The Era of Stable Coins
The Dai Stablecoin System
Overview of the Dai Stablecoin System
Popular digital assets such as Bitcoin (BTC) and Ether (ETH) are too volatile to be used as everyday currency. The value of a bitcoin often experiences large fluctuations, rising or falling by as much as 25% in a single day and occasionally rising over 300% in a month
The Dai Stablecoin is a collateral-backed cryptocurrency whose value is stable relative to the US Dollar. We believe that stable digital assets like Dai Stablecoin are essential to realizing the full potential of blockchain technology.
Maker is a smart contract platform on Ethereum that backs and stabilizes the value of Dai through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.
Maker enables anyone to leverage their Ethereum assets to generate Dai on the Maker Platform. Once generated, Dai can be used in the same manner as any other cryptocurrency: it can be freely sent to others, used as payments for goods and services, or held as long term savings. Importantly, the generation of Dai also creates the components needed for a robust decentralized margin trading platform.
Collateralized Debt Position Smart Contracts
Anyone who has collateral assets can leverage them to generate Dai on the Maker Platform through Maker’s unique smart contracts known as Collateralized Debt Positions. 2
CDPs hold collateral assets deposited by a user and permit this user to generate Dai, but generating also accrues debt. This debt effectively locks the deposited collateral assets inside the CDP until it is later covered by paying back an equivalent amount of Dai, at which point the owner can again withdraw their collateral . Active CDPs are always collateralized in excess, meaning that the value of the collateral is higher than the value of the debt.
The CDP interaction process
- Step 1: Creating the CDP and depositing collateralThe CDP user first sends a transaction to Maker to create the CDP, and then sends another transaction to fund it with the amount and type of collateral that will be used to generate Dai. At this point the CDP is considered collateralized.
- Step 2: Generating Dai from the collateralized CDPThe CDP user then sends a transaction to retrieve the amount of Dai they want from the CDP, and in return the CDP accrues an equivalent amount of debt, locking them out of access to the collateral until the outstanding debt is paid.
- Step 3: Paying down the debt and Stability FeeWhen the user wants to retrieve their collateral, they have to pay down the debt in the CDP, plus the Stability fee that continuously accrue on the debt over time. The Stability Fee can only be paid in MKR. Once the user sends the requisite Dai and MKR to the CDP, paying down the debt and Stability Fee, the CDP becomes debt free.
- Step 4: Withdrawing collateral and closing the CDPWith the Debt and Stability Fee paid down, the CDP user can freely retrieve all or some of their collateral back to their wallet by sending a transaction to Maker. Single-Collateral Dai vs Multi-Collateral Dai Dai will initially launch with support for only one type of collateral, Pooled Ether. In the next 6-12 months we plan to upgrade Single-Collateral Dai to Multi-Collateral Dai. The primary difference is that it will support any number of CDP types. 3
Pooled Ether (Temporary mechanism for Single-Collateral Dai)
At first, Pooled Ether (PETH) will be the only collateral type accepted on Maker. Users who wish to open a CDP and generate Dai during the first phase of the Maker Platform need to first obtain PETH. This is done instantly and easily on the blockchain by depositing ETH into a special smart contract that pools the ETH from all users, and gives them corresponding PETH in return.
If there is a sudden market crash in ETH, and a CDP ends up containing more debt than the value of its collateral, the Maker Platform automatically dilutes the PETH to recapitalize the system. This means that the proportional claim of each PETH goes down. After the Maker Platform is upgraded to support multiple collateral types, PETH will be removed and replaced by ETH alongside the other new collateral types.
Price Stability Mechanisms
The Dai Target Price has two primary functions on the Maker Platform: 1) It is used to calculate the collateral-to-debt ratio of a CDP, and 2) It is used to determine the value of collateral assets Dai holders receive in the case of a global settlement. The Target Price is initially denominated in USD and starts at 1, translating to a 1:1 USD soft peg.
Target Rate Feedback Mechanism
In the event of severe market instability, the Target Rate Feedback Mechanism (TRFM) can be engaged. Engaging the TRFM breaks the fixed peg of Dai, but maintains the same denomination.
The TRFM is the automatic mechanism by which the Dai Stablecoin System adjusts the Target Rate in order to cause market forces to maintain stability of the Dai market price around the Target Price. The Target Rate determines the change of the Target Price over time, so it can act either as an incentive to hold Dai (if the Target Rate is positive) or an incentive to borrow Dai (If the Target Rate is negative). When the TRFM is not engaged the target rate is fixed at 0%, so the target price doesn’t change over time and Dai is pegged. When the TRFM is engaged, both the Target Rate and the Target Price change dynamically to balance the supply and demand of Dai by automatically adjusting user incentives for generating and holding Dai. The feedback mechanism pushes the market price of Dai towards the variable Target Price, dampening its volatility and providing real-time liquidity during demand shocks.
With the TRFM engaged, when the market price of Dai is below the Target Price, the Target Rate increases. This causes the Target Price to increase at a higher rate, causing generation of Dai with CDPs to become more expensive. At the same time, the increased Target Rate causes the capital gains from holding Dai to increase, leading to a corresponding increase in demand for Dai. This combination of reduced supply and increased demand causes the Dai market price to increase, pushing it back up towards the Target Price.
The same mechanism works in reverse if the Dai market price is higher than the Target Price: the Target Rate decreases, leading to an increased demand for generating Dai and a decreased demand for holding it. This causes the Dai market price to decrease, pushing it down towards the Target Price.
This mechanism is a negative feedback loop: Deviation away from the Target Price in one direction increases the force in the opposite direction.
Collateralized Debt Positions have multiple Risk Parameters that enforce how they can be used. Each CDP type has its own unique set of Risk Parameters, and these parameters are determined based on the risk profile of the collateral used by the CDP type. These parameters are directly controlled by MKR holders through voting, with one MKR giving its holder one vote.
The key Risk Parameters for CDPs are:
- Debt Ceiling: The Debt Ceiling is the maximum amount of debt that can be created by a single type of CDP. Once enough debt has been created by a CDP of any given type, it becomes impossible to create more unless existing CDPs are closed. The debt ceiling is used to ensure sufficient diversification of the collateral portfolio.
- Liquidation Ratio: The Liquidation Ratio is the collateral-to-debt ratio at which a CDP becomes vulnerable to Liquidation. A low Liquidation Ratio means MKR voters expect low price volatility of the collateral, while a high Liquidation Ratio means high volatility is expected.
- Stability Fee: The Stability Fee is a fee paid by every CDP. It is an annual percentage yield that is calculated on top of the existing debt of the CDP and has to be paid by the CDP user. The Stability Fee is denominated in Dai, but can only be paid using the MKR token. The amount of MKR that has to be paid is calculated based on a Price Feed of the MKR market price. When paid, the MKR is burned, permanently removing it from the supply.
- Penalty Ratio: The Penalty Ratio is used to determined the maximum amount of Dai raised from a Liquidation Auction that is used to buy up and remove MKR from the supply, with excess collateral getting returned to the CDP user who owned the CDP prior to its liquidation. The Penalty Ratio is used to cover the inefficiency of the liquidation mechanism. During the phase of Single-Collateral Dai, the Liquidation Penalty goes to buy and burn of PETH, benefitting the PETH to ETH ratio.