Due to the extreme volatility of regular cryptocurrencies, a new type of crypto called stablecoins was introduced. It aims to combine the properties of cryptocurrencies (like Bitcoin) and traditional assets like USD and gold. Stablecoins maintain their value by *collateralizing* multiple purchases. Stablecoins are classed as fiat-backed, commodity-backed, cryptocurrency-backed, and algorithmic-backed (Seigniorage stablecoin).
It is not apparent how crypto-backed tokens work, as safe assets collateralized most stablecoins.
Should not the Stablecoin be Volatile if the Underlying Asset is?
This essay will examine how MakerDAO’s DAI token, a crypto-backed stablecoin, maintains price stability.
They differ from other stablecoins like Tether USDT. In most cases, a single entity controls the collateral, necessitating trust in the centralized authority. Recognizing this issue, MakerDAO created DAI, a fully decentralized stablecoin. Ethereum backs the DAI token (but now accepts different cryptos as collateral) has a price of $1. While the price of Ethereum has significantly fluctuated, the cost of DAI has remained relatively stable.
MakerDAO is a decentralized platform for lending DAI tokens with a predetermined cost.
Maker is an Ethereum smart contract platform that backs and stabilizes DAI’s value through a dynamic CDP system, autonomous feedback mechanisms, and external actors.
To comprehend how DAI tokens remain stable despite the tremendous volatility of ETH, we must first understand their creation. MakerDAO now accepts different cryptos as collateral. However, we will assume ETH is the only option.
An initial vault locks the collateral in a smart contract called Collateralized Debt Position (CDP). In this case, the collateral ratio is 150 percent. It means collateral must be 1.5x the value of loaned DAI.
For example, someone wishes to borrow $1,000 DAI at a current market price of $100. The minimum amount of Ethereum that he must collateralize is $1,500, or 15 ETH.
If the market price of ETH falls below 150 percent (i.e., below the liquidation ratio), the vault immediately enters the clearing stage, where the collateralized ETH is liquidated to cover all or part of the debt.
CDP Transactions
To get the DAI, the CDP user makes a transaction to the CDP, which results in a debt, which prevents them from accessing the collateral until they pay the debt.
If users want to retrieve their collateral, they must pay off the CDP debt plus the Stability fee. The Stability Fee is payable in MKR. When the user delivers the required DAI and MKR to the CDP, they will have paid debt and Stability Fee.
After paying the debt and stability charge, the CDP user can withdraw all or part of their collateral by the transaction to Maker.
We will look at how MakerDAO works when DAI prices diverge from the peg. The price here refers to the secondary market price of DAI. The Maker Protocol has “Keepers” that assist keep DAI at its Target Price ($1). Keepers get rewards for taking advantage of the arbitrage opportunity by purchasing and selling DAI tokens on the market, changing supply and demand. We assume the market is reasonable and that the price of DAI only changes over time.
DAI promotes price stability by altering the incentives for borrowing and holding DAI. The cost of borrowing DAI increases as the price falls below the target, while the cost of manufacturing DAI decreases when the price rises. These influences boost or decrease DAI supply, focusing on its target price and reducing volatility.
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