Chapter 5: Decentralized Stablecoins
The prices of cryptocurrencies are highly volatile. To mitigate this volatility, stablecoins that are pegged to stable assets like the US dollar have been created. Stablecoins can help users hedge against the price fluctuations of cryptocurrencies and serve as a reliable medium of exchange. Since then, stablecoins have rapidly evolved into a powerful component of DeFi, becoming a key part of this modular ecosystem.
Currently, there are 19 stablecoins listed on CoinGecko. The top five stablecoins by market capitalization have a total market cap of over $5 billion.
Source: CoinGecko.com
In this chapter, we will study US dollar-pegged stablecoins. Not all stablecoins are the same, as they use different mechanisms to peg to the dollar. There are two types of pegs: fiat-collateralized and crypto-collateralized. Most stablecoins use a fiat-collateralized system to maintain their peg to the US dollar.
For simplicity, we will examine two US dollar-pegged stablecoins, Tether (USDT) and Dai (DAI), to illustrate their differences in peg management.
Tether (USDT) anchors itself to $1 by holding $1 in reserves for every Tether token minted. Although Tether is the largest and most widely used stablecoin, with an average daily trading volume of about $30 billion in January 2020, its reserves are held in financial institutions, requiring users to trust that Tether as an entity indeed possesses the amount of reserves it claims. Therefore, Tether is a centralized, fiat-collateralized stablecoin.
On the other hand, Dai (DAI) is generated through the collateralization of cryptocurrencies such as ETH. The value of Dai is maintained through a protocol and smart contracts voted on by a decentralized autonomous organization. At any given time, the collateral used to generate Dai can be easily verified by users. DAI is a decentralized, crypto-collateralized stablecoin.
Based on the market capitalization of the top five stablecoins, we can see that Tether dominates the stablecoin market with about 80% market share. While Dai's market share is only around 3%, its trading volume is growing much faster. Since the beginning of January 2020, Dai's trading volume has increased by over 400%, whereas Tether's has only grown by 126%.
DAI is the most widely used native stablecoin in the DeFi ecosystem. Dai is the preferred US dollar stablecoin for DeFi trading, DeFi lending, and other areas.
To further understand DAI, we will introduce the platform that issues it, Maker.
Maker
What is Maker?
Maker is a smart contract platform running on the Ethereum blockchain. Maker has three tokens: the stablecoins Sai and Dai (both algorithmically pegged to $1) and its governance token Maker (MKR).
Sai (SAI), also known as single-collateral Dai, is backed solely by Ether (ETH).
Dai (DAI) was launched in November 2019 and is also known as multi-collateral Dai. Dai is currently backed by Ether (ETH) and Basic Attention Token (BAT), with plans to add other types of assets as collateral in the future.
Maker (MKR) is the governance token of Maker, which users can use to vote on proposals for improvements to the Maker platform. Maker belongs to a class of organizations known as decentralized autonomous organizations (DAOs). We will explore this further in the governance section of this book.
What is the difference between Sai and Dai?
Maker initially launched single-collateral Dai on December 9, 2017. Single-collateral Dai is minted using Ether (ETH) as the sole collateral. On November 18, 2019, Maker announced the launch of the new multi-collateral Dai. Multi-collateral Dai can be minted using Ether (ETH) and/or Basic Attention Token (BAT) as collateral, with plans to allow more cryptocurrencies to be used as backing in the future. To reiterate:
Single-collateral Dai = Legacy Dai = Sai
Multi-collateral Dai = New Dai = Dai
Looking ahead, multi-collateral Dai will become the actual stablecoin standard maintained by Maker, and eventually, Sai will be phased out and no longer supported by Maker. For simplicity, we will only introduce examples based on multi-collateral Dai (DAI) in the following sections.
How does Maker govern the system?
Let’s revisit our introduction to decentralized autonomous organizations (DAOs). This is where the Maker token MKR comes into play. MKR holders have voting rights in this DAO proportional to the number of MKR tokens they hold and can vote on parameters governing the Maker protocol.
The parameters that MKR holders vote on are crucial for maintaining the health of the ecosystem and ultimately help ensure that Dai remains pegged to $1. We will briefly introduce three key parameters you need to know about the Dai stablecoin ecosystem:
Ⅰ. Collateralization Ratio
The amount of Dai that can be minted depends on the collateralization ratio.
Ether (ETH) collateralization ratio = 150%
Basic Attention Token (BAT) collateralization ratio = 150%
Essentially, a 150% collateralization ratio means that to mint $100 worth of Dai, you need to collateralize at least $150 worth of ETH or BAT.
Ⅱ. Stability Fee
The stability fee is akin to the "interest rate" that borrowers must pay in addition to the principal debt owed to the Maker vault. As of February 2020, the stability fee is 8%.
III. Dai Savings Rate (DSR)
The Dai Savings Rate (DSR) is the interest earned after holding Dai for a period of time. It also serves as a monetary tool that influences the demand for Dai. As of February 2020, the Dai savings rate is 7.50%.
Purpose of Issuing DAI:
Why would you lock up a higher-value ETH or BAT to issue a lower-value Dai instead of directly selling your crypto assets for dollars?
