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DeFi Decrypted: Universal Market Access and $UMA

DeFi Decrypted: Universal Market Access and $UMA

Explainers DeFi

23 Oct 2020

Fairly new to the DeFi game, the Universal Market Access (UMA) project is set to take decentralized finance to the next level. Borrowing concepts from fiat financial derivatives, the protocol is designed to power financial innovation made possible by permissionless blockchains like Ethereum. UMA is an open-source protocol that essentially allows any two counterparties to create their own financial contracts and synthetic assets, secured strictly with economic incentives making them self-enforcing.

In traditional finance, financial contracts are enforced through 2 mechanisms: collateral posted by counterparties and legal recourse if one of the parties fails to uphold their end of the deal.

Getting legal assistance is an expensive way of enforcing a contract and therefore that is mostly available to bigger players. Decentralized, permissionless systems allow anyone to engage in financial contracts as it is the contract itself that enforces the agreement once certain conditions are met. That means with UMA, and DeFi generally speaking, the only thing required is collateral.

How does UMA work?

UMA contracts consist of the following components:

  • An oracle to provide verified data
  • Economic terms to calculate the value of the contract
  • Public addresses for all counterparties
  • Margin accounts for all counterparties
  • Function to maintain margin balances

With all these mechanisms in place, we can walk through a use case example as outlined on UMA’s website. Alice believes the price of UNI will go down over the next six months. Bob thinks UNI is cheap and wants to go long. They formalize their trade using an UMA contract and each deposit a margin requirement of 10% that will be lost if they misbehave.

Over the next months, the price of UNI swings up and down but overall it slowly goes further down as verified by the oracle. As the price drops further, Bob automatically contributes additional funds to cover his margin requirement. The more UNI drops, the more Bob deposits automatically.

After 6 months, the price of UNI has fallen by 40% meaning Alice was right. As Bob kept contributing funds to re-margin his position in order to protect his initial 10% margin requirement, the contract can be settled instantly. At any point, if Bob would have failed to rebalance the margin requirement, and his collateral would fall below the minimum requirement, Bob would be subject to pay the default penalty.

The importance of Oracles

Arguably one of the most important components of the example above is the oracle. Self-enforcing contracts require an oracle trusted by everyone involved in the contract for real-time valuations and settlements. Without secure oracles, many DeFi systems would collapse as collateralized positions fail with the loss of stable and reliable data-feeds.

ChainLink and Band Protocol have addressed this issue through decentralized oracles as that design mitigates the risk of a central point of failure. But the UMA team is taking it a step further. They believe that any oracle on a public blockchain “can be bribed”, in the sense that anyone would be incentivized to manipulate the oracle for their own financial benefit. Instead, UMA has created an oracle system where the cost of corrupting it far exceeds the potential profit of doing so. Taking out the financial incentive greatly reduces the appetite of bad actors to corrupt oracles.

Trustless tokenization

By combining self-enforcing contracts and provably honest oracles UMA allows users to tokenize the price of anything in a decentralized and permissionless manger. Global investors are now able to gain exposure to any type of asset in existence by digitizing and automating any real-world financial derivatives.

As UMA mostly targets developers who have their own customers, the idea is that UMA sets off an entirely new wave of creativity as product innovators figure out new and interesting ways to use the application – tokenizing assets no one else has even thought of yet. In an article, UMA did throw up a few ideas as what could be tokenized including equities, cryptocurrency dominance, DeFi total value locked, DEX market share, tokenized yield curves and even private pension plans.

The role of $UMA

The $UMA token, is the native governance token which grants holders the ability to vote on protocol decisions and challenge reference indexes. In order to incentivize voter participation, every time a voting process takes place on the network, an inflationary reward equal to 0.05% of the current $UMA supply is distributed among active voters proportionate to their current stake. The total supply of $UMA is a little over 100 million tokens, of which about 55 million are in circulation as of October 2020.

The token made waves when it was made available to the public through an Initial Uniswap Listing – the firs of its kind for any major DeFi token. With a 450K market cap, $UMA currently ranks 6th in the DeFi sector trailing just behind MKR and UNI. Like all other DeFi tokens, it saw massive hikes in the summer of 2020 reaching its all time high of $27.63, up 2282% from $1.16 when trading began. Today, $UMA has retreated down to the $5 to $9 range.

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