Ah, Dream demons are basically born from...well the leftovers from our dreams. They live in the dream world, separate but still connected to the awaken world through dreams.

Normally we can't really interact with one another but...um, [This part was a little vague. Yumeji and Merry knew this detail better than her.] There's a gate between the worlds that's now open, so dream demons can cross over to our world. It's how I met Engi.