How do MakerDAO and DAI stablecoin work?

Okay, no problem! Let's talk about how MakerDAO and DAI work in plain, simple terms. You can imagine the entire system as a decentralized pawn shop.

What Exactly Are DAI and MakerDAO?

DAI: You can think of it as the digital dollar of the crypto world. Its goal is to always be worth approximately 1 US dollar. However, its biggest difference from common stablecoins like USDT and USDC is that there isn't a single company (like Tether or Circle) holding actual USD in a bank account to back it. DAI's value is collateralized by crypto assets (like Ethereum ETH), operates entirely on the blockchain, and is completely transparent.
MakerDAO: This is what we just called the "de-cen-tral-ized pawn shop." It's an organization, a system of smart contracts, responsible for managing and issuing DAI. You can see it as DAI's central bank, but this bank has no governor, no board of directors. All rules and decisions are collectively voted upon by those who hold its governance token, MKR.

How Is DAI Created? (Collateralized Lending)

Imagine you need cash, but all you have is a treasured family heirloom (like your ETH). You don't want to sell it because you believe its value will increase in the future. What do you do? Go to a pawn shop!

In MakerDAO, this "digital pawn shop," the process is as follows:

Pawn your "heirloom" (collateralize assets): You lock your ETH into a smart contract in MakerDAO called a "Vault." This is like handing your gold watch to the pawn shop owner.
Get your "pawn ticket" money (generate DAI): Based on the value of your collateralized ETH, you can borrow a certain amount of DAI. Here's the key: you can't borrow 1:1. For example, if your ETH is worth $1500, the system might only allow you to borrow a maximum of 1000 DAI (which is $1000). This ratio is called the collateralization ratio (here, 150%). You must overcollateralize to prevent the borrowed funds from becoming unrecoverable if your collateral's value drops.
Redeem your "heirloom": Any time in the future, as long as you return the 1000 DAI you borrowed, plus a small fee (called the stability fee), you can retrieve all the ETH you initially collateralized.

This process "creates" new DAI out of thin air. Every DAI in circulation worldwide is backed by overcollateralized crypto assets locked in Vaults like this.

How Does DAI Maintain Its 1:1 Peg to the Dollar?

This is arguably the most ingenious part of the entire system, relying entirely on the market and human nature (arbitrage).

When DAI price > $1 (e.g., selling at $1.01)
- Arbitrage Opportunity: Smart people will realize, "I can use ETH worth $150 to generate 100 DAI in the MakerDAO system (costing me $100), then immediately sell it on the market for $1.01 per DAI, getting $101. I just made $1 out of thin air!"
- Market Impact: When a large number of people do this, the supply of DAI on the market significantly increases. According to supply and demand, the price will naturally be "pushed down" back to $1.
When DAI price < $1 (e.g., selling at $0.99)
- Arbitrage Opportunity: People who previously borrowed DAI by collateralizing ETH will be happy. For example, if they borrowed 100 DAI, they now only need to spend $99 to buy 100 DAI from the market, return it to the system, and get their ETH back. This is like getting a 1% discount on their debt.
- Market Impact: As many people buy DAI from the market to repay their debts, the demand for DAI significantly increases. The price will naturally be "bought up" back to $1.

Through this transparent incentive mechanism, the market spontaneously stabilizes DAI's price around $1.

What If My Collateral's Price Crashes? (Liquidation Mechanism)

This is a very important question and the system's safety net. Remember the 150% collateralization ratio we talked about?

For example, you borrowed 1000 DAI using ETH worth $1500. The system sets a liquidation threshold, for instance, if your ETH value drops to only $1200, your collateral becomes at risk.

Once this threshold is hit, the system initiates a liquidation process:

Your Vault will be seized.
The system will auction off your collateralized ETH on the open market, selling enough to cover the 1000 DAI you owe plus a liquidation penalty.
If there's any remaining ETH, it will be returned to you.

While this mechanism can be harsh for those who get liquidated, it ensures that every circulating DAI is always backed by assets of sufficient value, thereby protecting the stability of the entire system and the interests of all DAI holders.

What Role Does the MKR Token Play? (Governance)

If MakerDAO is the "digital pawn shop," then MKR token holders are the shareholders and board members of this pawn shop.

They have voting power and can decide all important rules of the pawn shop, such as:

Which assets are accepted as collateral? (e.g., besides ETH, can WBTC be used?)
What should the collateralization ratio be for different assets? (Higher risk assets require higher collateralization ratios)
What should the stability fee (interest) be? (Adjusting the fee indirectly controls DAI supply and demand)
What should the liquidation penalty be?

MKR holders manage the risks of the entire system through voting, ensuring its long-term healthy operation. Simultaneously, a portion of the system's earned stability fees and other revenues are used to buy back and burn MKR, which is equivalent to distributing dividends to "shareholders."

In Summary

💡 DAI is a decentralized stablecoin, like the digital dollar.

💰 It is created by overcollateralizing crypto assets (like ETH) and borrowing them from the MakerDAO system.

⚖️ Its price stability relies on an ingenious market arbitrage mechanism that incentivizes people to pull its price back to $1 when it deviates.

🏛️ MakerDAO is the decentralized organization that manages all of this, and MKR token holders are the managers and decision-makers of this organization.

I hope this explanation gives you a clear understanding of MakerDAO and DAI! It's truly a very foundational and classic project in the world of decentralized finance (DeFi).