I wrote about stable coin a few weeks ago, and specifically mentioned MakerDAO’s Dai coin as a good example of one of the most recent, and relatively successful attempts at creating a stable cryptocurrency. When I say “relatively successful,” what I really mean is totally unsuccessful in the sense that it has repeatedly suffered market shocks in excess of 25%, but those shocks have been short lived and the dai token has (so far) returned back to the value of the US dollar within about 2 cents — the same cannot be said for all stable coin projects.
The concept of stable coin continues to be very interesting to me, as it seems to be the next big step in allowing fintech, especially that powered by the blockchain, to really take off over the long term horizon. So I thought I would write some more about stable coin, but this time focusing on how it specifically operates in the case of MakerDAO’s dai.
At its most fundamental level, MakerDAO’s dai operates pretty much the same way as every other stable coin attempt on the market. It has some kind of collateralized backing, and the price of the asset on the open market is controlled by built-in monetary policy schemes that automatically attempt to adjust supply and demand dynamics in order to control the trading price. Specifically speaking, it looks something like this:
In order to purchase dai, you to send ETH into a “pool” contract on the Ethereum blockchain. This pool is then used to fund a “collateralized debt position smart contract (CDP),” which is a very fancy way of saying that when you “buy” dai (you’re not actually buying existing tokens; the CDP freshly mints new dai to match the value of your collateral), it represents a debt you owe to the MakerDAO framework, which is covered by the collateral you committed to the Ether pool. That debt can be repaid when you send the dai back to the original CDP, which then releases your collateral and lets you be on your way.
An important side note here: as a precaution, the MakerDAO framework insists on being over-collateralized. All that means is that if you send $100 US worth of ETH to the CDP, the CDP might only generate $50 US worth of dai in return. This over-collateralization of the dai protects the system against sudden shocks in the value of ETH, but also presents a serious annoyance for users. Under such a system, you’re digital wealth will always be significantly less than your fiat wealth; it also means that MakerDAO is putting all of the risk on you. In the event of a price shock, you’re the one losing money — not them. Your collateral will be confiscated, liquidated, and distributed throughout the system to save the company; you are the corporate insurance policy that allows the founders to sleep at night.
So even though you don’t really have a choice in the matter, good on you for thinking about their health.
Once the dai token is in circulation, the monetary policy instruments of the stable coin framework kick in to ensure that the free market doesn’t cause the price of the dai to shift too far off the target price of exactly $1 US. To achieve this goal, there are basically two types of actions automatically employed by the smart contract — which, unsurprisingly, are very similar to the actions taken by central banks to ensure price stability in fiat currencies. If the price of dai begins to shift too far in a negative direction, the smart contract will raise the “target rate,” which is the desired rate of change in the price of the dai smart contract. This inflationary pressure will cause the price of issuing new dai to increase (negative incentive) and the reward for holding dai to increase (positive incentive), which, when taken as an aggregate, increases the demand for die thus raising the market price back to the desired level. If the price of dai begins to shift too far in the positive direction, the opposite forces are at play to bring it back down.
Here’s a link to MakerDAO’s whitepaper if you’d like to follow up and read more.
Almost all stable coin systems that I’ve seen operate in a similar way. Can anyone else think of another way to do it… maybe even without the need for collateral? I’d like to get a little discussion going here about the design of stable coins, so if you have anything to say, leave it below! 