Cryptocurrencies are just about the most volatile assets in the financial economy, having seen multiple (and drastic) price swings since their inception in 2009.
It quickly became apparent that if cryptocurrency was ever to achieve its primary aim of replacing traditional fiat currencies as a medium of exchange, it first had to attain stability (or some degree of stability at least). Hence, the advent of stablecoins – digital assets that remain pegged in a 1:1 ratio to fiat currencies, mainly USD.
Out of many other stablecoins, all with various methods to how this stability against a stable asset (like fiat currency) is achieved, the DAI is the biggest decentralized currency in the crypto market today.
In this article, we explore the DAI, its use cases, and real-world applications.
What is DAI?
DAI is a decentralized stablecoin created in 2017 and designed to be soft-pegged (i.e. maintain a close value) to the United States Dollar (USD), hedging cryptocurrency investors against market fluctuations of regular crypto assets. The DAI is managed and run by a DAO – decentralized autonomous organization known as MakerDAO.
A DAO, as the name implies, is not controlled by any single entity making it averse to financial regulations and theoretically impossible to be shut down by central authorities. Instead, it is governed and controlled by smart contracts – self-executing programs deployed on the Ethereum blockchain, with changes to the smart contracts being voted upon by holders of a governance token – MKR.
With the DAI being an open-source project, anyone in the world can propose these changes to the DAI. The issuance and distribution of the DAI can also be audited by any interested party, making for a trustless and transparent ecosystem.
How DAI Tokens Work
DAI is an Ethereum-based asset built according to the ERC-20 token standard, and it is only created by locking up other supported ERC-20 tokens in smart contracts as collateral. Unlike many other stablecoins issued by centralized corporations that claim to hold a dollar for every coin created, the issuance of the DAI is governed by the Maker protocol -a software developed and managed by MakerDAO.
In the beginning, the DAI was only issued by locking up ETH – the second-largest cryptocurrency by market capitalization. However, MakerDAO made changes to the Maker protocol to support multiple tokens that can be locked up as collateral – a typical example of one of such democratic voting events in the DAI ecosystem.
Overcollateralization helps keep the DAI stable, given that the locked up tokens are ever-fluctuating. The Maker protocol requires that a higher value of the collateral token be locked for DAI tokens to be created with the collateral asset unlocked again when the DAI is returned. By managing the interest rates at which users borrow DAI tokens, leveraging smart contracts that track the value of locked tokens, the price is kept pegged to the USD.
What is DeFi Liquidation?
For example, a user looking to create DAI will be required to provide a higher percentage of the collateral crypto asset (usually up to 66% more) at the risk of losing a significant portion of the locked asset if the price drops below a preset liquidation limit before the DAI is returned. If this happens, the user is issued a 13% liquidation fee penalty, and the collateralized-debt position (also called vaults) is closed.
This means that the collateralized asset is auctioned to cover the vault and regain DAI tokens. If the price drop is too significant to cover the DAI expected to be returned, the Maker protocol automatically mints and auctions new units of its governance token (MKR), with the proceeds used to satisfy the vault requirements.
Besides locking up assets in smart contracts, DAI tokens can also be owned by purchasing them on crypto exchanges (centralized and decentralized). Centralized exchanges like Binance and Coinbase have DAI markets listed as well as decentralized exchanges like Uniswap. DAI can also be purchased and traded against other crypto assets on MakerDAO’s own platform – Oasis, although there is not enough liquidity when compared with major exchange platforms
DAI Use Case: Hedge Against Volatility
Perhaps, the most popular use case of the DAI is to hedge against crypto market volatility (i.e. the price instability of regular digital currencies). Cryptocurrencies like Bitcoin and Ethereum are known for their ever-fluctuating prices.
The DAI as a stable medium of capital preservation allows crypto users to manage their investments during substantial price swings in the cryptocurrency markets. Traders can hold DAI tokens as an equivalent alternative to holding fiat currencies while still enjoying all the benefits of blockchain technology and cryptocurrencies.
DAI Use Case: Lending
Another major use case of the DAI is its lending functionality. Investment in cryptos for regular traders simply means holding certain digital assets in hopes that they appreciate over a period of time. However, we live in a world of uncertainties. One could need to tend to other financial responsibilities requiring that a user liquidates their position prematurely.
Users can opt to borrow DAI by locking their crypto assets as collateral for a certain amount of DAI, which in turn, can be traded for fiat currencies to attend to any pressing needs. The DAI can then be returned at a later date, with a relatively small stability fee (i.e. interest), thereby unlocking the collateralized token. This way, investors are able to maintain their investment positions by taking out a loan without the endless requirements of traditional financial institutions controlled by central banks.
Additionally, for more experienced crypto traders, DAI tokens can be exchanged for other cryptocurrencies (such as Bitcoin) to quickly leverage trading opportunities in other crypto markets.
DAI Use Case: Medium of Exchange
With DAI having solved price volatility issues in the world of cryptocurrencies, it presents itself as a convenient, fast and low-cost remittance medium of exchange. Although cryptocurrencies have not attained widespread usage like most national currencies, DAI can be used for overseas payment transactions in a peer-to-peer manner as well as a payment method for goods and services – regardless of the transaction volume.
Unlike traditional financial institutions, which operate within certain “business hours” (often leaving transactions pending for days), DAI transactions are executed in a matter of minutes on the Ethereum blockchain, ensuring secure transactions that are available at any hour of the day, all year round.
Furthermore, DAI is gaining a solid foothold in the decentralized finance (DeFi) ecosystem as the go-to stablecoins, seeing that many other reputable stablecoins like USD Coin (USDC) are managed by centralized organizations. DAI token holders can also earn on their tokens leveraging MakerDAO’s DAI Saving Rate – a feature that allows users to lock their DAI in special smart contracts for a percentage ROI.
DAI in Finance
As cryptocurrency continues its journey to global adoption, stablecoins remain the closest solution to the usage of crypto in daily transactions. With various types of stablecoins available today in the crypto space – all with the same goal of attaining price stability pegged against a stable unit like traditional currencies; the DAI distinguishes itself as a truly decentralized collateralized stablecoin.
Besides use cases in day-to-day transactions, lending and borrowing purposes, and protection against price fluctuations, DAI is used in many decentralized applications such as in-game currency, non-fungible tokens (NFTs) marketplaces, and liquidity provisioning platforms. With the DeFi industry being in its nascent stages and a wide variety of products and applications being developed almost on a day to day basis, other potential use cases of the DAI remains to be seen.