DAI is a stablecoin without collateral, how is this possible

26.05.2022 | mnalilovich

The problem of cryptocurrency stability still remains quite high. In the near future, it is hardly worth waiting for the stabilization of this situation. Many people tried to find a solution, for example, Tether released a secured cryptocurrency USDT. However, with this approach, the whole meaning of cryptocurrencies is lost, namely decentralization. Also, the presence of a single manager leads to a number of problems. Algorithms and classical mathematics came to the service of the community here, which led to the emergence of algorithmic stablecoins.

The history of DAI

DAI was launched at the end of 2017 by Maker as a token ERC-20 as a decentralized cryptocurrency with a stable price. Its cost will always be equal to $1, regardless of the volume of issue. However, like other tokens and distributed finance protocols, DAI may be subject to a hacker attack, which will lead to fluctuations.

Unlike the stablecoins that existed up to that time, which assumed physical security in fiat currency or other assets, DAI abandoned dollars in bank accounts, preferring market regulation and community management.

The principle of operation of the DAI stablecoin

DAI is a collateral loan on the distributed registry Ethereum in the form of a token ERC-20. Thus, anyone can issue their own coins in the MakerDAO ecosystem, having only a certain amount of ETH on their wallet and being able to use decentralized applications. However, for the vast majority of users there is no need to issue their own coins, they turn around in sufficient quantities on exchanges, and their value remains stable even with large transactions in one of the parties. All operations do not differ in their essence from the use of other tokens of the standard 20.

Algorithm for guaranteeing a stable price

Algorithmic stablecoins involve economic incentives for users themselves to maintain a stable value of tokens.

• If the cost increases, then it is profitable for the user to issue new coins and sell them on the market.
• If the cost falls, then it is profitable to burn tokens, paying off the loan at a cheaper price.

Thus, although small holders of coins who do not have time to constantly monitor the cost, and cannot have any significant impact on the price, large companies are able to make good money on this.

Simple example:

In the simplest case of visual price stabilization, let’s take an example when a user issues 1000 DAI coins, blocking funds in a loan contract in ETH in the equivalent of one thousand dollars. Then he pays with these coins, let’s say, with a pizza seller. At some point, the price for one DAI coin on the market drops to $0.995, which is only half a percent less than the nominal. However, if our user buys 1000 tokens at this moment at this price, then he will have the opportunity to repay his collateral contract with a discount of the same 0.5%, thus earning $ 5.

Thus, it is clear that it is profitable for users to redeem coins at a cheaper price, paying off their “loans” at a discount. This increases the demand, and hence the price. In the opposite direction, this mechanism works in the same way, only when the DAO $1 quotes exceed, there is an incentive to issue new coins, sending them to the market.

Why the cost of Ethereum does not affect the DAI stablecoin

Even in 2018, when Ethereum collapsed in price more than three times, the DAI stablecoin remained stable and cost $1. This is explained quite simply, and again has the roots of economic incentives for users.

At its core, the DAI protocol does not imply the issuance of coins in full accordance with the amount of collateral. The threshold value, which is set as an absolute risk, is 60% of the value of the collateral in dollar terms. Most users prefer to use a ratio value in the region of 20-30%. That is, for every thousand dollars in Ethereum, only 200-300 DAI coins are issued.

If the value of the underlying asset of the contract begins to fall, then it is advantageous for users to extinguish risky contracts in order not to lose funds, and with growth — to make a profit. Thus, users themselves are interested in removing riskier loans from the system.

Simple example:

Our user issued 500 DAI by depositing $1,000 in Ethereum. Thus, the risk is 50%. With these 500 stablecoins, he ordered pizza for his party. And then the stimulation of the pizza maker comes into play. If the value of Ethereum is growing, then it is profitable for him to continue to hold DAI, because the share of collateral is growing. But if the price of ETH has gone down, then the best solution for the seller will be to enter fiat money in the very near future, because for his 500 DAI he will still receive 1000 ETH, and his value is falling at the moment.

What advantages does DAI give as an algorithmic stablecoin

The main advantage of DAI is the decentralization of many familiar financial processes.

The first is the ability to sell goods and services at a clear and fixed price without the need to involve intermediaries. So, when selling for fiat or even cryptocurrencies, companies have to resort to the help of third-party services in the form of banks and processing centers. By specifying the price per unit of their product in dollars, the buyer will know how much he will need to pay in cryptocurrency only at the time of payment. Also, do not forget about the fees charged by payment gateways, which further increases the final cost of goods and services. DAI also allows you to abandon this practice, remaining completely in the field of distributed registry.

Although partially this problem was solved by secured cryptocurrencies, but the presence of a single control center and the opacity of the software did not allow us to talk about absolute security.

And the second point is the possibility of margin trading in cryptocurrencies without the need to use centralized exchanges. In the simplest example, it looks like this:

• with confidence in the growth of the Ethereum price, the user issues new DAI coins,
• ETH is bought again for the tokens received,
• this step occurs several times, most often using automation scripts,
• when the trader decides that the Ethereum price has peaked at the moment, he also consistently closes his contracts, each time selling another one a portion of base coins.

Conclusion

Although we have considered the essence of the work of the protocol for algorithmic stabilization of the cryptocurrency price, this will not be necessary when working with the DAI token. A lot has already been done for its success. So it has been in existence for four years, and all this time its price was extremely close to $ 1. The longer this situation persists, the more trust the coin will gain from the community. A good example of the stability of the chosen algorithm was shown in 2018, when the price of Ethereum fell three times, and DAI continued to cost $ 1. Thus, algorithmic stablecoins have a great future.