all. Doesn’t Tether already fulfill the purpose of a dollar-denominated token? My answer is that Tether, or any other centralized stablecoin, can be hacked, shutdown, steal your money, and is always operating at the whims of politics and human fallibility. Indeed, there is an enormous amount of speculation that Tether is operating fraudulently.
Not-so with Dai. As a true decentralized stablecoin, you only need to trust the blockchain.
How Dai Works
Dai is a masterpiece of game theory that carefully balances economic incentives in the pursuit of one goal — a token that is continuously approaching the value of $1 USD.
When Dai is worth above $1, mechanisms work to decrease the price. When Dai is worth below $1, mechanisms work to increase the price. The rational actors that take part in these mechanisms do so because they earn money anytime Dai is not perfectly worth $1. This is why Dai is always floating slightly above or below $1 — it is an endless wave function bouncing infinitely close to $1, but never quite achieving it. The farther Dai goes from $1, the more incentive there is to fix it. This is the magic of Dai.
The rest of this article will explain precisely how these pricing mechanisms function as well as risks, safe guards, and actions that occur in response to events.
What is Dai?
Dai is simply a loan against Ethereum. Anyone can create Dai — all that’s needed is ETH and the technical know-how to use a decentralized app (dApp).
Most users — 99.999+% — will never need to create Dai, nor understand how it’s created. The longer Dai is worth $1 USD, the more faith users will have in it, and users will spend, accept, and convert Dai as needed.
Even most cryptocurrency enthusiasts won’t need to create Dai, nor understand how it’s created. They will simply acquire Dai by trading for it on exchanges, including decentralized exchanges that live entirely on Ethereum, which makes Dai an essential component of any decentralized exchange.
Dai is quite complex, and some have argued this complexity makes Dai too obtuse to ever catch on. This is a fallacy, as the primary use-case of Dai is being a stable $1 USD pegged token, which requires no deeper understanding of how Dai works. Again, 99.999+% of Dai users will never need to understand how Dai works.
However, if you truly want to understand why you can trust Dai, you must understand all aspects of the Dai system and the economic incentives involved.
We will now go down the rabbit hole.
How is Dai Created?
As I said, Dai is simply a loan against Ethereum. By using the MakerDAO dApp, advanced users can take loans out in Dai against their ETH holdings.
First, ETH is turned into “wrapped ETH” (WETH), which is simply an ERC20 wrapping around ETH. This “tokenizes” ETH so it can be used like any other ERC20 token.
Next, WETH is turned into “pooled ETH” (PETH), which means it joins a large pool of Ethereum that is the collateral for all Dai created.
Once you have PETH, you can create a “collateralized debt position” (CDP), which locks up your PETH and allows you to draw Dai against your collateral, which is PETH.
As you draw out Dai, the ratio of debt in the CDP increases. There is a debt limit that sets a maximum amount of Dai you can draw against your CDP.
Once you have Dai, you can spend or trade it freely like any other ERC20 token.
Creating Dai is complex — why would anyone do this? Can’t I just buy Dai on an exchange?
Yes! Creating Dai is complex, and you can indeed buy Dai on exchange! This is one reason why 99.999+% of people will never go through the nonsense of creating a CDP.
However, there are several important reasons why you would create Dai, despite the hassle:
You need a loan, and have an asset (ETH) to use as collateral for your loan
You believe ETH is going up in value. You can use your CDP to buy ETH on margin — you lock up your ETH in a CDP, draw Dai against it, use the Dai to buy more ETH on an exchange, and then use that ETH to further increase the size of your CDP. This can be accomplished without any third-party or centralized authority allowing you to do so — margin trading can be accomplished entirely on the blockchain.
The demand for Dai has driven the price above $1 USD. When this occurs, you can create Dai then immediately sell it on an exchange for greater than $1 USD. This is essentially free money, and is one of the mechanisms the Maker system uses to keep Dai pegged to $1 USD. Dai being worth over $1 USD encourages more Dai to be created.
These three reasons are enough to ensure that Dai is continually created.