In later December of 2017, the company Maker released their long-awaited system for a decentralized stablecoin named “Dai”. Dai is an Ethereum ERC20 token that is pegged to $1 USD — every Dai is worth $1, and will always be worth $1, 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.

I won’t say much about the Maker organization itself, except that it’s one of the oldest Ethereum-focused companies and has been working on this project since before Ethereum existed. The team is very well-regarded in the space and is backed by Vitalik Buterin, the creator of Ethereum.

NOTE: The author works for Airfox which created the AirToken. This post is unrelated to Airfox or AirToken.

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.

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.