How to Borrow Dai Stablecoin on MakerDAO
Over the last few months, stablecoins have been attracting a lot of attention, particularly Tether (USDT), what with its ties to Bitfinex, what with the price manipulation accusations. At the same time, a number of new stablecoins have begun to emerge. One such stablecoin is Dai, claiming to be the first decentralized stablecoin. Sounds impossible? Well, maybe not anymore.
The organization behind Dai is MakerDAO, whose main niche is concerned with developing decentralized finance solutions, including a decentralized exchange called OasisDex, and the option of borrowing Dai autonomously by providing ETH as collateral.
More on MakerDAO & Dai
MakerDAO was founded in 2015, although the organization’s first governance meeting took place in January 2016. Dai is MakerDAO’s first product, intended to be used as an actual everyday currency, something that other cryptocurrencies have so far been unable to do owing to their volatility.
In other words, Dai is a stablecoin, which means that MakerDAO relies on mechanisms to make sure that the price of Dai relative to the US dollar does not change. The cryptocurrency ecosystem needs stablecoins, both for trading (for example when prices fluctuate and it takes some time for transactions to go through), as well as for storing value during periods of increased market volatility (safe havens).
With other stablecoins in the past, the party that issued the tokens needed to make sure that for every token on the market, there is one US dollar in the bank, i.e. the fact that the stablecoin could theoretically be used to reclaim USD in a 1:1 ratio guarantees the stablecoin’s stability/equivalence. Consequently, stablecoins have so far roleplayed as the US dollar in exchanges and situations where the use of actual US dollars is not practical or when there are legal impediments that prevent that from happening.
Does this mean that Dai is also backed by truckloads of US dollars in the bank?
No, and this is what makes Dai special. MakerDAO does not rely on banks, meaning that its accounts cannot be frozen or its funds stolen. Also, MakerDAO does not control or issue the tokens and has no influence over how many tokens get issued. This is determined by user demand, and every single step of the way, the users are in control – meaning no tampering and full transparency.
How Does Dai Work, Then?
Just like with other stablecoins, Dai needs to be backed by something to ensure its stability. Only, with Dai, it’s not about MakerDAO getting loans from banks and then issuing tokens. In this case, the users themselves provide the collateral and receive Dai in return.
In MakerDAO lingo, users who want to use Dai tokens can open so-called Collateralized Debt Positions (CDPs), which means that they can borrow Dai on the Maker platform by depositing Ether as collateral. After that, they can use the Dai in whichever way they like – either to send it to others, pay for goods and services, or for storing value in the long-term.
The owners can get their ether back by paying back the loan. It is important to note, however, that CDPs are collateralized in excess, which means that the value of the collateral that users provide must always be higher than the value of the debt. The excess amount is determined by the so-called “collateralization ratio”.
Just as an example, if the collateralization ratio is 1.5, that means that, in order to get 66 ETH worth of Dai, you need to provide 100 ETH in collateral.
Why would anyone want to do that if they have good old ether already?
To reiterate, simply because Dai is more stable and therefore more practical to use in different situations. There is some risk involved, however – for example, if the price of ether drops significantly.
To quote the MakerDAO team, “if the value of your ether goes below a certain threshold, you either have to pay back the smart contract as you would a bank or it will auction off your ether to the highest bidder.”
To make sure that the value of Dai remains stable, all Dai tokens need to be backed. When you return your loan, the Dai you borrowed is no longer backed, so it gets destroyed – otherwise it would cause inflation or it could arbitrarily inflate crypto prices, like Tether is now accused of doing.
Dangers in Price Fluctuations
What happens if the price of ETH changes, though?
If Ether gets stronger, nothing changes. Dai just gets more collateralized, making the system stronger and more stable. If Dai’s collateral is worth more, it just means that Dai’s backup has more depth to it.
What is MakerDAO’s plan to stop the system from crashing if the price of Ether decreases dramatically in a short span of time?
What we are referring to is the so-called “black swan event”, whereby Dai’s collateralization ratio drops significantly below one-to-one.
Enter makercoin (MKR). Makercoin holders govern the system, for example, by voting on the collateralization rate. They earn fees for their efforts, so there is a real incentive to get MKR and with it the governance rights over Maker smart contracts.
While the collateral that the system uses (Ether) is Dai’s first line of defense, MKR serves as an additional buffer zone that ensures that Dai’s value remains stable. As soon as the system no longer has enough collateral, i.e. the value of the collateral can no longer support Dai’s 1 USD price, MKR gets created and sold to the highest bidders on the open market.
Naturally, the price of MKR also decreases as a consequence, which means that the current Makercoin holders lose a percentage of their funds. As scary as that may sound at first, it is a good mechanism for making sure that the MKR holders govern the system responsibly and set realistic collateralization rates.
Apart from these two layers of protection, the Maker platform is also protected by a system called global setlement. Based on decentralized decision making, in cases of extreme emergencies, such as security breaches, hacking, or long-term market irrationality, MKR voters can shut down the Maker platform before any serious damage is done, making sure that all users get the net value of assets that realistically belongs to them.
Havven’s Criticism of Dai & Response
Dai is not the only big new stablecoin on the market, with Havven and Basis (formerly Basecoin) as its biggest competitors at the moment.
Four months ago, a fruitful and civil discussion developed on Reddit concerning Havven’s criticism of Dai. According to the critique, the supply of Dai relies too heavily on the anticipated future price of its collateral (ETH at the moment). When users expect the prices of the collateral to grow, they will want to create Dai, but otherwise, when the prices of the collateral are expected to fall, they will be disincentivized to take out loans. The problem is that stablecoins are needed precisely during periods when other cryptocurrencies are losing value. So, if ETH keeps losing value, and you cannot create more Dai because of that, you are trapped.
Havven creators also believe that, since all cryptocurrencies are highly correlated when it comes to prices, collateral diversification (introducing additional assets as collateral) cannot realistically reduce the impact of a potential black swan event.
According to one response, however, there is always an incentive for generating Dai, since the opportunity for profit and market making with Dai can easily offset any potential losses.
Additionally, with a diversified collateral portfolio, Dai will rely on completely different asset classes. All of these classes will not have downturns at the same time. Even when certain classes experience losses, users will be able to hedge their exposure. Alternatively, they will be able to move on to safe-haven asset classes.
On the other hand, Havven received criticism as a self-referential or faith-based stablecoin, unable to support the value of its token in a bank run scenario.
At any rate, Dai appears to have a better working solution at the moment. The fact that Dai can maintain its stability without relying on banks, fiat currencies, and centralized companies is revolutionary in and of itself. It makes this stablecoin stand out, and, as it gets recognized and adopted, it could potentially revolutionize the crypto market.
UPDATE: In an older version of this article, we talked about a 15% governance fee. That information was incorrect. There is no governance fee for MakerDAO.
There is only a 0.5% stability fee (so, not 10% or 15%). The only other fee is the 13% Liquidation fee. This fee is a bit higher because of Dai’s current single collateral system. As soon as multi-collateral goes live, the liquidation fee will drop to 1.5-2.5%.