After the collapse of Terra’s UST stablecoin in May and the wipeout of $60B in market capitalization it has become increasingly urgent to see how stablecoins are backed. DAI, one of the earliest stablecoins, is one of the most important such tokens in DeFi.
On a spectrum between fully algorithmic and backed by cash reserves, DAI stablecoin lies somewhere in between. Let’s learn more about DAI.
DAI Origin and Purpose
DAI stablecoin is supported by MakerDAO, a DeFi lender. Founded by Rune Christensen, the Maker Foundation launched open-source MakerDAO in 2014 to spearhead decentralized finance. Like other protocols, Maker runs on Ethereum’s smart contracts to replicate traditional finance without intermediaries such as banks.
As a lending protocol, MakerDAO was missing a key component — money that is digital but not as volatile as cryptocurrencies. This is where stablecoins come in.
MakerDAO launched the DAI stablecoin in December 2017 to be reliable collateral for loans and to transfer crypto funds free of price swings.
By 2022, DAI had become the fourth largest stablecoin by market cap, exceeding $7B. Since it launched, DAI’s circulating supply remained below $11B.
DAI is the most widely-used stablecoin when it comes to integration of decentralized applications, or dApps. It supports 400 dApps and wallets.
Moreover, DAI is separately run by the Maker Foundation, which is the coordinating body that runs the MakerDAO ecosystem through decentralized governance powered by MKR governance tokens.
As an extra layer of security that is not fully decentralized, there is the Dai Foundation, based in Denmark. This non-profit foundation is the custodian of both Dai and Maker trademarks and IP open-source copyrights.
The Importance of Stablecoin Collateralization
Stablecoins use collateral to insulate themselves from the volatility of the marketplace. When the Federal Reserve started raising interest rates in April 2022, it triggered market selloffs. In turn, this suppressed the price of Terra’s LUNA coins, the main collateral for Terra’s UST stablecoin.
Eventually, this triggered a classic bank run, in which investors sold their LUNA coins, poleaxing the UST stablecoin in the process. These types of stablecoins are backed by another cryptocurrency instead of fiat currency such as the U.S. dollar, which is what Tether (USDT) and USD Coin (USDC) do.
In other words, stablecoins run the gamut between centralized (fully backed by cash which is stored in traditional banks) and decentralized (backed by other crypto coins). Where is DAI on this collateralization spectrum?
How Is DAI Backed?
DAI is unique in that it is collateralized by multiple stablecoins and cryptocurrencies. By far, the biggest share of DAI’s backing consists of centralized stablecoins USD Coin (USDC) and Pax Dollar (USDP), followed by Ethereum (ETH), Wrapped Bitcoin (WBTC), and dozens of other cryptocurrencies.
Some of the crypto coins from that green collateral bar are Basic Attention Token (BAT), Compound (COMP), TrueUSD (TUSD), 0x (ZRX), Decentraland (MANA), Chainlink (LINK), Gemini Dollar (GUSD), Uniswap (UNI), and others.
Overall, one could say that DAI is a hybrid algorithmic stablecoin, largely centralized but flexible enough to become fully decentralized.
How Does DAI Minting and Stability Work?
As an ERC-20 token, not only can DAI be purchased on major exchanges such as Binance or Coinbase but also on decentralized exchanges like Uniswapl. Because MakerDAO is an open-source protocol on Ethereum, which itself is the most decentralized blockchain outside Bitcoin, anyone can issue DAI stablecoins.
This is not something that USDC and USDT users can do, as they are both tightly governed by centralized companies, Circle and Tether, respectively. To generate new DAI stablecoins, users need to borrow it by simply opening Maker collateral vaults. This option is available via Oasis dApp, one of MakerDAO’s hundreds of dApps within its ecosystem.
Using the Oasis dashboard, borrowing entails depositing ETH-based collateral. This creates a smart contract called a vault, holding those assets as an escrow. Once a DAI loan is paid, they are released to the user’s wallet. In other words, DAI is created by borrowing crypto funds (minting), and it is dissolved by repaying loans (burning).
Therefore, DAI’s collateral aligns with the collateral that borrowers deposit to finance loans. Because the collateral comprises volatile cryptocurrencies, these deposits are always over-collateralized — the deposit is bigger than the loan.
Additionally, MakerDAO’s native governance token MKR serves as a stability regulator. All MKR token holders can use their tokens to set DSR — DAI Savings Rate. In extreme market conditions, even if regular overcollaterization isn’t sufficient, MKR holdings would be used as another liquidation source.
As a reward for this service, MKR holders receive an interest paymentsalso available via Oasis dApp.
In early August 2022, a U.S. Treasury Department agency sanctioned Tornado Cash as an alleged money laundering operation. This means that any individual or business connected could face legal action.
But what did Tornado Cash do to deserve such harsh sanction? It is simply an open-source protocol to make online transactions, particularly on Ethereum, private. In the same way Signal messenger app makes conversations private by using end-to-end (E2E) encryption, Tornado Cash conceals wallet address involved in crypto transfers.
For example, if you wish to send someone an anonymous gift you could use Tornado Cash. Likewise, if you were to donate to a polarizing cause, such as donating to Ukraine charity, you would use Tornado Cash as Vitalik Buterin (co-founder of Ethereum) did.
Although making transactions private on Ethereum is legal, it has the potential to be abused by money launderers. To avoid getting sanctioned, the managers of centralized stablecoins like USDC had to act.
Jeremy Allaire, the CEO of Circle, explained why he had no choice but to immediately block users’ wallets that interacted with Tornado Cash.
Consequently, MakerDAO founder Rune Christensen considered ditching USDC collateral and converting it to ETH. This would mean that even DAI’s soft-peg to USD (via USDC) would be removed.
In the coming years, this will be the space in which DeFi’s fate is decided. If there is no fully decentralized stablecoin, the likelihood for financial privacy is very low. The U.S. government may continue sanctioning other platforms if it determines they are enabling money laundering.
The whole purpose of a DeFi ecosystem is in jeopardy. Instead, it would just be a more efficient, online version of a traditional financial system with little financial privacy.
As the largest dApp platform, Ethereum is at the center of that battleground, with DAI as its lifeblood. In other words, if DAI stablecoin continues to be collateralized by vulnerable centralized stablecoins, demand for it could crater.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.