Financial contracts and other synthetic assets such as derivatives serve as a vital backbone to the incumbent financial system. It is estimated that over $540 trillion in financial derivatives are currently outstanding, making the derivatives market the largest financial market in the world by a wide margin.
With the rise of DeFi and the ethos of open and permissionless finance, it should come as no doubt that derivatives and other synthetic assets will play an important role in its impending adoption. Generally speaking, derivatives touch a very broad range of unique investment vehicles. In a crypto-focused lense, synthetic assets could allow individuals in developing countries to invest in US stocks, allow crypto investors to short a basket of altcoins, or even bet on Bitcoin’s market dominance in the future. The potential is endless.
With that being said, it is crucial that a robust protocol establishes itself in order to securely tokenize the hundreds of trillions of dollars in derivatives and other potential assets we’ve yet to consider.
Introducing UMA Protocol (Universal Market Access)
UMA Protocol is a decentralized protocol creating globally accessible financial markets on Ethereum. In other words, UMA establishes a generalized framework for creating synthetic assets on Ethereum. They accomplish this through two core components:
- A Framework for Self-Enforcing Financial Contracts
- Secure Oracles with Economic Guarantees
While this seems fairly complicated, we’ll attempt to break down these two core components in a simple manner along with outlining some potential applications with UMA.
A Framework for Self-Enforcing Financial Contracts
In traditional finance, derivatives and other financial contracts are largely enforced through two mechanisms: (1) margin, where counterparties post collateral as the value of the contract changes and (2) legal recourse, where one of the counterparties can sue if the other fails to uphold their contractual agreement.
In decentralized, permissionless systems like Ethereum and other blockchain networks, legal recourse is fairly difficult as most users are pseudo-anonymous and the network operates on a global scale. Moreover, legal recourse can be very capital intensive, making it only accessible to large players. Fortunately, Ethereum smart contracts and UMA’s framework create a trustless, permissionless mechanism that secures the contract by economic incentives alone. This is highly important as the barriers-to-entry are reduced significantly by eliminating legal recourse as an enforceable action and the ability to solely rely on margin to enforce the contracts.
With all of this in mind, UMA defines an open-source protocol that allows any two counterparties to design and create their own financial contracts.
Each UMA contract consists of five components:
- Public addresses of all counterparties
- Margin accounts for each counterparty
- Economic terms to calculate the value of the contract
- Functions to maintain margin balances
- An oracle to act as a verified data source
As outlined on their website, we’ll take an example with two of the most famous crypto users: Alice and Bob.
Alice and Bob are betting on the price of Bitcoin in the next 12 months. Bob believes the price of Bitcoin will go down whereas Alice, knowing the effect of the Bitcoin halving in May, believes it will go up in the next 12 months.
Bob and Alice will formalize their trade using UMA’s self-enforcing financial contracts. Both sides agree to set the minimum margin requirement at 10% with a default penalty of 5%. With this, they deposit their respective amounts into the contract. It’s important to note that the price of Bitcoin, margin requirements and default penalty are all denoted in USD while all margin is paid and stored in ETH equivalents (more on this later).
Over the next 12 months, the price of Bitcoin increases so Bob will automatically contribute more ETH to cover his margin requirement in order to avoid the penalty. The more the price increases, the more Bob has to contribute (and vice versa). After 12 months, the price of Bitcoin has increased by 50% and Alice was correct. Since Bob was automatically contributing funds to cover the margin as the price of the contract changed, the transaction can be settled instantly and Alice will receive her earnings.
In the case that Bob failed to rebalance the margin requirement at any point in the contract, and his collateral fell below the minimum requirement, Bob would be subject to pay the default penalty.
Secure Oracles with Economic Guarantees
With UMA’s self-enforcing financial contracts, contracts require a trusted oracle for real-time valuations, settlements, and dispute resolution. The oracle problem is one of the major challenges imposing the success of DeFi. Without secure oracles providing stable data-feeds, many DeFi systems in existence today would collapse as collateralized positions would fail. Many projects today, such as ChainLink or Band Protocol, are attempting to solve this issue through decentralized oracles as it mitigates the risks of a central point of failure.
With this in mind, in tandem with developing trustless financial contracts, the UMA team created a decentralized “provably honest” oracle design. One of the major assumptions UMA made when designing their oracle was that “any oracle on a public blockchain can be bribed”. In other words, anyone has an incentive to manipulate the oracle for their own financial benefit.
Therefore, UMA created an oracle system where the cost of manipulating the oracle (Cost of Corrupting) is always greater than the profit that could be earned by corrupting the oracle (Profit from Corrupting). By leveraging game theory where the Cost of Corrupting (CoC) is always greater than the Profit from Corrupting (PfC), you can eliminate any financial incentive to corrupt the system and deeply mitigate security risks.
If you’re looking for more technical and lower-level details surrounding the design choices and mechanisms with the financial contracts and the oracle system, the research in UMA’s whitepapers do a phenomenal job.
The Potential of UMA’s Trustless Tokenization
1/ How @UMAprotocol enables "Trustless Tokenization", aka how to create an ERC20 token for synthetic crypto or *real-world* asset exposure in ETF-like format. Mechanics below for creation, re-margining, and redemption (or default): pic.twitter.com/FZYpUV3DTt— Hart Lambur (@hal2001) December 6, 2018
With the combination of self-enforcing contracts and a provably honest decentralized oracle design, UMA essentially allows you to tokenize the price of anything in a permissionless and open fashion. With this, global investors can now gain exposure to any asset in existence. Even better, UMA allows for financial product innovators to use their creativity and tokenize assets that have even yet to ever been conceived in traditional finance. Some conceptualized applications for UMA include:
- US & Global Equities
- Long & Short on Altcoins
- Bitcoin or Ethereum Dominance
- Perpetual Swaps
- Tokenized Yield Curves
- Decentralized Crypto Futures
- Decentralized Private Pension Plans
- Decentralized Insurance and Annuity Products
- DAO Governed Hedge Funds and Endowments
While investors have exposure to the asset, it is important to understand those holders do not actually hold the asset itself. As an example, an individual in Malaysia who purchases a tokenized version of Apple’s stock through UMA does not actually hold any Apple stock, they simply have exposure to the price of Apple stock.
By establishing this protocol for global and permissionless access to financial contracts, UMA presents a massive opportunity for DeFi to expand its reach across the globe. One of the major benefits of UMA over existing competitors, like Synthetix, is leveraging existing assets like ETH and DAI to collateralize financial contracts rather than obscure utility tokens like SNX.
The future for decentralized and open finance is promising. With UMA Protocol, it will be interesting to see what unique and game-changing DeFi-native financial products are created in the coming years. In the next article, we’ll take a deep dive into a recent whitepaper from UMA outlining the specifications for BitDEX, a decentralized and permissionless version of BitMEX.
If you’re interested in learning more about DeFi and staying on top of any news, be sure to stay tuned to DeFi Rate.
Director at Fitzner Blockchain Consulting. Lucas also has experience working with multiple blockchain-based startups as head of community, blockchain strategist and project manager where he focused on token economics, writing, and marketing.