What Is DAI?

By Mohammad Musharraf

Unless you’re new to the cryptocurrency market, you’ve likely come across stablecoins before. Put simply they are cryptocurrency assets, the value of which is pegged to existing real-world assets such as fiat currencies or commodities.  Like traditional cryptocurrencies, they operate on blockchain networks and thus benefit from cross-border settlement capabilities and fast transaction speeds. However, their purpose differs significantly from cryptocurrencies such as Bitcoin or Ether. Traditional crypto assets are perfect for long-term storage. On a long-term basis, Bitcoin isn’t just stable, but appreciating.  However, its volatility in the short-term makes Bitcoin, and other similar currencies, much less suited for making everyday payments.

In this case, stablecoins offer a much more appropriate medium of exchange. They are a great way to unlock blockchain-based payments for institutional and day-to-day retail purposes. For example, you could use them to pay grocery bills at your local store or buy a specific service. 

Stablecoins operate as fiat on-chain, allowing you to spend and receive funds in a similar way to cash. They are crucial for the crypto market, offering not just a medium of exchange, but also a way for crypto traders to hedge against volatility, and a stable currency to charge for crypto services. 

There are various types of stablecoins available: fiat-backed, commodity-backed, crypto-backed, and algorithmic. Each approach maintains the value of their respective assets slightly differently. 

DAI, from the open-source Maker platform, is among the top three stablecoins at the time of writing, with a market cap of over $5.3 billion.

But what is DAI and how does it work? Let’s explore DAI, its history, and how it differs from other stablecoins you might know.

What is DAI?

DAI is a hybrid, multi-collateral-backed stablecoin managed by MakerDAO. It operates on the Ethereum network as an ERC-20 token. Using Ethereum smart contracts, DAI aims to function in a trustless, permissionless, and decentralized manner. While it was created as one of the Maker Protocol’s native tokens,  it’s now extremely popular for countless dapps outside the Maker ecosystem too.

 So how did that come about exactly?

History of DAI

In 2014, Rune Christensen formed the Maker Foundation and launched the open-source Maker Protocol. The goal was to build a decentralized, crypto-collateralized credit system for lending and borrowing without traditional intermediaries. However, the protocol needed a stable, non-volatile digital currency for loan payouts and other transactions. Thus DAI was born; with it launching in December 2017. The stablecoin borrows its name from a Chinese letter, meaning ‘to lend or provide capital for a loan.’ 

Although it was created and issued by the Maker Foundation, it transferred full control to MakerDAO, a Decentralized Autonomous Organization now overseeing the ecosystem’s distributed and community-led governance. This is just one example of how DAI has become one of the most decentralized stablecoins in existence so far. 

To understand its role in the crypto ecosystem, let’s dive into its use cases.

What are the uses of DAI?

DAI is a widely adopted stablecoin, supporting over 400 wallets and dApps. As such, it has a wide range of use cases. However, some of the common use cases for DAI include:

To avoid the impact of market fluctuations

Cryptocurrencies like BTC, ETH, SOL, etc., are driven by market dynamics like supply and demand. Meaning, that their prices fluctuate heavily: going up and down several points even daily at times. Conversely, DAI maintains a stable price which lends itself to multiple use cases. 

As an alternative medium of fiat currency

Banks usually offer low to negative interest rates for savings deposits. That, alongside inflation, means storing fiat currencies in the bank can cost you more than you’d think. If you use a non-custodial wallet to manage your DAI, you can rest assured that it will not cost you to store your funds. Plus, no one can revoke your access to them: only you control your wallet. Thus, DAI is an alternative to fiat currencies: its value is stable, just like the assets in your bank, but it lives on the blockchain which is much more secure and permissionless.

