Robert has reported for a variety of international publications including the Associated Press, The Guardian, Vice, and Decrypt. Current areas of interest include the political economy of technology, cryptocurrencies, and privacy. Robert has a Bachelor of Science from UCL, and a Master's degree from the University of Oxford's Internet Institute.
Derivatives are financial instruments that derive their value from the worth of some underlying asset. Think of derivatives like trades on top of trades; speculation about speculation. They come in many different forms, the most well-known being options and futures contracts. The global market for derivatives is worth anywhere between $500 trillion and up to over a quadrillion dollars, yet these financial markets are traditionally not very inclusive.
Usually, only institutional investors—rich people from large companies—can trade derivatives, since doing so requires investors to open brokerage accounts, have buckets of money, and a great tolerance for risk. And to make the most of derivatives, investors then need to stake a lot more money to maintain these complicated, risky and potentially lucrative positions. If markets are against the investor there could be legal repercussions as well as huge losses. It’s all very daunting.
The range of derivatives contracts that trade on public markets is pretty limited. Investors can easily place simple trades, like buy and sell trades, and maybe some futures and options contracts here and there, but they’ll have a harder time finding more bespoke derivative contracts. That’s much to the annoyance of anyone shut out of the system who wants to participate in the wild world of high finance.Buy and sell Bitcoin and Ethereum instantly with Wealthsimple. Sign up to trade here.
Enter Universal Market Access, a decentralized financial contracts platform built on the Ethereum blockchain that seeks to give every trader—yes, even you—the means to enter these complicated financial agreements and create wild ones of your own. Universal Market Access, better known as UMA, operates on a peer-to-peer basis, bypassing the need for brokers, clearing houses, or legal aid.
UMA creates synthetic derivatives on the Ethereum blockchain by drafting self-enforcing smart contracts. These smart contracts are governed purely by code and clever decentralized verification mechanisms. Thanks to UMA, two counterparties can create their own financial contracts without the need to scale mountains of bureaucracy. All of this works through cryptocurrency, of course, and is therefore unregulated and risky by virtue of its novelty. UMA only launched in May, 2020. But the promise of UMA is to upend the existing financial infrastructure and open up derivatives trading to everyone brave enough to attempt it.
Synthetic Derivatives: As good as the real thing?
Synthetic derivatives on blockchain didn’t start with UMA, but UMA’s protocol is a very smart way of realising them. Synthetic derivatives are collateral-backed assets that track the price of a real asset. For example, you could have a synthetic token representing the price of gold, or a share in Elon Musk’s car company Tesla. These are the most common kinds of derivatives contracts that you’ll find on UMA.
Thanks to UMA’s self-enforcing smart contracts and its data verification mechanism, the protocol allows for a staggering amount of contracts to be entered into. The more creative applications track non-tradable indices, like the number of downloads of a certain Chrome extension, for instance.
Price feeds for more exotic, less in-demand assets like rare currencies, commodities, stocks and altcoins are not tracked by conventional off-chain oracles, but UMA’s DVM allows developers to structure derivatives contracts to anything they can track, from tokenized yield curves to the total value locked in retirement and insurance plans.
The most common type of synthetic UMA token is “priceless,” which means that it doesn’t depend on on-chain price feeds to make sure its counterparties collateralize on their positions. Instead, it creates an open transparent environment where UMA users help to identify under-collateralized positions.
How does UMA work?
Each UMA derivatives contract has five components: a public address for each counterparty, margin accounts for each counterparty, economic terms to calculate value, smart contract functions that maintain the counterparties’ margin balances, and an oracle to provide secure and verified off-chain information. Through these five components, UMA contracts enforce themselves in a trustless and secure manner. That means that they can be automated without the need for a centralized authority, like an investment bank (to structure the trade) or a clearing house (to settle the score).
Should two counterparties enter into a self-enforcing UMA contract, they will both have to deposit a margin into the smart contract. The margin is the money that the counterparty borrows to place a trade. Said counterparty also agrees to pay a default penalty; this disincentive mechanism stops them from defaulting on margin requirements should their position fall below a minimum level. While margin and prices are denoted in US dollars, money gained from UMA smart contracts is paid and stored in Ethereum.
