Stablecoins like DAI are an essential part of the cryptocurrency market because they facilitate easy transfer of value and they help cryptocurrency holders to protect their wealth from market volatility. However, their value is pegged on the value of an underlying asset, usually the U.S dollar which means they are just as centralized as the U.S dollar. Because of this, stablecoins traditionally need to be backed by actual dollar reserves. But what if there was another approach that is decentralized and is not subjected to the same regulations as stablecoins?

DAI is a decentralized stablecoin that is not backed by the U.S dollar but still maintains a dollar peg through collateralized crypto debt and its price is kept at equilibrium using smart contracts on a decentralized ledger. DAI was created in 2017 by Maker Dao, a decentralized autonomous organization based on the Ethereum blockchain.

Maker Dao is the same organization responsible for the MKR ERC20 token and it plays a vital role in maintaining DAI. It also makes important decisions regarding risk parameters, global settlement decisions, target rates, and others that are essential to managing the DAI ecosystem. Because DAI is an ERC20 token, it can be easily moved and stored in the Ethereum ecosystem, users have complete control, does not require backing by a central authority and there is no need for reserve audits.

How does DAI’s price stability work?

DAI uses a mix of game theory and economic incentives to maintain its dollar peg. Arbitrage opportunities occur every time that the value of DAI deviates from the dollar value. It has a digital vault where users can lock up BAT tokens or Ethereum to take advantage of the arbitrage opportunity while facilitating the return of the DAI value to the dollar peg.

Users can put their ETH or BAT in the vault to unlock or lock DAI and a small fee to unlock their ETH or BAT. Because one can use their crypto holdings to generate DAI through the vault, one can get DAI when its value goes above $1 and then sell it on an exchange to make a small profit, thus the arbitrage opportunity. For example, if DAI is selling for $1.05 on Binance, one can lock their ETH in the Maker vault to generate DAI at $1, which can then be sold on the exchange to make a $0.05 profit.

The amount of profit made will depend on the amount of ETH locked into the vault. How does this affect the stability of the stablecoin? You will have contributed to the supply of DAI and this supply is automatically adjusted to match the pricing differences. More supply at constant demand leads to a price drop, thus contributing to the return to the dollar price peg.

The same mechanism works in reverse. One can borrow DAI when its price drops below $1, lock it to generate ETH and then sell the ETH for DAI once the price reaches $1 to repay the loan. Because the DAI was borrowed when the price was below $1, there will be some profit on top. The arbitrage incentive helps to maintain stability.

 There are also some mechanisms that discourage users from taking advantage of drops in ETH prices. For example, the system requires over-collateralization which means users have to put in more ETH than the DAI. If the ETH price goes up, the borrower can unlock DAI up to the collateral threshold and if prices drop, the borrower has to increase their collateral or repay borrowed DAI to avoid 13% liquidation. Maker also holds surplus auctions that help to control the supply of DAI in the market.

DAI’s stability mechanisms have held up quite well and the fact that it is decentralized means it can be used in DeFi. It is one of the ideal stablecoins because it cannot be seized especially when used in Decentralized ecosystems.