How does a crypto-backed stablecoin like DAI stay near one dollar?

Locking crypto to mint dollars

A crypto-backed stablecoin has no company holding cash. Instead, users lock crypto in smart contracts and mint stablecoins against it.¹ One example is DAI, created by MakerDAO.³ Its white paper calls DAI a decentralised, collateral-backed cryptocurrency, soft-pegged to the US dollar.³

Users mint DAI by depositing collateral, such as ether, into a smart contract called a vault.^3,2 Collateral means the assets locked up as security for the stablecoins minted against them.³

Crypto prices swing a lot, so these stablecoins are usually over-collateralised: the locked crypto is worth more than the stablecoins minted.¹ A Fed note gives an example: $150 worth of ether locked for 100 DAI.²

In 2024 MakerDAO renamed itself Sky and launched a new stablecoin, USDS, which works in a similar way.³

The liquidation ratio

The white paper defines the liquidation ratio as the collateral-to-debt ratio at which a vault can be liquidated.³ Each type of collateral has its own ratio, set by the protocol's governance vote.³ The white paper names MKR holders as the voters; since May 2025 the vote has used Sky's SKY token instead.^4,5

Two sums tell you where a vault stands. The first is its collateral ratio: collateral value ÷ stablecoin debt.³ The second is what we call its liquidation price: the price at which that ratio falls to the liquidation ratio. That term and the sum are ours, not the white paper's.

Here is a worked example, with our own numbers. A vault locks 5 ether at $3,000 each, worth $15,000, and mints 10,000 stablecoins. Its collateral ratio is $15,000 ÷ 10,000 = 150%.³ If its liquidation ratio is 130%, it can be liquidated once its ether is worth less than $13,000, which is an ether price of $2,600.³

Vault owners also pay a stability fee, a yearly charge on the debt. To get their collateral back, they must repay the stablecoins plus the fee.³

What a liquidation does

Keepers, which are people or automated bots, watch for vaults below the liquidation ratio and start an auction of the collateral.³ Bidders pay DAI for the collateral, and the DAI repays the vault's debt plus a liquidation penalty.³ Any collateral left over goes back to the vault owner.³

Sky's documentation shows the penalty at work. With a debt of 1,000 DAI and a 13% penalty, the auction aims to raise at most 1,130 DAI.⁶

If an auction raises too little, the shortfall becomes debt of the protocol itself.³ So the system depends on liquidations keeping up with falling prices.³ An auction's opening price is set from a price feed that runs one to two hours behind the market.⁶

The risks

• Falling collateral. Fed staff say crypto-backed stablecoins add a weakness: the collateral itself can swing sharply in dollar terms, so runs may be more frequent and severe.¹
• Leverage. Some users borrow stablecoins to buy more crypto. Fed staff say that can make a run worse, as losses force more selling.¹
• Links to other stablecoins. DAI's Peg Stability Module lets users swap USDC for the same number of DAI.^2,7 That ties DAI to USDC. In March 2023, when USDC lost its peg, DAI fell in a very similar pattern.²