Synthetic assets and derivatives rely on constantly tracking asset prices and liquidating undercollateralized investors.
If the economy is a large pie with everyone taking their own small slices of it, then decentralized finance (DeFi) and its corresponding decentralized applications (dApps) might instead be thought of as baking fresh pies. To continue the metaphor even further, if DeFi can effectively cut out the legacy financial powers currently stemming the flow of global capital, then DeFi makes more of the original pie edible to ordinary people, starving out rent-seekers carving out percentages before the pie hits the table. That is not to say that financial regulation is unwelcome, but rather to acknowledge that the status quo will be greatly tilted in favor of regular people as their ability to store and transfer wealth is enhanced by DeFi.
Therefore, innovations and opportunities in the DeFi space should be thought of not as new competitors in an old arena, but rather the founders of entirely new and modernized playing fields. While some dApps resemble traditional markets in superficial ways and are thus novel improvements, others are completely new and innovative, altering not only the tools we use, but the way we orient ourselves in the world. Readers old enough to remember the cultural zeitgeist of the 1990’s will recall that the Internet was still used in the punchlines of jokes, with ‘cool’ characters laughing at the absurdity of people spending their time online. Now, to experience the absurdity of such scenes is to witness the anachronism of life before the Internet; perhaps blockchain, DeFi, and related Web 3.0 applications are simply continuations of this trend.
“Readers old enough to remember the cultural zeitgeist of the 1990’s will recall that the Internet was still used in the punchlines of jokes, with ‘cool’ characters laughing at the absurdity of people spending their time online.”
Using blockchain technology to trade derivatives and futures may seem like a technological novelty, but looking under the hood reveals new and groundbreaking opportunities. Of course, the derivatives market may be familiar to stock traders and institutional investors, and so explanations regarding their functionality and risk profile will be left for those interested in traditional options. Rather, the purpose here will be to explore the distinguishing aspects of a specific derivatives protocol, Universal Market Access (UMA), which facilitates the minting of synthetic assets using Ethereum-based (ERC-20) tokens as depositor collateral, as well as to briefly explore the risk-profile of participating in such networks. First, let us lay the groundwork for why these markets exist, how they function, and some issues to consider before investing in these products.
To illustrate synthetic derivatives, consider the following: an investor (Jane) currently holds 5 Ethereum tokens, and wants to hold those tokens long term since she is quite bullish on the network. Jane also thinks that MicroStrategy will outperform Facebook in the coming year as their CEO piles into Bitcoin, buying up each price dip to add to their corporate balance sheet. However, Jane doesn’t have enough capital on-hand, or is struggling with cash-flow issues for whatever reason, and therefore can’t acquire Microstrategy without selling other assets in order to do so.
Therefore, she would like to expose herself to the upside that she believes MicroStrategy will experience without selling her Ethereum. Jane might seek to utilize a synthetic derivatives protocol which would allow her to use Ethereum as collateral to access tokenized Microstrategy, minted on the Ethereum blockchain with its origins being derived from the Ethereum collateral. Enter UMA, a synthetic derivatives protocol which allows users to mint synthetic tokens as smart derivatives contracts on Ethereum.
UMA Protocol Functionality & Priceless Oracles
The design of UMA is distinguished by its attempts to minimize the protocol’s reliance on oracles, and instead make use of an internal pricing system that only consults oracles in rare events, like price disputes. DeFi applications commonly make use of oracles as a means of tracking asset prices off-chain, with incoming API feeds triggering contract executions and receiving price queries. UMA, on the other hand, allows its users to actively dispute oracle prices, reducing the tail risk of oracle manipulation and stolen funds. As such, a mapping of the protocol topology is helpful in understanding its advantages and disadvantages in relation to DeFi powerhouses like Aave, Maker, Synthetic, and Compound, among others.
“Think of UMA’s DVM as a voting process which internally polices price disputes without off-chain oracles, allowing users to create, trade, and liquidate smart futures contracts using an internal pricing system.”
The UMA protocol can be best understood by dividing it into three main branches of operation: the token facility, its Data Verification Mechanism (DVM), and governance. Think of UMA’s DVM as a voting process which internally polices price disputes without off-chain oracles, allowing users to create, trade, and liquidate smart futures contracts using an internal pricing system. In addition, there are five main actors within the UMA network which carry out its operations: token sponsors, liquidators, disputers, the DVM, and UMA tokenholders. The aim is that each of these actors are economically incentivized to behave honestly and earn token rewards for veracity, while negative incentives aim to make malicious behavior uneconomic.
The first stage after signup and deposit of assets is the token facility. This is where synthetic assets are minted by users, or token sponsors, based on the value of collateral deposited on the platform. Basically, a smart derivatives contract is agreed upon in which three parameters are defined: the newly-minted synthetic asset must track an external asset price, there is an expiration date for the contract, and an overcollateralization rate is set. The minimum overcollateralization rate is 120%, meaning a token sponsor could theoretically deposit $120 of USDC and mint $100 of their chosen synthetic asset, like a synthetic Uranium ETF, for instance. Of course, this collateralization must be tracked one way or another in order to maintain the levels agreed upon in the initial contract.
Next, in order for token sponsors to trade their newly-minted synthetic assets, they must be able to track the corresponding spot price of the real-world Uranium ETF. The most common and obvious solution to this is to use price oracles, or third-party network nodes which fetch, validate, and deliver price feeds to blockchain dApps. Of course, this harms the integrity of the dApps as the oracles risk becoming single points of failure if safeguards are not put in place. Despite best efforts, DeFi protocols like UMA are still faced with ‘The Oracle Problem,’ or the risk that erroneous oracle data results in disastrously erroneous execution of smart contracts on their order books. In response to this problem, UMA opted to sidestep the use of oracles in their protocol (except in the case of disputes) and use something dubbed “priceless financial contracts” instead. To clarify, priceless here refers to this method of oracle-free price tracking.
