You may have noticed that cryptocurrencies seem to gain value over time especially if they have special use cases. Their price action is similar to stocks, only more volatile, and minus dividends, although you can earn handsome gains if you hodl for a long duration. But what if you could earn some interest on your crypto while hodling?
DAI is not only becoming one of the most popular stablecoins, but also one of the most fascinating ones. The main reason is that it is not backed by reserves of other assets such as the U.S dollar as is the case with USDT or USDC. Instead, it relies on collateralized debt positions and an incentivized mechanism to maintain its peg with the U.S dollar.
DAI has managed to maintain its price stability ever since it was created, thus proving that a stablecoin can exist without backing by US dollar reserves. It also happens to be fully decentralized which means it is free from the influence of centralized authorities or institutions.
Using Ethereum to create a CDP
The collateralized debt positions present an opportunity for users to use their digital assets such as Ethereum and BAT tokens to contribute to DAI’s stability. If you have ETH in your wallet, which you plan to hodl perhaps until it reaches a higher price tag, you can take advantage of that waiting duration by using the ETH to make some extra cash.
Although the mechanisms involved are quite complex, all you need to understand is that you can lock up your ETH in the DAI vault to mint DAI. You will however need to lock up a higher dollar value of ETH than the DAI that will be minted as part of the over-collateralization mechanism to disincentivize users from taking advantage of ETH price fluctuations.
Market forces trigger price fluctuations for almost every asset including DAI. Its mechanism creates arbitrage opportunities that incentivize participation and the facilitation of a stable price. For example, when the price of DAI goes up to $1.02, a user can lock up ETH, mint DAI and sell it on an exchange. This action will lead to a higher supply of the stablecoin without influencing demand, thus forcing the price to drop, while the user makes a profit of $0.02 if they exchange the higher-priced DAI for another stablecoin such as USDC.
Remember that the DAI that the user just sold on the market is the collateralized debt which still has to be paid. In case the price of DAI falls below $1, the user can buy at a lower price, repay the debt and the balance will add to their profit. They get to pay a lower amount of the original loan through price arbitrage.
Paying off the borrowed DAI unlocks the ETH used as collateral and the whole process can be repeated whenever DAI experiences price fluctuations. Note that the DAI repaid as the loan is burned, thus taking it out of supply, to balance out the price. Reduced supply at constant demand leads to a higher price and this mechanism is used to aid DAI’s recovery when the price is lower than $1.
The arbitrage gains that earn, are equivalent to using their ETH to earn some interest with relatively low risk. Note that this approach is only reasonable with larger amounts because they offer bigger margins to counteract the small price changes in DAI. Because the system is overcollateralized, the price changes are very minimal and as such, only large amounts of money are effective to make meaningful gains. Nevertheless, a great way of making some extra cash out of your crypto assets.