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This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
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While Bitcoin resolved the double spending problem, it lacked a stability mechanism, which Dai (DAI) set out to address. It was designed as a stable payment token pegged to the U.S. dollar, and also one of the first DeFi applications to be explicitly governed through the vehicle of a DAO called “MakerDAO.” The governance token MKR was designed to grant token holders the right to participate in decision-making processes that influence DAI’s economic policies and strategic operations. In 2024, MakerDAO initiated a rebranding to "Sky" as part of its "Endgame Plan," aiming to enhance governance and token economics.
Disclaimer: This chapter repeats certain concepts that have already been introduced in a previous chapter on Stable Tokens, but goes much deeper into the use case of MakerDAO. Since the crypto landscape is dynamic, details about these protocols are subject to frequent changes. Staying informed through official channels and recent updates is advisable.
Many early blockchain protocols, such as Bitcoin, were impractical for daily payments in stable economies due to their price volatility. These challenges prompted the emergence of stable tokens which have become indispensable building blocks to decentralized applications. The stable token Dai (DAI) and its governance institution MakerDAO stand out as early and influential examples of a decentralized approach to exchange rate stability. Despite many challenges along the way, Dai has constantly evolved and remains a landmark decentralized stable token.
Dai was conceptualized in 2014 by Rune Christensen, who introduced his idea for a stable cryptocurrency on Reddit under the name “eDollar.” It was later renamed Dai, with the goal of creating a stable token pegged 1:1 to the U.S. dollar. A combination of collectively maintained monetary policy mechanisms executed by voluntary contributors with different roles within the system was designed to guarantee that the peg would be maintained.
The first white paper was published in 2017, outlining a protocol where anyone could deposit collateral tokens into Ethereum-based smart contracts and receive newly minted DAI in return. These collateral tokens served as reserves to back the value of the stable token. Adaptive monetary policy mechanisms were designed to incentivize traders to maintain stability by offering arbitrage opportunities through various auction mechanisms. These mechanisms served as semi-automated security functions. They ensured that collateral assets held in reserve would be sold off if their price fell below a certain threshold, allowing traders to buy them at a discount and maintain exchange rate stability.
Initially, Dai relied solely on Ether (ETH) as collateral. Any ETH token holder could deposit their ETH in a smart contract to generate DAI tokens in return, which resulted in a debt position for DAI tokens. The exchange rate would be determined by the ETH-USD price. These newly issued DAI were designed to function as a de facto loan by the Maker protocol. They resulted in a debt position for which DAI owners had to pay interest, which is why these smart contracts were originally referred to as collateralized debt positions. The ETH held as collateral would only be released by the smart contract upon repayment of all DAI debts. Through this mechanism, Maker Protocol inadvertently became more than just a stable token project, as the smart contract issuing DAI, while holding collateral assets in escrow, was one of the first decentralized lending protocols of its kind. It served as a use case for other decentralized lending and borrowing protocols. The term collateralized debt position is not used anymore, and has been replaced by the term “Vault.” Many other aspects of the Maker protocol have evolved over the years, including its monetary policy parameters, collateralization mechanisms, accepted collateral types, and collective governance rules.
DAI started out with a 150 percent collateral-to-debt ratio to ensure that the system had enough excess collateral to mitigate the volatility risk. However, overcollateralization could not completely mitigate the volatility risks of ETH, leading to the introduction of “Multi-Collateral Dai” in 2019 through a series of protocol upgrades. This upgrade allowed a range of “crypto-native” assets to be used as collateral. Different collateral-to-debt ratios were implemented to account for the specific volatility risk of each underlying collateral asset.
To further reduce volatility risks, competitor stable tokens such as USDC, as well as tokenized real-world assets, were eventually accepted as collateral. At the time of writing, USDC is the dominant collateral type used for backing DAI. While this move mitigated the volatility risks associated with many crypto-native assets, it also raised controversy around the re-centralization of DAI. After all, USDC is a fiat-backed and centrally managed stable token, which exposes DAI to many of the systemic risks of traditional financial services that the founders originally set out to combat. In 2022, MKR holders approved a real-world asset vault for Société Générale, enabling the bank to borrow DAI against tokenized corporate obligations and home loans. This milestone marked the increasing integration of traditional financial institutions with decentralized protocols.
The governance structure of the stable token evolved in tandem with these developments. Initially managed by a foundation, the project transitioned to community governance, with MKR holders gaining full decision-making authority by 2021. However, challenges with voter participation and governance complexities led to the introduction of the Endgame Plan in 2024, aimed at simplifying operations. Under the Endgame Plan, MakerDAO began a rebranding to Sky, introducing new governance tokens (SKY) and a stable token (USDS) while maintaining support for the legacy tokens DAI and MKR. The idea was to allow MakerDAO and Sky to operate in parallel, providing users the choice to adopt the new ecosystem while minimizing disruptions.
When Dai was created, its primary goal was to offer a stable, collectively maintained payment token suitable for Web3-based transactions. The goal was to have low exchange rate volatility, making it a reliable medium of exchange that can be easily used in any decentralized application. Given the design of the system and the statements made by the founders in the early years, it is safe to say that the system pursued two main political principles:
The main challenge in designing the system was decentralizing monetary policy interventions in the absence of a central bank or other monetary authorities. Traditional financial institutions influence exchange rates and monetary stability through various tools, including interest rate adjustments, reserve requirements, open market operations, and direct currency interventions. In contrast, a decentralized system required novel mechanisms to replicate similar economic functions without centralized oversight.