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A Beginner’s Guide: What Is Dai and How Does It Work?

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The crypto sphere has experienced drastic growth recently with Bitcoin leading the way. Multinational financial companies have started to invest large sums of money in Bitcoin — a move that could precede a wave of crypto adoption. 

For some individuals, and especially for day-traders, volatility is seen to be positive and perhaps the most attractive thing with which cryptocurrencies are characterized. But for others, it is just the opposite; volatility is seen as a weakness for cryptocurrencies — an argument frequently used by opponents of the industry to criticize cryptocurrencies, calling it an unstable asset. 

Enter stablecoins — a solution of sorts, often used by traders to minimize their exposure to extreme price movements typically found in cryptocurrencies. One of the most popular stablecoins at the moment is the Dai (DAI) token. In this guide, you will get to understand what Dai stablecoin is, how it works, who created it, where to find it, and more.

What Is a Stablecoin?

A stablecoin is a form of cryptocurrency that minimizes volatility. Stablecoins may be pegged to the U.S. dollar or other assets such as gold, for example.

Bitcoin and Ethereum are the two of the most popular cryptocurrencies in the space, but they can be highly volatile. This price behavior may hinder these assets from mainstream adoption or widespread use as a form of payment. For example, a business may be hesitant to pay someone’s salary in Bitcoin if its price keeps fluctuating.

Crypto volatility is an obstacle for loans that are based on blockchain and prediction markets. Volatility could also be an obstacle for other long-term smart contracts that need stability. And it is obvious that there are users who want to store and use their money in an asset that serves as a store of value.

Ideas for creating stable-priced cryptocurrencies have been around for a while. The main challenge, however, has been price stabilization. Therefore, creating stablecoins is considered the crowning achievement in the crypto sphere by many.

The purpose of stablecoins is to minimize volatility by maintaining stability. How do stablecoins achieve this? By being pegged with an external asset. These assets are centralized and their stability is maintained by central authorities.

Stablecoin pegging. Source: Research.algalon.com

So while the value of the fiat currency for example can move drastically, central authorities control supply and demand to keep the price stable. When it comes to cryptocurrencies, such a thing is impossible because cryptocurrencies are not controlled by anyone, and are therefore prone to price fluctuations.

There are various types of stablecoins:

  • Fiat-backed stablecoins — Stablecoins that are backed by currencies such as USD, EUR, or GBP. Fiat-backed stablecoins are backed at a 1:1 ratio. Therefore one stablecoin equals one unit of the fiat currency.
  • Commodity backed stablecoins — Stablecoins that are backed by commodities such as gold. One coin is equally worth one unit of the pegged commodity (such as one ounce of gold).
  • Crypto-backed stablecoins — Stablecoins backed by other cryptocurrencies. In order to reduce the volatility risks potentially present in the reserve cryptocurrency, crypto-backed stablecoins are usually over-collateralized. This means that instead of having collateral at a 1:1 ratio, the ratio takes a 1:2 weightage instead. Usually, it involves reputable cryptocurrencies such as Bitcoin or Ethereum. Crypto-collateralized stablecoins are decentralized and the most popular one is Dai stablecoin. Dai is pegged to USD and built on the Ethereum network.

Non-collateralized stablecoins — These types of stablecoins do not hold any kind of collateral. To keep the value stable, they depend on smart contracts, which alter the supply of stablecoins depending on market demand.

What Is Dai?

There are many stablecoins out there, but Dai is unique. Dai is an Ethereum based stable coin (ERC-20 token) that aims to maintain a value equal to one U.S. dollar. This is done through an automatic system of smart contracts on the Ethereum blockchain. The Dai stablecoin price is indirectly pegged to the U.S. dollar and is collateralized by a blend of other cryptocurrencies. 

Since cryptocurrencies are volatile, Dai can be used as a hedge against volatility, especially at times when traders believe the price of cryptocurrencies could crash. Dai token keeps the value of $1 since it is soft-pegged to the dollar. Currently, the market cap of Dai is at $2.8 million and it is expected to grow.

The market cap of Dai has experienced significant growth. Source: Coinmarketcap.com

Who Created Dai?

Dai stablecoin was created by MakerDAO, which is a decentralized autonomous organization. It operates in a decentralized methodology by using smart contracts. MakerDAO was established in 2014 by Danish entrepreneur Rune Christensen. 

MakerDAO is managed through a democratic system where MKR holders vote on decisions to be made regarding changes to MakerDAO, Maker Protocol and DAI. The power of their vote is proportional to the number of Maker tokens they possess.

Dai token and its smart contracts were officially launched on the Ethereum blockchain on Dec. 18, 2017. Venture capital firm Andreessen Horowitz invested $15 million in MakerDAO in September 2018, making it the owner of 6% of the total MKR token. That year, even as ETH saw a drastic drop in price, Dai managed to successfully maintain its $1 handle. 

In 2019, there were divisions within MakerDAO because founder Christensen wanted to create a more favorable environment to allow for assets besides cryptocurrency to serve as collateral for Dai. After some discussion, the Chief Technical Officer (CTO) left MakerDAO.