Here are three possible scenarios:
Ⅰ. You need cash now and have a crypto asset that you believe will appreciate in the future.
- In this scenario, you can deposit your crypto asset into the Maker vault and immediately obtain funds by issuing Dai.
Ⅱ. You need cash now but do not want to trigger a taxable event by selling your crypto assets.
- You can extract a loan by issuing Dai.
III. Investment leverage
- Given your belief that your crypto assets will appreciate, you can leverage your assets.
How can I acquire some Dai (DAI)?
You can acquire some Dai (DAI) in two ways:
- Minting Dai We will introduce how to mint Dai through an analogy with a pawn shop.
Suppose one day you need $10,000 in cash, but you only have gold bars worth $15,000 at home. Believing that gold prices will rise in the future, you decide to go to a pawn shop to borrow $10,000 in cash by collateralizing your gold bars instead of liquidating them. The pawn shop agrees to lend you $10,000, with a cash loan interest of 8%. Both parties sign a contract to finalize the transaction.
Now let’s switch terms to understand the story told by DAI:
In the story told by DAI, you will mint or "borrow" Dai on the Maker platform by collateralizing your Ether (ETH) or Basic Attention Token (BAT). When you want to redeem your ETH or BAT after the loan period, you must repay your "loan" and "loan interest," which is the stability fee.
To provide an overview, let’s look at how to mint your own Dai.
On the Maker platform (www.oasis.app), you can borrow Dai by depositing your ETH or BAT into the vault. Suppose ETH is currently valued at $150, then you can lock 1 ETH in the vault to obtain a maximum of 100 DAI (worth $100) at a 150% collateralization ratio.
The amount you withdraw should not exceed the maximum of 100 DAI, and you should leave some buffer for a potential decline in ETH price. It is advisable to leave more room to ensure that your collateralization ratio remains above 150%. This will ensure that your vault is not liquidated and subjected to a 13% liquidation penalty in case of a decline in ETH price (which would lower the collateralization ratio).
- Trading DAI
The above methods are ways to mint DAI. Once DAI is created, you can send it anywhere you want. Some users may send their DAI to cryptocurrency exchanges. Therefore, you can also purchase DAI from these secondary markets without minting them.
Buying DAI on the secondary market is more straightforward since you do not have to lock up collateral or worry about collateralization ratios and stability fees.
To streamline this section, you can check CoinGecko for a list of exchanges trading DAI.
Black swan events refer to a class of unpredictable extreme events that can have severe consequences. If both ETH and BAT prices drop significantly, it will trigger an emergency shutdown. The shutdown process to liquidate the Maker platform is used as a last resort. This process is designed to ensure that Dai holders and Maker vault users can recover the net value of the assets they are entitled to.
Why use Maker?
As mentioned in the previous section on stablecoins, there are currently many stablecoins on the market, and the core difference between stablecoins lies in their protocols. Unlike most stablecoin platforms, Maker operates entirely on a distributed ledger. Therefore, Maker inherently possesses the characteristics of blockchain: security, immutability, and most importantly, transparency. Additionally, Maker's infrastructure enhances the system's security through real-time information-based and comprehensive risk protocols and mechanisms.
This is Maker's stablecoin, Dai. If you want to start using or testing it, we will next provide a step-by-step guide on how to: (i) mint some DAI for yourself and (ii) deposit DAI to earn interest. Otherwise, please proceed to the next chapter to read more about the next DeFi application!
Maker: Step-by-Step Guide
Mint Your Own DAI
Step 1
- Go to https://oasis.app/
- Click on Borrow
- The website will prompt you to connect your wallet. Connecting your wallet is free; you just need to sign a transaction.
Step 2
- After entering the borrow page (https://oasis.app/borrow/), click "Start Borrowing"
- Select the crypto asset you want to lock (collateralize)
Step 3
- In this example, I choose to lock ETH.
- Enter the amount you wish to lock. Note: You must lock assets worth 20 DAI or more. (i.e., you cannot borrow less than 20 DAI).
- Click continue and follow the prompts.
Step 4
- Congratulations! Your ETH vault has been successfully created.
In addition to minting DAI, you can also deposit on the Maker platform to earn interest on your assets. Below we have prepared a step-by-step guide on how users can deposit DAI:
Deposit DAI
Step 1
- Navigate to the deposit page on the left sidebar (https://oasis.app/save)
Step 2
- Click on Start Deposit
- Enter the amount of DAI you wish to deposit
- Click Deposit
- Confirm in your wallet
Step 3
- All done!
- Note: You only have one DSR account. If you want to deposit more DAI after your first deposit, they will be added to that DSR account.
Recommended Reading
- Maker Protocol 101 (Maker)
https://docs.makerdao.com/maker-protocol-101
- Maker for Dummies: A Plain English Explanation of the Dai Stablecoin (Gregory DiPrisco)
- What's MakerDAO and what's going on with it? Explained with pictures. (Kerman Kohli)
- How to get a DAI saving account (Ryan Sean Adams)
https://bankless.substack.com/p/how-to-get-a-dai-saving-account
