DAI is simply explained as a stablecoin (stable cryptocurrency) that has collateral in cryptocurrency, and which aims to maintain a stable 1:1 value against the US dollar.
What do you mean by collateral?
DAI's value is “secured” by having monetary values stored so that these can “back up” the DAI value. If you have 1 DAI in your crypto wallet, this value is represented by keeping values equivalent to 1 USD stored at Maker DAO. In theory, you should be able to exchange your DAI for values corresponding to the same amount. This is how you know that DAI is not just "fantasy money" that is created out of thin air.
Underlying security is required to maintain the value of the DAI pegged to the US dollar, and Ethereum (ETH) and a number of other Ethereum-based cryptocurrencies are used as collateral.
The smart contracts on which DAI is built belong to the Maker Protocol, which in practice is a decentralized protocol and application on the Ethereum blockchain. All DAIs are generated from a tool called Market Vaults:
- The user deposits ETH or another supported cryptocurrency as security.
- DAI is then generated
- DAI is paid out to the user in the form of a loan
- The user can give the same amount of DAI back and pay a small fee and get back their security.
To make this more understandable, you can compare it with taking out a loan from the bank, and in that context using your own home as security for the loan (so that you can prove that you can repay).
DAI is thus lent against a selection of Ethereum-based cryptocurrencies. When users receive DAI in exchange for Ethereum (ETH), one can use DAI in exactly the same way as other cryptocurrencies.
How to secure against people not repaying loans from DAI?
When you borrow DAI, you must provide at least 150% of the value as security. You thus unlock more money in security than the value of the loan. If the security falls below 150%, the security deposited is forcibly sold (liquidated) and the borrower is also deducted a small fee. As volatility is high in cryptocurrencies, there is a danger of being liquidated if such a high safety margin is not used.
If you want 100 DAI, which is equivalent to the value of 100 US dollars, you must deposit Ethereum worth at least 150 US dollars in Maker Protocol's smart contract. Should the $ 150 in Ethereum fall in value to, for example, $ 149 in Ethereum, the smart contracts in Maker Protocol will automatically sell the Ethereum that was used as collateral. In this way, the protocol ensures that the value you deposit as collateral will never be lower than the amount you borrow. It is therefore wise to have an extra margin to go on.