Why DAI Is A Different Kind Of Stablecoin
It may be worth a dollar, but DAI serves a different role from dollar-backed tokens.
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The key distinction is that Dai is backed by Ether (ETH) tokens, rather than actual US dollars.
That’s already very well-known, but its true significance has been glossed over. Dai may be called a stablecoin, but its primary importance is completely different. Whereas most stablecoins allow fiat to interact with the world of digital assets, Dai works the other way: it allows the value of cryptocurrencies to interact with assets in the real world.
How does that fit in with being a stable store of value? We’ll explain.
How Does Dai Work?
Most stablecoins are backed by real-world currency. A user deposits fiat – usually USD – with an issuer to mint tokens at a 1:1 ratio. These can be exchanged at any time and the present holder, even if they’re not the original depositor, can redeem these tokens for fiat currency.
But Dai is rather more complex. Anyone looking to acquire Dai must deposit Ether into a smart contract, called a Collateralized Debt Position (CDP) which issues Dai tokens according to the dollar value of the collateral. The dollar peg is maintained by a system of incentives, through the MakerDAO system.
But, unlike USDT, Dai is overcollateralized: users must deposit an additional 50% to stand as surety against ETH’s fluctuating value. The Dai borrower also has to pay a ‘stability fee‘, an interest rate set by stakeholders, which prevent the contract from liquidating.
Although it started the year at 3.5%, the stability fee has increased six times since then, reaching as high as 19.5% by the beginning of May.
What’s the point an over-collateralized stablecoin? Essentially, Dai allows someone to leverage their crypto holdings to seamlessly secure a digital dollar-tracked loan, which can be used to buy real-world goods and services.
There have been stories of people using Dai for mortgage repayments, as well as to purchase a new car, or even a coffee cart. It’s also used as the benchmark for value held in Burner Wallets, Ethereum’s answer to the loose-change draw.
Although there has been a sharp increase in Ether locked into Maker contracts, this is only a short-term remedy to volatility. The recurring stability fee incentivizes CDP holders to redeem their Dai as soon as possible.
Dai tokens are essentially tokenized portions of a loan. Once issued and spent by the original CDP creator, they can enter the open market as a tradeable asset.
In this circumstance, Dai becomes something similar to Tether. Unless the ETH price decreases and the Maker ecosystem liquidates CDPs to buyback Dai to keep the system stable. Alternatively, until such time as a CDP holder decides they no longer want to pay the stability fee and buys Dai back from the open market to release the original Ether collateral.
How Dai and Tether are different
Dai offers the digital asset market something unique: it gives holders of a still-obscure asset-class the chance to leverage its value. There aren’t many people who are crypto rich but cash poor, but that may change as the sector matures.
When (and if) Ethereum successfully transitions to a PoS consensus model, ether tokens will allow users to earn passive income by securing the network. A trader might be unwilling to sell their ethers, even if they need the capital for their immediate circumstances. Using Dai they would be able to use some of their ETH to secure a dollar-valued loan.
Stocks and shares have long been accepted collateral for securities-based loans. Dai would offer that same opportunity, but for crypto-backed loans.
At the time of writing, just shy of $456M worth of Ether – 1.6% of the circulating supply – were locked in a Maker contract. That value has been leveraged across the wider financial market.
Tether has turned out to be an excellent hedge against market volatility; TrueUSD is overhauling forex. They both harness the benefits of a stable store of value from fiat currency and frictionless transactions from cryptocurrency. This is a very different use case to Dai.
Stable value is secondary.
It may seem that this entire argument boils down to an exercise of splitting hairs. At the end of the day, Dai is still pegged to the dollar. We’ll leave that up to you.
But it does show that the industry has loosely thrown around its terminology. Besides the dollar-peg, there is very little in common between Dai and something like Tether. They are structured differently and fulfill completely different market requirements.
A catch-all term like ‘stablecoin’ overlooks what makes coins like Dai and USDT uniquely attractive. Dai maintains a stable store of value through a series of algorithmic checks, but that’s a secondary purpose. Its ultimate goal is to lower the barriers separating cryptocurrency from established finance, allowing the value of digital assets to be spent in the real world.
If we look at it from this angle, we can see that Dai may indeed be a reliable store of value, but it’s totally unlike the other horses in the stable.