In lesson 2 you met the fiat-backed crowd — USDC, USDT — coins whose dollar peg rests on a company swearing it holds real dollars in a real bank. Trustworthy-ish, but you’re trusting an institution: its auditor, its banking partners, and its willingness not to freeze your address.
Now the rebellious cousin. What if you wanted a dollar-pegged coin with no company, no bank, and no reserve account — backed by nothing but crypto you locked up and a few thousand lines of smart-contract code? No CEO to subpoena, no balance sheet to fudge, no withdrawal button for a regulator to push. That coin exists. It’s DAI, born at MakerDAO (now rebranded Sky, where the same dollar is also issued under the ticker USDS). Let’s open the hood.
Before you read — take a guess
A fiat-backed coin like USDC is worth a dollar because a company holds a real dollar for each one. What backs a crypto-backed coin like DAI instead?
The core trick: borrow a stablecoin into existence
Here’s the move that makes DAI click. You don’t buy freshly-minted DAI from a company — you borrow it into existence against your own crypto, exactly like the over-collateralized DeFi loans from the previous topic.
The mechanics:
- You lock crypto (say ETH) into a smart-contract vault — the canonical name is a CDP, a collateralized debt position. Think of it as a digital safe deposit box that only opens on the contract’s terms.
- Against that locked collateral you mint new DAI — the contract creates it on the spot and hands it to you. This DAI is a loan, not a gift.
- To get your collateral back, you repay the DAI you minted (plus a fee, more on that later). The repaid DAI is burned — destroyed — and the vault unlocks.
So DAI is, quite literally, a loan you took out against your own crypto. Every single DAI in circulation is the debt side of somebody’s vault. There is no “DAI factory” stamping coins; there are thousands of users each minting a little DAI against their locked ETH, and the sum of all that debt is the DAI supply.
A pawn shop you run yourself
A vault is a pawn shop where you’re both the customer and (collectively, via the protocol) the pawnbroker. You hand over something valuable (ETH), walk out with cash (DAI), and your pledged item waits in the back. Pay the cash back plus interest and you reclaim your ETH. Don’t pay — and the shop sells your ETH to make itself whole. The twist: there’s no shopkeeper, just code.
Fill in each blank to describe how DAI is created and destroyed.
Pick the right option for each blank, then check.
To create DAI, a user and then . The minted DAI is . To unlock the collateral, the user .
Why over-collateralize? Lock more than you mint
A fiat-backed coin can be backed 1-to-1: one dollar in, one coin out, because a dollar in a bank stays worth a dollar. Crypto collateral does no such thing — ETH can drop 20% before your coffee gets cold. If you minted exactly a dollar of DAI for a dollar of ETH, a single bad afternoon would leave the DAI under-backed, and the peg would snap.
The fix is to insist you lock more value than you mint. The key number is the collateralization ratio:
Each vault type sets a minimum ratio you must stay above — for many ETH vaults this floor has historically been around 150%. Stay above it and you’re fine; drop below it and the protocol comes for your collateral (next section).
Worked example. You lock ETH worth USD 15,000 and mint 10,000 DAI:
You’re sitting exactly on a 150% floor — technically compliant, but with zero cushion. One tick down in ETH and you’re underwater. A careful borrower mints far less. Lock the same USD 15,000 of ETH but mint only 6,000 DAI and your ratio is 15,000 ÷ 6,000 = 250% — ETH could fall 40% before you’d even approach the 150% line.
| ETH locked | DAI minted | Collateralization ratio | Cushion above 150% floor |
|---|---|---|---|
| USD 15,000 | 10,000 | 150% | none — on the edge |
| USD 15,000 | 7,500 | 200% | comfortable |
| USD 15,000 | 6,000 | 250% | very safe |
Minted DAI is not free money
The number-one rookie mistake: treating the DAI that appears in your wallet as a windfall. It is debt. You spent or invested it, sure — but the vault behind it still owes that DAI back, with a fee, and your ETH is hostage until you repay. People who forget this discover the truth the hard way during the next section’s main event.
You lock ETH worth USD 20,000 and want to keep a collateralization ratio of at least 200%. What's the most DAI you can safely mint?
Liquidation: the protocol shows no mercy
So what happens when ETH falls and your ratio sinks below the minimum? The protocol liquidates you — automatically, instantly, and without a shred of sympathy.
Liquidation means the smart contract auctions off your locked collateral to pay back the DAI debt, plus a liquidation penalty (a punitive surcharge, often around 13%, for letting it get that far). There’s no margin call email, no grace period, no “let me top it up real quick.” The moment your ratio crosses the line, your collateral is fair game. You keep whatever’s left after the debt and penalty are covered — frequently a lot less than you’d like.
A handy way to feel how close you are is the health factor — the collateralization ratio rescaled so that the danger line sits at 1.0. Above 1, you’re solvent; the moment it dips < 1, you’re liquidatable. Drag the collateral price below and watch a vault march straight into the red.
Liquidation threshold: 66.7% · 10 × $2,000 · health factor vs $11,000
- Collateral value
- $20,000
- Health factor
- 1.21
- Health factor
- At risk
Drag the collateral price down and watch the vault cross into liquidation. The health factor is just your collateralization ratio rescaled so the danger line sits at 1.0 — above it you're safe, below it the protocol auctions your collateral to repay the DAI (plus a penalty).
Worked example. Lock 10 ETH at USD 2,000 each — USD 20,000 of collateral — and mint 11,000 DAI. Your ratio is 20,000 ÷ 11,000 ≈ 182%, healthy. Now ETH slides to USD 1,200: collateral is worth 12,000, the ratio is 12,000 ÷ 11,000 ≈ 109%, and you’ve blown through a 150% floor long ago. The protocol auctions your ETH, repays the 11,000 DAI, skims its penalty, and returns the scraps. Your ETH is gone — sold at the worst possible moment.
