After Terra’s stablecoin UST collapsed in May and wiped out $60 billion in market capitalization, it has become increasingly urgent to see how stablecoins are supported. DAI, one of the first stablecoins, is one of the most important such tokens in DeFi.
On a spectrum between fully algorithmic and backed by cash reserves, DAI stablecoin falls somewhere in between. Let’s learn more about DAI.
Origin and purpose of the DAI
DAI stablecoin is supported by MakerDAO, a DeFi lender. Founded by Rune Christensen, the Maker Foundation launched open-source MakerDAO in 2014 to lead decentralized finance. Like other protocols, Maker works on Ethereum smart contracts to replicate traditional finance without intermediaries such as banks.
As a lending protocol, MakerDAO lacked a key element – digital money but not as volatile as cryptocurrencies. This is where stablecoins come in.
MakerDAO launched the DAI stablecoin in December 2017 to be a reliable collateral for loans and to transfer crypto funds without price fluctuations.
By 2022, DAI had become the fourth-largest stablecoin by market cap, surpassing $7 billion. Since launch, DAI’s outstanding supply has remained below $11 billion.
DAI is the most widely used stablecoin when it comes to integrating decentralized applications, or dApps. It supports 400 dApps and wallets.
Additionally, DAI is managed separately by the Maker Foundation, which is the coordinating body that manages the MakerDAO ecosystem through decentralized governance powered by MKR governance tokens.
As an additional layer of security that is not fully decentralized, there is the Dai Foundation, based in Denmark. This non-profit foundation is the custodian of Dai and Maker trademarks and open source IP copyrights.
The Importance of Stablecoin Collateral
Stablecoins use collateral to protect against market volatility. When the Federal Reserve started raising interest rates in April 2022, it triggered a sell-off in the market. This in turn removed the price of Terra’s LUNA coins, the primary collateral for Terra’s UST stablecoin.
Eventually, this sparked a classic bank run, in which investors sold off their LUNA coins, monopolizing the UST stablecoin. These types of stablecoins are backed by another cryptocurrency instead of fiat currency such as the US dollar, which is what Tether (USDT) and USD Coin (USDC) do.
In other words, stablecoins run the gamut between centralized (fully backed by cash stored in traditional banks) and decentralized (backed by other cryptocurrencies). Where is DAI on this spectrum of collateralization?
How is DAI supported?
DAI is unique in that it is backed by multiple stablecoins and cryptocurrencies. By far, the largest share of DAI’s support 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 cryptocurrencies in this 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 typing and stability work?
As an ERC-20 token, DAI can not only 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 of Bitcoin, anyone can issue DAI stablecoins.
This is not something USDC and USDT users can do, as they are both tightly regulated by centralized companies, Circle and Tether, respectively. To generate new DAI stablecoins, users need to borrow it by simply opening Maker Collateral Chests. This option is available through Oasis dApp, one of MakerDAO’s hundreds of dApps within its ecosystem.
Using the Oasis dashboard, borrowing involves posting ETH-based collateral. This creates a smart contract called a vault, holding these assets as an escrow. Once a DAI loan is paid off, it is paid into 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 post to fund the loans. Since the collateral includes volatile cryptocurrencies, these deposits are always over-collateralized – the deposit is more important 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 the DSR – DAI savings rate. In extreme market conditions, even if regular overcollateralization is not enough, MKR holdings would be used as another source of liquidation.
As a reward for this service, MKR holders receive an interest payment also available through Oasis dApp.
A legal action
In early August 2022, an agency of the US Treasury Department sanctioned Tornado Cash as a suspected money laundering operation. This means that any person or company connected could be subject to legal action.
But what did Tornado Cash do to deserve such a harsh penalty? It is simply an open-source protocol to make online transactions private, especially on Ethereum. Much like the Signal Messenger app makes conversations private using end-to-end encryption (E2E), Tornado Cash conceals the wallet address involved in crypto transfers.
For example, if you want to send someone an anonymous gift, you can use Tornado Cash. Similarly, if you were to donate to a polarizing cause, such as a donation to a Ukrainian charity, you would use Tornado Cash as Vitalik Buterin (co-founder of Ethereum) did.
Although making Ethereum transactions private is legal, it is possible for money launderers to abuse it. To avoid being sanctioned, managers of centralized stablecoins like the USDC had to act.
Circle CEO Jeremy Allaire explained why he had no choice but to immediately block the wallets of users who interacted with Tornado Cash.
Therefore, MakerDAO founder Rune Christensen considered dropping the USDC collateral and converting it to ETH. This would mean that even DAI’s soft peg to the USD (via USDC) would be removed.
In the years to come, this will be the space in which the fate of DeFi will be decided. If there is no fully decentralized stablecoin, the likelihood of financial privacy is very low. The US government may continue to sanction other platforms if it determines that they enable money laundering.
The whole purpose of a DeFi ecosystem is in jeopardy. Instead, it would simply 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 this battleground, with DAI as the engine. In other words, if the DAI stablecoin continues to be backed by vulnerable centralized stablecoins, demand could collapse.
This article in the series is intended for general guidance and informational purposes only for beginners participating in cryptocurrencies and DeFi. The content of this article should not be construed as legal, business, investment or tax advice. You should consult your advisers for all legal, business, investment and tax implications and advice. The Defiant is not responsible for lost funds. Please use your best judgment and exercise due diligence before interacting with smart contracts.