How does DAI keep its price stable?

Today we are going to explain how the DAI cryptocurrency manages to keep its value constant against the dollar, even though it is not dollar-backed.

Unlike traditional stablecoins like USDC and TrueUSD, where each token is issued from the deposit of dollars that are held in a company’s custody, algorithmic stablecoins use sophisticated mechanisms to pair their value to the dollar. In the case of the DAI cryptocurrency, this mechanism is based on the concept of loan with guarantees. 

For example, let’s say you want to take out a $1000 loan from a bank. Usually, the bank will require some collateral which can be used in the future to repay the loan if you don’t pay back what you owe. The bank will also charge interest on the loan. The DAI cryptocurrency model works the same way: you can borrow dollars by providing a guarantee and paying interest. 

These borrowed dollars are issued through the DAI token, which is equivalent to one dollar. The guarantee provided is made by another cryptocurrency, such as the ETH token.

 

Let’s imagine the following scenario: the price of one ETH is $500, the interest charged for borrowing DAIs is 1% per year, and you want to borrow $1000. You could, for example, leave 4 ETHs as collateral for the loan. In other words, you lock 4 ETHs to be entitled to receive 1000 DAI tokens. This way, if you don’t return the 1000 DAI tokens with the respective interest the protocol can sell your ETH tokens to pay off the debt. Notice that in this example the collateral is twice the value of the debt. This is important because the price of the ETH token fluctuates. 

If the guarantee were exactly the value of the debt ($1000) and the price of the ETH token were to fall the loan would be insolvent.

 

So in practice there is a limit beyond which the user is liquidated. 

In the case of loans with the ETH token as collateral, this limit is 1,5 times the value of the debt. 

If you placed 4 ETH tokens as collateral, you would be automatically liquidated if the price of 1 ETH drops to $375 losing your ETH tokens as your collateral would reach the limit of $1500.

It is evident that the higher the value of the collateral, the safer the user is from not being liquidated.

The moment a user pays off their loan, the deposited collateral is unlocked and the returned DAI tokens are burned.

If the user has been liquidated, the collateral is sold to buy DAI tokens,

which are burned in the same way.

 

This is a good summary of how the system works, from the creation to the destruction of DAI tokens.The amount of DAI tokens circulating in the market depends on the amount of collateral that is currently deposited.

Seeing the advantages of this system, John decided to issue DAI tokens as a loan to buy bitcoin depositing ETH as collateral. In this scenario, John did not have to sell his ETH tokens, betting on the appreciation of both.

When John used his DAI tokens to buy bitcoin, he traded with Olivia who sold her bitcoins in exchange for DAI.

Note that Olivia can hold her DAI tokens as long as she wants without paying any interest, because she just made an exchange of one token for another in the market. The person who needs to return the DAI tokens and pay interest is John, who issued these tokens. At some point John will need to repurchase DAI in the market to pay off his debt and get his ETH tokens back.

By now you may be noticing that collateral serves as backing to allow DAI tokens to have real value in the market.

But who guarantees that its value remains stable to a dollar?

This is done through the interest rate, also called the Dai Savings Rate (DSR). 

If the interest rate that was 1% rises to 8% borrowers are encouraged to return their DAI tokens and settle the debt soon, removing tokens from the market.

The opposite occurs if interest rates are low, which would encourage more people to issue DAI tokens (increasing the supply of tokens in the market).

Thus, if the token price in the market is losing parity with the dollar up or down due to momentary swings in demand, the interest rate change helps move the supply, keeping the price stable.

Now that you have a good general understanding of how the system works, we can get into the details.

We’ve seen the conditions for a liquidation to happen, but we haven’t seen how it happens.

In practice, an auction takes place for each liquidation, where interested users can offer amounts to buy the locked collateral.

If John applied for a loan of 1000 DAI offering 4 ETH as collateral

and was liquidated when the price of the ETH dropped to $375, 

it means that at that time an auction is started having a duration of 24 hours where different users can dispute with each other who makes the highest bid for the purchase of these 4 ETH.

The bids are made in DAI tokens. If the auction ended with a final bid of 1400 DAI for the 4 ETHs, it means that the winner of the auction paid the equivalent of $350 per ETH. In that scenario, the 1000 DAIs referring to the original loan will be burned and the surplus amount will go into a surplus reserve, which can be used in problematic scenarios.

What scenarios?

Well, imagine that the auction had ended with a bid of 300 DAI for the 4 ETHs. This could happen if at the time of the auction the market is experiencing a flash crash. 

This means that the debt has not been paid, creating a deficit in the system.

The first candidate to cover this deficit is the surplus reserve. This reserve is also fed by the interest rates charged on loans.

If a very large amount of deficits occur that the surplus reserve does not cover, a debt auction is started, where MKR tokens are issued and auctioned to cover the debts in DAI. These MKR tokens correspond to the Maker project, which is responsible for the governance of the DAI token.

MKR token holders can vote on the parameters of the system, deciding on the values of important parameters such as the limit of collateral for settlement, auction criteria, etc. They also decide on the upper limit of the surplus reserve.

If the surplus reserve has more money than this limit, the extra amount will go to a surplus auction, 

where DAI tokens are sold in exchange for MKR tokens, which in turn are burned.

Thus, the supply of MKR tokens is regulated by the system situation decreasing when the system is robust and increasing when the system is in deficit.

It is worth pointing out that as the project progresses, the dynamics can also evolve.

Today it is already possible to deposit different tokens as collateral, with each one having a different set of rules depending on its liquidity.