Liquidation fires at the worst time, by design
The cruel irony: liquidations cluster exactly when the market is crashing and gas fees spike, because that’s when ratios collapse all at once. The defense isn’t to watch the chart all day — it’s to mint conservatively (a high ratio) so you’ve got room to survive a crash, or to repay/add collateral before you’re near the line.
Keeping DAI pinned at $1
Backing alone doesn’t pin a price — plenty of well-backed things trade off-value. So how does DAI actually stay near a dollar? Four forces pull in concert:
- Liquidations keep every DAI fully backed. By ruthlessly closing under-collateralized vaults, the system guarantees the total collateral always exceeds the total DAI debt. DAI is never “printed naked,” so holders trust it’s redeemable for at least a dollar of value.
- The stability fee throttles supply. The stability fee is the interest rate borrowers pay to keep DAI minted (the cost of the loan). When DAI trades below $1, governance raises the fee — minting gets expensive, borrowers repay and burn DAI, supply shrinks, and the price floats back up. When DAI is above $1, they lower it to encourage more minting. It’s a money-supply dial.
- The DAI Savings Rate (DSR) supports demand. The DSR pays holders a yield just for locking their DAI in a savings contract. Crank it up and holding DAI becomes attractive, soaking up supply and pushing the price toward (or above) $1. It’s the demand-side lever to the stability fee’s supply-side one.
- The Peg Stability Module (PSM) hard-pegs via swaps. The PSM lets anyone swap DAI 1-to-1 for fiat-backed coins like USDC (and back). If DAI drifts to $0.99, arbitrageurs buy cheap DAI, redeem it 1:1 for USDC through the PSM, and pocket the cent — relentless arbitrage that clamps the peg tight.
That last one carries a delicious irony, which is worth dwelling on.
Honest answer: less than its marketing implies. The PSM works by holding a big pile of USDC to back all those 1:1 swaps — which means a meaningful chunk of DAI is, indirectly, backed by a centralized, freezable, company-issued stablecoin. So the “no company, no bank” coin quietly leans on exactly the kind of company-and-bank coin it was meant to replace.
The trade-off is deliberate: USDC in the PSM makes DAI’s peg far tighter and more reliable than pure crypto collateral could manage alone. But it imports USDC’s risks — if USDC ever depegged or froze (as it briefly did during the 2023 SVB scare, dragging DAI down with it), DAI feels it. Decentralization here is a dial, not a switch, and the PSM turns it toward “more stable, less pure.”
Match each MakerDAO/Sky mechanism to what it does.
Pick a term, then click its definition.
Trade-offs versus fiat-backed coins
Crypto-backed and fiat-backed stablecoins aren’t better or worse in the abstract — they swap one set of trade-offs for another. Lay them side by side:
| Property | Crypto-backed (DAI) | Fiat-backed (USDC) |
|---|---|---|
| Decentralization | High — no issuer can mint or seize at will | Low — one company controls issuance |
| Censorship resistance | Strong — hard to freeze a single address | Weak — issuer can blacklist addresses |
| Transparency | Total — collateral is on-chain, auditable live | Partial — trust periodic attestations of bank reserves |
| Capital efficiency | Poor — lock USD 150+ to get USD 100 | Excellent — USD 1 in, $1 coin out |
| Exposure to collateral crashes | Yes — a crypto crash can trigger mass liquidations | No — dollars don’t crash against dollars |
| Hidden centralization | Some — the PSM leans on USDC | N/A — it is the centralized coin |
The headline tension is capital efficiency: to get 100 dollars of spendable DAI you might lock 150 or more of ETH, freezing capital you can’t otherwise use. USDC asks no such sacrifice — but it asks you to trust a company and accept that it can freeze you. Pick your poison: lock-up-your-capital-but-trust-no-one, or trust-a-company-but-keep-your-capital-free.
Sort each statement under the stablecoin it describes.
Place each item in the right group.
- Backed roughly 1:1 by dollars held at banks, so capital-efficient
- Minted by locking volatile crypto worth more than the coins created
- An issuing company can freeze or blacklist a holder's address
- Holders can be liquidated when their collateral price falls
- Peg rests on trusting periodic attestations of a company's reserves
- Stability fee and savings rate adjust supply and demand to hold the peg
Key Takeaways
What to remember
- DAI (MakerDAO / Sky, also issued as USDS) is a dollar-pegged coin with no company reserve — it’s borrowed into existence against crypto locked in a vault (CDP).
- Because crypto is volatile, DAI is over-collateralized: the collateralization ratio (collateral ÷ debt) must stay above a minimum (often ~150%). Minted DAI is debt, not free money.
- Fall below the minimum and you’re liquidated — collateral auctioned plus a penalty, automatically and without mercy. The health factor is that ratio rescaled so liquidation sits at 1.0.
- The peg is held by four forces: liquidations (full backing), the stability fee (supply lever), the DAI Savings Rate (demand lever), and the Peg Stability Module (1:1 swaps with USDC) — the last quietly importing some centralization.
- Versus USDC, DAI trades better decentralization, censorship-resistance and transparency for worse capital efficiency, exposure to crypto crashes, and PSM-borne centralization.
Lesson 3 check
What is the fundamental difference in how DAI comes into existence versus USDC?
Check your answer to continue.
Next up: stablecoins that try to ditch collateral entirely and hold their peg with pure algorithmic magic — and the death spiral that turned one of them into a $40-billion crater overnight.