The Financial World of the Future, Part 2

By Juan Villaverde on September 25, 2019

In Part 1 of this series, I explained the powerful potential of Decentralized Finance (DeFi) to create the financial world of the future. In that scenario …

  • Distributed Ledger Technology replaces custodians …
  • The risk that custodian institutions might collapse is virtually eliminated, and …
  • The middlemen of trillions of transactions are replaced.

At the same time, I also pointed out a major challenge:

The instability of cryptocurrency prices.

One Coin Aiming to Meet That Challenge is DAI

DAI falls under the general rubric of stablecoins. But it’s quite different from ordinary stablecoins in a very critical way.

You see, typically, a stablecoin is backed it up with another asset that the custodian controls — typically U.S. dollars — held in the custodian’s bank account. That’s what guarantees the tokens can be redeemed one-to-one.

The problem: That set-up brings us right back to square one: A financial structure that revolves around a centralized — and fallible — custodial institution.

Ask yourself: How can you have a supposedly decentralized financial system of the future if the assets are again mostly controlled by a single entity or counterparty? That’s way too much control in the hands of a single individual or group.

For that kind of centralized structure, we already have a solution; it’s called the traditional financial system, including megabanks.

That’s where DAI is different from other stablecoins. In fact, in this sense, the term “stablecoin” is a misnomer. DAI is actually better described as …

A Decentralized Central Bank

Here’s how it works …

Let’s say you’re a user.

You deposit Ether (and pretty soon, other crypto assets as well) in a smart contract.

In return, the smart contract credits your account with the equivalent value in DAI tokens. For example, if the Ether and/or other coin deposit has a total value of USD $100, the credit will be a $100 of DAI.

That’s the general bare-bones theory. In practice, of course, nothing is ever that simple the crypto world.

In this case, due to the volatility of Ether or any other crypto token, DAI is always over-collateralized: If you have $100 USD worth of Ether, you’ll probably get only up to 66 DAI tokens for it.

Thus, there are always more assets backing each DAI token than there are DAI in circulation. In fact, the system requires that every DAI token created is backed by assets worth at least 1.5 times its value.

I stress “at least” because in the present day, there are actually about $86 million worth of DAI that have been created, and these tokens are backed by over $314 million of Ether that have been deposited in the DAI smart contract.

That means DAI is currently over-collateralized by a whopping 336%.

In sum …

1. The only way to create new DAI tokens is to deposit assets with the DAI smart contract.

2. This smart contract holds these assets in reserve.

3. The smart contract then issues the amount of DAI specified by each user in such a way that the value of the assets deposited exceeds the value of the new DAI created by at least 50%.

The Big Takeaway: This System Resembles a Central Bank.

One of ways a central bank issues new currency is by acquiring assets to back those new euros, dollars, yen, etc.

The Federal Reserve, for instance, holds U.S. Treasuries. This, in effect, supports the issuance of new dollars backed by those government bonds, as it does with Quantitative Easing (QE), the post-debt-crisis euphemism for old-fashioned money printing.

The DAI smart contract is similar in some ways.

The Ether deposited in a smart contract enables it to create new DAI. The difference is that with QE, there are virtually no rules other than those made up on the fly by the Federal Open Market Committee (FOMC).

In contrast, with DAI …

1. The money is created by the smart contract, a piece of self-executable code which lives on an immutable distributed ledger.

2. The code replaces the centralized entity.

3. The code allows anyone who holds Ether to participate in the process of creating new DAI.

4. The rules are applied transparently and fairly to all actors in the system, regardless of who they may be.

So far we’ve explained how new DAI is created.

The big remaining question is: How does DAI maintain its parity to the U.S. dollar?

That’s where another critical piece of the puzzle comes into play:

DAI issuers are required to pay interest on the DAI that they have created. They have to pay back the DAI plus interest.

This is the key to guaranteeing a stable value to the DAI token, and we’ll explore precisely how in a follow-up article.

For savers, the big payoff is this: The interest you earn can be substantial, especially in the current environment of ridiculously low — or even negative — yields.

Stand by for a step-by-step explanation of how this works, and how you can take advantage of it.

Best,

Juan

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