The network uses an inbuilt liquidation mechanism to ensure that counterparties always have enough money to back their positions. The homebrew method has a benefit: UMA contracts don’t cost anything.
More than that, the network pays people to use it. Similar to how Bitcoin rewards miners for verifying transactions in Bitcoin, the UMA network pays out UMA tokens to members of the network who can identify under-collateralized positions. This, theoretically, resolves disputes about pricing or data information before they occur (like about, say, the number of Chrome downloads or the price of Bitcoin at a certain time), allowing people to place synthetic derivatives trades safely.
To do this, UMA has its own DVM, or Data Verification Mechanism. The DVM responds to price requests made by registered financial contracts. When a price request is made, UMA token holders can vote with their UMA tokens on the value of the price of the contract’s underlying asset at a given time. Each staked token accounts for one vote. The decentralized DVM takes 2-4 days to settle. Once votes are collected, the mode of the prices voted on is calculated and the value is used to settle the contract. The contract then distributes the money to counterparties according to the result of the vote.
The strength of UMA’s DVM oracle design is that it is designed to ensure that the cost of manipulating the oracle is always larger than the amount of money that someone could profit by breaking the system; you’d have to hold 51% of the UMA voting tokens to trick the DVM, meaning that it’s always unprofitable. In order to make sure that the inequality holds, the DVM must ensure the UMA token is above a certain price. This is done by charging users fees and burning some of the outstanding supply.
What is a UMA token?
UMA’s native utility token (the in-house token that users can earn and trade in the protocol) is an ERC-20, which means that it is built on the Ethereum blockchain using a common set of smart contract standards. There is a total supply of 100 million UMA tokens. It had an Initial Listing on the popular decentralized exchange, Uniswap, on April 29, 2020, selling two million tokens (2% of the supply) at 26 cents per token. Of the remaining tokens, 48.5% were reserved for UMA’s founders, early contributors, and investors while 35% are shared by the users and developers. Some 14,500,000 are reserved for future token sales, amounting to 14.5% of the total supply.
You can trade UMA’s token on cryptocurrency exchanges such as Binance and Coinbase, or store it in hardware or software wallets. But you can also do other things with the token.
The UMA token can be redeemed within the UMA ecosystem, where it has three main functions. The first is governance. Token holders are asked to participate in votes on proposed improvements to the protocol. As with the DVM, one token equates to one vote, and voters are rewarded with 0.05% of the total network supply distributed proportionally according to the number of tokens staked. This is the rate of protocol inflation, and it means that the total supply of UMA increases every year, albeit at a nominal rate compared to other cryptocurrencies.
The second function is to incentivise users to verify price requests on the protocol’s DVM. Owners of UMA tokens are periodically asked to vote on price requests from financial contracts. There are two rounds for these votes. The first is the commit period, where users encrypt and commit their vote. In round two, users decrypt and reveal their vote. Each round is open for 24 hours. At the end of the reveal round, voters get their protocol-generated inflation reward.
The final use of the UMA token is to pay the protocol’s fees. Fees are charged to burn the supply of UMA and increase its price. This is an inherent part of the DVM’s design, since burning the supply makes sure that the cost of corrupting the oracle is always greater than the profits that could be gained from corrupting it.
The exact amount that is charged in fees increases in proportion to how much money is locked inside UMA contracts. As more contracts bring more funds into the protocol, the price of UMA will rise in order to secure the DVM. This is all done with increasing fee burns to decrease the supply. The price pressure coming from the burns vastly outstrips the protocol’s built-in inflation.
UMA has given blockchain traders an impressively versatile set of tools for structuring and entering into financial contracts, while at the same time providing them with a secure and thorough oracle system. Through the use of economic incentives, UMA provides a framework for users to enter into decentralized, secure, and trustless financial contracts on any underlying asset. UMA’s protocol is a transparent and self-enforcing way to trade synthetic derivatives without the need for brokers or bureaucracy.
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