Authors:
(1) Zhenbang Feng, Department of Electrical and Computer Engineering, Viterbi School of Engineering, University of Southern, California Los Angeles, CA, USA ([email protected]);
(2) Hardhik Mohanty, Department of Electrical and Computer Engineering, Viterbi School of Engineering, University of Southern, California Los Angeles, CA, USA ([email protected]);
(3) Bhaskar Krishnamachari, Department of Electrical and Computer Engineering, Viterbi School of Engineering, University of Southern, California Los Angeles, CA, USA ([email protected]).
Editor’s note: This article is part of a broader study. You’re reading part 2 of 5. Read the rest below.
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II. THE MECHANISM
Our particular interest lies in the mechanisms that enable these synthetic assets to maintain track of their underlying assets under market pressures and volatility. MakerDAO’s DAI stands out as an important example of such a synthetic derivative, a stablecoin designed to peg US Dollar. We find it instructive to explore the inner workings of DAI’s stability protocol, which relies mostly on decentralized mechanisms without centralized authority. While DAI has transitioned to a multi-collateral DAI starting in November 2019, our analysis below will delve into the single collateral form, known as SAI, which operated from December 18, 2017, until the protocol’s transition to the multi-collateral system. SAI reflects the core mechanism of DAI and provides ease of exposition and analysis.
A. Basic Structure and Functionality of DAI
DAI functions by allowing users to lock up collateral (e.g., Ethereum) in a smart contract. The action of doing this is called opening a Collateralized Debt Position (CDP). The process of collateral lock-up and DAI generation was designed to ensure over-collateralization, typically requiring a collateral value exceeding the value of DAI by at least 150%. This requirement ensures the creation of a buffer to absorb market volatility. The specific over-collateralization ratios are subject to change based on governance decisions and market dynamics throughout SAI’s tenure.
B. User Interaction with DAI
Users typically interact with DAI in the following ways. As illustrated in Figure-1, users generate a CDP and obtain DAI by locking up their collateral assets. This DAI can then be used to transact, invest, or leverage in other decentralized financial applications. When users wish to retrieve their collateral, they repay the DAI they generated plus a stability fee to unlock their original assets. In addition to direct interaction with CDPs, users can buy or sell DAI on various exchange platforms just like any other cryptocurrency.
C. Role of Price Oracles
Oracles serve as bridges that bring real-world information, in this case market data, into the blockchain environment. In the context of the DAI stablecoin mechanism, oracles play an indispensable role, because DAI’s stability and over-collateralization rely on the accurate and timely valuation of collateral assets. Oracles provide this service by feeding external data, in this case, the current market prices of collateral assets, into the blockchain. In DAI, this data is used to verify whether the value of the collateral in a CDP falls below a certain threshold, and if so, triggers a liquidation event to ensure DAI remains adequately backed.
D. The Liquidation Mechanism
While the emphasis often rests on creation and utilization of DAI, an equally important mechanism is how the system handles potential under-collateralization. If the value of the collateral in a CDP drops below a predefined threshold, the system automatically liquidates a portion of the collateral to ensure DAI remains over-collateralized. This liquidation process involves auctioning off the collateral for DAI. Keepers, independent actors in the ecosystem, play a significant role in these auctions, bidding on and buying the liquidated collateral. This automatic and decentralized liquidation process is essential to maintain trust in DAI’s stability, even during significant market downturns.
