DSR Explained

DAI’s DSR (Dai Savings Rate) is the tool that allows collecting interest by lending DAI to DeFi users. In fact, DAI tokens, once created, can be locked in a special smart contract, called Dai Savings Rate, which allows DAI holders to earn interest as long as they leave them locked in the smart contract.

Since it is a decentralized and open smart contract, based on the Ethereum blockchain, anyone can use it freely, with the freedom to enter and exit at will at any time. This was the first mechanism of its kind to be successful in the DeFi sphere, so much so that today Maker still holds more than half of all the assets locked in all DeFi instruments. In other words, MakerDAO’s DSR is continuing to dominate the decentralized finance sector, despite some recent technical problems.

The DSR, however, is also the monetary policy tool of the DAI protocol, because by regulating the interest rate, which is variable, it also regulates the demand for DAI tokens, thereby ensuring that the balance between supply and demand keeps the price of DAI stable at around 1 US dollar. DAI is, in fact, a stablecoin whose value is kept always around the parity with the dollar, precisely as a result of the adjustment of the DSR interest rate.

Consequently, if on the one hand the DSR is used to stabilize the price of DAI, on the other, it offers the owners of this token a way to earn money by lending them. In fact, the borrowers are required to pay so-called stability fees, i.e. a commission calculated on an annual basis that matures gradually as the loan is kept open. Over time, this methodology has set the standard, so much so that several other DeFi projects have adopted similar approaches.

Specifically, when a user decides to lend his DAI, he locks it into the smart contract of the DSR and immediately begins to earn interest at each new block of the Ethereum blockchain. However, the interest rate varies over time, and when the user wants to reclaim the DAI lent, all he has to do is close the position, and collect both the DAI lent and the interest accrued over time.

The interest rate, annualized, can never be negative, and increases as demand for DAI loans increases, while it decreases when demand for DAI loans decreases. There are no time constraints, so the user is free to leave his DAI to accrue interest as much as he wishes, and can withdraw it at any time. There is also no limit to the amount of DAI that can be lent.

The fact that positions can be opened and closed at any time means that the DSR allows DAI holders to maximize the return on unused or otherwise used tokens. Moreover, since the smart contract is non-custodial, the user actually has full freedom to exit quickly at any time, which makes this type of investment safe. On the other hand, however, the DSR is also Maker DAO’s monetary policy tool that regulates market demand for DAI to keep its price as balanced as possible in relation to the value of the US dollar.

The price in dollars haw always been Stable

Stablecoin

In fact, Maker DAO also employs the stability fee as monetary policy to regulate supply, and in this way, it can act on two fronts to keep this equilibrium as balanced as possible. So far, in fact, the price of DAI in dollars has always been quite stable. For example, since the launch of the new multi-collateralized DAI, the minimum price has been slightly below $0.98, while the maximum price has been $1.05, but these fluctuations have only lasted for very short periods.

Typically the price is always quite close to $1, which makes it clear that the supply and demand regulation system is working.

Particularly when the price of DAI rises too high above $1, the stability fee is lowered, so that the supply and demand are increased. In fact, this gives users an incentive to generate and borrow more DAI, given the lower interest charges, which will increase supply and, with the same demand, the price should fall. If, on the other hand, the price of DAI is too much below $1, the stability fee is increased so as to reduce supply, as this would mean having to pay more interest to generate and borrow DAI. This is what happens on the supply side, but by regulating the DSR it is also possible to influence demand.

Interest Rates

MakerDao

In fact, raising the DSR gives users an incentive to acquire and lock more DAI, which increases demand. Therefore, when its price is too low, it is possible to increase the DSR to encourage demand and, for the same supply, to raise the price. Conversely, when the DSR is reduced, holding DAI becomes less profitable, thus reducing demand. So if its price is too high the DSR can be lowered to reduce demand and, with the same supply, reduce the price.

These two interest rates, receivable and payable, are decided by the holders of MKR, i.e. the governance token of Maker DAO, by means of special on-chain voting. Therefore, every now and then these votes are used to adjust one rate or the other in order to regulate supply or demand, and therefore the price of DAI.

In general, it is mainly the stability fees, i.e. payable interests, that are affected, while the DSR, i.e. receivable interest, is calculated as a spread over the rate applied to the stability fees. Voting can occur relatively frequently, depending on how much the price of DAI fluctuates against the US dollar, which means that the DSR rarely remains constant for long periods of time.

However, as mentioned earlier, it can never fall below 0%, so in the medium to long term, it always produces a certain return. This return is higher the less market demand is developed, while it tends to fall as market demand grows. In other words, the more DAI becomes widespread the more likely it is that the DSR will be low, whereas it certainly was not when demand was low and few people used it.

In fact, the more people lock DAI into the DSR smart contract, the more DAI will be available for those who want to borrow them, and this will inevitably reduce the rate of return, with the same demand. Such a system, which has proved effective so far, is the basis of many other DeFi platforms, but Maker DAO’s DSR remains the benchmark in decentralized lending.

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