How Does Dai Work?

Dai is created when users borrow against locked collateral, and it is destroyed when loans are repaid. If you deposit Ether or other cryptocurrencies accepted as collateral, you will create a new Dai. When you pay back the borrowed Dai, the locked collateral will be recovered. 

As mentioned above, Dai is pegged to the U.S. dollar. To maintain its value, Dai uses Target Rate Feedback Mechanism (TRFM). So, the goal of Dai is to keep the value at $1. If the price target is below $1, then TRFM increases so that the price goes back up. When the price goes back up, Dai crypto holders make profits, and demand increases. As demand increases, the supply decreases since users borrow Dai through Collateralized Debt Position (CDPs) and buy from the market. Thus, they cause the Dai price to go back up to its target price.

Dai’s goal is to maintain a value equal to one U.S. dollar. Source: Hackernoon.com

There are other stablecoins such as Tether (USDT), True USD (TUSD) and Paxos Standard (PAX). All of these stablecoins have one thing in common: they are pegged to stable assets (such as the U.S. dollar). Dai differs from the rest for several reasons. The main advantage is that Dai is decentralized. It is managed by a decentralized autonomous organization via a software protocol. Since Dai stablecoin is built on the Ethereum blockchain, anyone can create Dai without permission. 

Every activity on the blockchain is publicly recorded by the Ethereum-powered self-enforcing smart contracts. Therefore the system Dai uses is transparent and less prone to corruption.

Also, within Dai, there is a democratic system of governance, where every change and decision is made with the votes of regular participants.

What Uses Does Dai Have?

Dai stablecoin is mostly used as a hedge against volatility since it maintains a stable value. What characterizes these assets is precisely the ability to maintain their stability even in a volatile market. Dai does just that because it can maintain the $1 price in any situation.

Dai can also be exchanged relatively easily for real money or traded for other goods. It is one of the most popular crypto assets in Decentralized Finance (DeFi). Lending with Dai deposits come with a number of benefits as well. In countries such as the United States, United Kingdom, Netherlands, Australia, France, and Spain, customers can obtain two percent a year on their Dai deposits by lending through Coinbase.

Dai can also be used in cross-border transactions. Making international transfers to other countries through traditional methods like Western Union can be very expensive and time-consuming. With the Maker Protocol, which is based on blockchain technology, you can make transfers of Dai for a fraction of the price of the traditional method, within a few seconds.

Also, it has always been difficult for developers to integrate dollars into FinTech applications. Dai token makes this process much easier because developers can enable users of their platforms to make transactions using Dai. This is possible because Dai is accessible to everyone since it exists in the Ethereum blockchain.

How Do You Get Dai Tokens?

In the early days of cryptocurrencies, it could be difficult to buy them since there weren’t many cryptocurrency exchanges. These days, the amount of cryptocurrencies have grown dramatically and it has never been easier to buy them.

The first place that comes to mind when it comes to getting Dai tokens is the MakerDAO platform. However, you can buy Dai crypto on many cryptocurrency exchanges also. Some of these exchanges are:

  • Coinbase Pro
  • Huobi Global
  • KuCoin
  • Kraken
  • Binance
  • OKEx
  • HitBTC
  • Gemini

You can also get Dai through Decentralized Finance (DeFi) token swap protocols such as:

  • Uniswap
  • Compound

How Do You Store Dai?

Dai is an ERC-20 token so it can be stored in any ERC-20 compatible wallet such as Atomic, MyEtherWallet, Metamask, Exodus, Jaxx, Mist, and Trust.

Dai tokens can also be stored in hardware wallets such as Ledger or Trezor. Hardware wallets are more secure to store your tokens as they are not connected to the internet, and is therefore impossible to hack. 

What is The Future of Dai Token?

MakerDAO has made great strides in making Dai as competitive a stablecoin as possible. Since Dai launched in 2017 on the Ethereum blockchain, one can safely say that the token has had considerable success.

Since the purpose of MakerDAO is for Dai to be an “unbiased currency”, they have even made the Dai logo in a way that is more easily identified as a currency at a glance. Something similar to fiat currencies’ logos such as the Euro and Dollar. 

The Dai symbol alongside popular global currencies. Source: MakerDAO.com

To succeed in the future and achieve its goals of being adopted and used by millions of people, Maker must work and focus on the tokens’ branding, educate people about the token and the benefits they will have if they decide to use the token. 

However, since Dai differs from other stablecoins in many respects, then it seems that such a thing is not impossible and it seems that Dai’s future is bright. The future of cryptocurrencies in general seems to be very promising, as they are expected to be an important part of the financial world.

The Bottom Line

There are many stablecoins out there. But Dai is truly unique, as it is an ERC-20 token based on the Ethereum blockchain.  It is Dai’s democratic system of governance that makes it stand out from the crowd. 

Dai can be used as a hedge against inflation as it maintains the value of $1 in any situation. Although this may be the goal of all stablecoins, what makes Dai stablecoin special is that it does this through an automated system of smart contracts on the Ethereum blockchain. 

Disclaimer

This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisions. Please seek professional advice before trading.

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