Welcome to PYMNTS’ series on decentralized finance, or DeFi.

In these articles, we’ll look at every part of DeFi – the biggest, hottest, most rewarding, and riskiest part of the blockchain revolution. At the end, you will know what DeFi is, how it works, and the risks and rewards of investing in it.

See part 1: What is DeFi?

See part 2: What are the best DeFi platforms?

See part 3: What is a smart contract?

See part 4: What are Yield Farming and Liquidity Mining?

See part 5: What is staking?

See part 6: What are the top 10 uses of DeFi?

See part 7: DeFi and DAO unboxing

See part 8: The very real risks of DeFi

See part 9: What are the best DeFi blockchains?

See part 10: What’s real, what’s hype, what matters

See part 11: How to buy an NFT in 19 easy steps

So what is an algorithmic stablecoin?

Well, what is a stablecoin? It’s a fairly simple concept to grasp. Take a dollar, put it in a bank account and mint a cryptocurrency token. Offer to exchange this token for $1 at any time. Now you have a dollar to dollar parity, and that token has price stability because it is never worth more or less than that $1.

As long as crypto buyers are confident that the dollar actually exists and can be traded, the stablecoin will retain its value. This dynamic is at the heart of one of the problems the United States and other governments have with stablecoins: if that trust erodes, it will create a run like a bank run, only faster.

Simple enough.

Now let’s talk about the algorithmic stablecoin, which maintains this one-to-one dollar peg without this fiat currency cache supporting it.

MakerDAO’s DAI stablecoin isn’t alone – four of the top 10 stablecoins, with a combined market cap of $26.6 billion, are algorithmic. But, launched in 2015, DAI was the first to break out. And it became full DAO, dissolving the Maker Foundation which was the centralized driving wheels of the DeFi project.

So how does MakerDAO do it? Pure capitalism. Algorithmic stablecoins use artificially controlled supply and demand to maintain their price. To do this, they need a partner.

MakerDAO, the decentralized autonomous organization controlling the project, uses two tokens – DAI and MKR – as well as a DeFi lending/borrowing platform.

Chicken or Egg?

Depending on your perspective, MakerDAO is either a DeFi borrowing platform that uses an algorithmic stablecoin or a stablecoin backed by the funds locked in a DeFi borrowing platform. Then there is a second token, MKR, which acts as a governance token for the entire shooting match and also supports Dai’s dollar peg.

Let’s start with the borrowing platform. MakerDAO allows crypto owners to borrow against cryptocurrencies like ether (ETH), Compound (COMP) and even stablecoins tether (USDT), USD Coin (USDC) and Pax Dollar (PAX) .

The goal is to unlock the value of your crypto without actually selling it, because you believe its price will rise in the long term. The collateral amount is up to 175% of the amount you can borrow, with the rate depending on the volatility of the cryptocurrency used as collateral.

In exchange, you are loaned dollar-pegged Dai stablecoins (DAI on exchanges), which can be used for everything from investing in DeFi projects like yield farming and liquidity mining to trading other cryptocurrencies – which is cheaper and easier when using a stablecoin rather than trading one token for another – or simply as a currency usable on crypto Visa and Mastercard debit cards, or on other crypto projects like the NFT-based game Axie Infinity.

See also: PYMNTS DeFi Series: What is Yield Farming and Liquidity Mining?

The risk is that if the value of your collateral drops too low – easy enough in the volatile crypto market – MakerDAO’s contract-controlled smart borrowing platform will liquidate your collateral, selling it at the market low, to ensure that the loan can be repaid.

So much like any other DeFi lending platform.

Balancing law

The Dai stablecoin is where MakerDAO gets creative. For one thing, there is no fixed amount of Dai. Instead of being backed by a fiat currency cache like the major USDT and USDC stablecoins, Dai is backed by this cryptocurrency collateral. When you lock crypto collateral in MakerDAO, new Dai stablecoins are created. When you pay off the loan – plus a fee – it gets burned.

OK, so how does this keep the price of Dai stable? This is where the second token on the platform, MKR, comes in.

First of all, MKR is a governance token, giving users a vote on how the MakerDAO platform is run – like setting interest rates and borrowing transaction fees, the latter payable only in MKR.

But he has another role. The MKR is used to stabilize the price of Dai. If Dai begins to fall below its $1 peg, MKR is created and sold for Dai to increase its value. If Dai begins to heat above $1, MKR is bought into the market and burned, knocking it down.

Why? Supply and demand. If the price of Dai starts falling below $1, arbitrage traders will borrow Dai at $1 and then buy Dai in the market at, say, $0.99 to pay off their Dai-denominated debt for less than they borrowed – which has the effect of reducing Dai’s offer. on the market and therefore to increase its price.

Similarly, if the price of Dai rises above $1, these traders will post collateral and borrow Dai at the standard price of $1, then resell it on the open market for a profit (likely enough to cover costs), increasing the offer and lowering its price. drop.

If that seems like a lot of weight to put on supply and demand, there is a safety net. If Dai’s price rises too much, MKR tokens are minted and sold for Dai, increasing his supply. If Dai falls too far, MKR is bought for Dai and burned, decreasing Dai’s supply.

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