Everyday payments: in dApps and DeFi platforms and the physical world

As an ERC-20 token, DAI is interoperable with countless applications, protocols, and blockchain platforms. This gives you a simple way to spend fiat on-chain. Since it can operate on any EVM chain, that also means you can use it to pay for everyday items, using a chain with much cheaper gas fees than the Ethereum mainnet. This makes it accessible and convenient for everyday purchases such as in-game items and online purchases, but also physical world purchases, such as buying a croissant or coffee in your local café.

Taking Profits: As a Crypto Trader, Artist, or Service Provider

Stablecoins play a vital role in the crypto landscape, offering a reliable way for participants to take profits. For example, crypto traders often use them to take profits during market volatility. Similarly, crypto artists and service providers also periodically swap their earnings to stablecoins, ensuring their hard work isn’t hostage to crypto volatility. In short, stablecoins such as DAI offer users a way to realize profits without off-ramping. To clarify, that means profits made on-chain don’t necessarily need to go through the bank or even leave the network. A creator or trader can take profits without the burden of making transfers on and off-chain.

How does DAI work?

DAI is overcollateralized, which means the collateral’s value is greater than the issued DAI’s value. This protects lenders against the fluctuations of the crypto market. As a stablecoin, DAI aims to maintain a stable 1:1 value with the USD. It has mostly achieved this goal so far, except for minor fluctuations. To achieve this stability, DAI employs a few methods:

Vault & Keeper Accounts

Issuing and destroying DAI relies on Vault and keeper accounts. To explain, vault accounts are for depositing your collateral. Once you fill your vault account with ETH or another supported asset, you will receive newly issued DAI. Then when you want to repay the loan, you receive your collateral back and the DAI you were issued is destroyed. This process is controlled by a smart contract, meaning there are no middlemen needed.

If the value of a vault account falls below the issued value, it is liquidated. To handle this process, DAI uses keeper accounts. In short, the keeper accounts provide liquidity to pay off undercollateralized vault accounts. This keeps the circulation of DAI steady.

Stability Fee

The stability fee works much like interest on a loan and it’s charged only when returning your DAI for your collateral, whether that’s ETH or BAT. The rate of this fee is determined when your DAI is issued, and it fluctuates depending on the current supply and demand. If there is more supply than demand, the stability fees increase and vice versa. This helps alleviate the selling pressure to keep the coin’s price stable.

DAI Savings Rate (DSR)

The final mechanism to keep DAI stable is its DAI savings rate (DSR). It essentially operates much like a bank’s savings account, but unlike a bank these contracts operate without the need for a centralized entity. If you lock your DAI in a DSR contract, you automatically earn consistent interest. 

For example, if you put 100 DAI into a DSR contract for a year and the DSR is 3.3%, you will receive an additional 3.3 DAI in your account when you unlock your collateral. 

The rate itself is controlled by MakerDAO, the decentralized autonomous organization that governs the coin. Then the interest is funded by the stability fee. 

Is DAI backed by fiat currency?

Unlike Tether’s USDT and Circle’s USDC, DAI is not backed by fiat currencies. Instead, it’s backed by various stablecoins and cryptocurrencies. USD Coin (USDC) and Pax Dollar (USDP) account for the biggest share in DAI’s backing, followed by ETH, Wrapped Bitcoin (WBTC), Basic Attention Token (BAT), Compound (COMP) and TrueUSD (TUSD).

Using multiple assets for collateralization also boosts diversification, which is a better practice from a stability and risk management perspective. Then, since many of the assets DAI is backed by tend to be volatile, DAI is always overcollateralized. This is to avoid the impact of fluctuations in these underlying asset’s values.

Advantages of DAI

As a versatile stablecoin, DAI has several benefits, ranging from stability to low entry barriers and robust security. From a practical perspective, however, its advantages can be seen in two broad categories. 

Stability & Security

DAI is one of the most stable stablecoins, thanks to its multi-collateral and hybrid algorithmic nature. It doesn’t merely rely upon backing reserves but also has codified systems to maintain the value. 