Instead, network participants designated as liquidators, often bots, are deployed to constantly seek out and liquidate undercollateralized positions if the agreed-upon threshold levels are not maintained. Therefore, it is a sort of self-policing system in which oracles are not relied upon for price data for collateral liquidation, unless the token sponsor opts to dispute a liquidation during the 2-hour time window following a liquidation signal from liquidators. Disputers, also bots, serve to monitor those contracts set to be liquidated during the 2-hour window, and cross-reference the legitimacy of each liquidation before it takes place. In order to dispute a liquidation, they must stake a bond and make a request to the DVM to resolve the dispute. Disputers therefore use their own off-chain price references, meaning that all of this takes place without the UMA protocol referencing DVM price oracles unless arbitration is needed for disputed liquidations.
Undisputed liquidations make no requests to oracle price feeds, with the DVM handling any escalation of a dispute. Three potential dispute resolutions are shown, with rewards distributed for correctness and node participation.
A dispute may be resolved when UMA tokenholders vote and reach a consensus on the asset price proposed by the DVM, by checking it with their own off-chain sources using relevant time stamps. The Optimistic Oracle allows users to request price information; those users may then either act upon the price proposed by the oracle, or opt to dispute it and escalate the dispute to the DVM for nodes to vote. Of course, successfully disputing a liquidation earns disputers and voting tokenholders token rewards and nullifies the pending liquidation. On the other hand, unsuccessfully disputing liquidation results in penalization for the disputers and rewards for liquidators and voting tokenholders.
UMA Protocol Consensus & Governance
UMA tokenholders are granted voting rights in two exclusive domains. First, as mentioned, the DVM proposes a given asset price with time stamp, relevant to a liquidation event and the tokenholders vote on its veracity. Secondly, tokenholders may vote on protocol changes. Users vote by staking tokens on the network first and casting a vote on the veracity of smart contracts. UMA estimates the cost of corruption to the DVM voting system as being 51% of the network’s staked tokens. The primary governing principle of UMA’s protocol is to create a system of economic incentives in which the profit-from-corruption (PfC) does not outweigh the costs to attempt any corruption. If the cost of corruption outweighs the PFC, malicious actors will be disincentivized from their attacks.
Naturally, data on what exactly the PfC is, and if the balance always protects the protocol from malicious actors, is debatable. For instance, UMA lists “parasitic usage” as one of a few potential issues on their own website. That is, that PfC may not always be properly calculated, especially if users are making use of UMA contracts without being directly registered and exposed as actors within the UMA ecosystem. This likelihood is increased as the composability of DeFi assets traded on UMA makes these calculations difficult if not impossible to get precisely right. Instead, being within one to two standard deviations of the PfC calculation is more realistic. As such, users may be wantonly engaging in high-risk leverage trading with unknown and potentially devastating counterparty risks, not to mention market manipulation.
As for protocol changes, tokenholders govern using a voter dApp to make new assets available to mint and trade, remove unused or illiquid assets, and even vote to cancel smart contracts in the case of emergencies. The ‘one token, one vote’ system is applied, with a 51% consensus needed in order to approve a proposal for protocol updates or price veracity on the DVM. Voters earn an inflationary reward of 0.05% of the total token supply, distributed proportionately amongst stakers based on the amount of capital initially put forth. UMA voters are even provided monthly rebates for Ethereum’s gas fees which must be paid to write their votes on-chain. The rebate is given as a dollar-for-dollar amount, distributed monthly in UMA tokens.
UMA Risk Assessment
Though UMA’s code has been audited for security by community members at OpenZeppelin, there are a few points of concern with which investors are concerned. While the code may actually be robust enough to prevent attackers from generating profits on the protocol, the lack of price oracles and reliance on disputer bots may actually create unintended incentives. For example, without truly decentralized and robust price oracles, there is a potential for covert manipulation of asset prices by market whales outside the bounds of the protocol.
After all, if the smart contracts are written on-chain and the exchange hosts a long list of long or short orders, bots might be able to recognize imbalances and inevitably use strategic means to liquidate and then buy up assets when the opportunity presents itself. If disputer bots, for example, delay their responses to liquidation requests, the right players might have time to step in and front-run trades to manipulate the results one way or another. This might not be a malfunctioning of the protocol, and would thus take inexperienced traders by surprise and likely causing heavy losses. Properly secured and decentralized price oracles would be ideal, but as of Q4 2021 the options to choose from are insufficient.
Another potential area of concern for investors comes from UMA’s tokenomics. At its ICO, UMA only put forth 2% of the token supply for sale. With so much supply in the hands of the founding team and developers, users have expressed centralization concerns. To be fair, this is a common practice considering the network runs on a proof-of-stake consensus model, meaning to distribute tokens too generously would threaten the security of the DVM at such early stages of operation.
UMA whales keep the order books and move markets when the time is right, while users fixate on the fairness of its algorithms.
Therefore, UMA cannot truly be considered decentralized in terms of its user base, though it may be moving in that direction. In its current form, UMA relies on an economic incentive system to foster honest behavior on the protocol in order to collect passive income via UMA tokens. To be able to mint synthetic assets using Ethereum has truly amazing potential, and Universal Market Access should be commended for bringing synthetic crypto assets to the retail market. Finally, the notion of priceless oracles is indeed terribly clever, but the market will likely favor more robust and decentralized price oracles once they are made available.
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