Besides low-cost remittances, people in unstable or weak economies can use DAI to safely store their capital in a USD-equivalent currency, without needing an overseas bank account. This helps preserve their purchasing power against hyperinflation or devaluation. 

Moreover, since you can store DAI in secure, encrypted crypto wallets, your funds are much less prone to theft, etc. This is particularly true when using hardware wallets that provide top-notch security against hacks and frauds. 

Interoperability & Accessibility

DAI is an ERC-20 token that works with any Ethereum-based dApp, wallet, protocol, or platform. This level of interoperability is pretty much unforeseen in the crypto or stablecoin space, which makes DAI unique. 

Its broad compatibility also makes DAI very accessible for a variety of use cases, boosting innovation and user interactions across sectors. DAI also fosters financial inclusion in this manner, as people worldwide can use this stablecoin for their financial needs and goals. 

They no longer have to rely on value-sucking intermediaries or, for that matter, wear their shoes off trying to get an account with the local bank. 

Disadvantages of DAI

Given DAI’s multi-collateral-backed nature, it must rely on the stable and efficient functioning of all the assets supporting its value. Even one of them collapsing drastically can affect DAI’s stability and 1:1 value with USD.  Although DAI is a robust stablecoin overall, there are some downsides to the way it operates. Let’s explore how.

It’s Backed partially by volatile Crypto

DAI is backed by cryptocurrencies that are subject to market fluctuations, such as ETH, BAT, and WBTC. This means DAI relies on the strength of the market. If ETH and WBTC drop significantly in price, it will diminish the value of DAI’s backing, thus depreciating the price of the coin; potentially leading it to depeg.

To safeguard against these risks,  DAI has a pretty robust hybrid, algorithmic model: its stability mechanisms aim to minimize the impact of these possible crashes, such as over-collateralization and its stability fee. Plus, its diversification aims to soften the blow should any of its collateralized coins fail.

It’s also backed by centralized Stablecoins

A great portion of DAI’s backing is in USDC, a centralized stablecoin. USDC is one of the most popular stablecoins to date, but unlike DAI, it is managed and issued by the centralized entity Circle. This means you’re trusting Circle not to go bankrupt or mismanage funds. Believe it or not, USDC actually has a back door that allows Circle to freeze accounts and retrieve stolen funds. Although this is useful to combat on-chain crimes, it also means DAI relies on Circle to act effectively and in good faith. If Circle mismanages USDC, it will also impact the price of DAI.

Counterparty Risk

Since DAI is largely backed by USDC, it’s important to note that USDC is backed by reserves in Circle’s control. Circle keeps its reserves in centralized financial institutions, a.k.a. banks. This introduces counterparty risk as if one or more of those banks fail, USDC’s price is impacted. Unfortunately, anytime USDC depegs, DAI depegs along with it. In fact, that’s exactly what happened in March 2023 when Silicon Valley Bank failed. USDC kept $3.3 Billion in SVB, thus both USDC and DAI depegged by 13% under $1.

Final thoughts on DAI

DAI is among the earliest and most popular stablecoins. It has established a robust market record through various ups and downs, adapting to meet various demands and needs. Today, it’s one of the three most popular stablecoins, and the only one aiming to become truly decentralized. If you’re into DeFi, this may be the stablecoin for you, as it doesn’t have a centralized issuing body, and is not subject to the same centralization risks as some of its competitors. Plus, anyone can initiate the process to issue DAI: it aims to be truly permissionless, and you’re able to collateralize it with countless supported assets—not just ETH. Plus, as an ERC-20 token, it’s easy to secure and manage with compatible crypto wallets. 

So what are you waiting for? Dive into the wonderful world of stablecoins from the safety of the Ledger Ecosystem. Using a Ledger device you can protect and manage DAI with a dedicated  DAI Wallet to take part in multiple crypto apps and services—and all with the benefit of self-custody. Because if not self-custody, then why crypto?