Crypto

UMA: The Blockchain Evolution of Financial Derivatives

What Is UMA? Crypto Derivatives on Ethereum

UMA stands for Universal Market Access. The Ethereum-based protocol allows anyone in the world to access and create tokenized financial derivatives with self-executing agreements. Financial derivatives are a huge part of global financial markets, and are used to trade against quantifiable traits of an asset rather than the asset itself. The most common type of derivative is a futures contract (or future), which is an agreement to trade the price of a commodity — crude oil, gold, or soy beans, for example — on a set date. Financial derivatives are useful for hedging for or against risk, diversifying portfolios, and creating deeper, more mature financial markets — all without any goods or equity ever actually being exchanged.

However, the remarkable flexibility of derivatives as a financial instrument is not always a good thing. The global financial crash of 2008 was triggered when a bubble of securities representing huge bundles of risky subprime mortgages popped. Although the effects of derivative trading were felt by people around the world, access to traditional derivative markets remains limited to banks, hedge funds, and institutions. UMA opens access to these powerful financial tools for anyone using Ethereum, while addressing key problems with traditional derivatives.

UMA’s application of tokenization to derivatives dramatically increases the scope of assets that can be traded upon. Further, the transparency afforded by blockchain’s shared ledgers offers unprecedented insight into potentially risky market trends. The automation made possible by Ethereum smart contracts makes debt defaults and non-payments virtually non-existent. The value proposition for a blockchain update for derivatives markets is very high, and UMA is emerging as a leader in the sector alongside projects like Synthetix.

What Are Financial Derivatives?

Simply stated: Financial derivatives are contracts that can be bought and sold and have set terms on a future price of a particular metric of an asset. The most common type of derivative is a futures contract, an agreement to pay a certain price for a certain asset at a certain date. Let’s walk through an example of a futures contract for the price of bitcoin (BTC).

Keep in mind that derivatives contracts do not involve the actual exchange of assets, but are trades made against a metric — in this basic instance, market price. A futures contract can be an agreement to sell 1 BTC for $10,000 one year from now. If the price of BTC is $20,000 one year from now, the futures contract creator would be obligated to sell you BTC at $10,000 — or half the market price. If BTC is worth $5,000 one year from now, the contract creator could sell the futures contract for double its market value. Over the course of the contract, the market price of the derivative contract fluctuates on the expected outcome of the trade.

Financial derivatives represent a huge chunk of global financial market activity, in large part because they can be traded for a huge array of assets and markets like metal, grain, oil, currencies, stock prices, and animal stock. Anything with a trait that can be assigned a price can be traded on a derivatives market. However, the market remains largely inaccessible to the general public.

In the traditional financial world, investment banks charge high fees to create and enforce derivatives contracts. Those who engage in derivatives trading are limited to hedge funds, commercial banks, and other institutional players. Many derivatives are privately held agreements between two parties — the opaque nature of which is one reason for the $500-trillion gap in the estimated total market valuation.

UMA is building the infrastructure to bring trillions upon trillions in value from a highly permissioned, opaque, and closed market to a completely permissionless, transparent, and open financial system on Ethereum. If it succeeds, the ability to create powerful financial contracts will be available to anyone with an internet connection and holdings in ether (ETH). More importantly, blockchain-integrated crypto derivatives can offer a more transparent, equitable, and open global financial system.

Universal Market Access

UMA is a platform for creating crypto derivatives that operate like traditional derivatives, and which are native to Ethereum. Without needing to go through a broker, creating a futures contract for the price of gold becomes as simple as buying or minting an ERC-20 asset called a synthetic token. These tokens can be traded on DEXs and utilized around the decentralized finance (DeFi) ecosystem.

In a derivatives contract, there are two parties, and both parties must commit to settling payment if they end up on the losing side of the contract. As a smart contract platform, Ethereum automatically enforces the agreement, removing a need for legal enforcement.

Like most lending and borrowing on DeFi currently, UMA ensures trading viability through overcollateralization. Assets must be deposited as collateral in order to create a new synthetic token. Once a new synthetic token is created, other users can supply collateral to mint more of the same token using the same contract. Token minters — called token sponsors on UMA — must always keep their collateral above a certain value to avoid liquidation.

Creating a new synthetic token requires not only collateral, but also a price identifier, which is a price determination process agreed on by UMA token holders. Without a price identifier, there is no way for the UMA system to verify the price of a synthetic token.

If you want to become a token sponsor and create a synthetic gold token using UMA with an already available gold price identifier, you would need to take the following steps:

  • Supply collateral to UMA in the form of DAI, ETH, or another approved collateral asset

  • Set an expiration date for the contract (e.g., one year from today)

  • Mint gold tokens with an expiration date of one year from today

  • Deposit the gold tokens into an automated market maker (AMM) like Uniswap so they can be bought and sold by others

  • During the life of the token, keep the collateral value above the minimum requirement to avoid being liquidated

At the close of the contract period, the tokens become forever redeemable for the price of gold on that day. This means that you can always trade that gold token for the DAI or ETH collateral used to create it. Sell the token for more than its market value prior to contract expiration, and you have profited; selling it for a lower price results in a loss.

While gold prices are a good example of what synthetic tokens can represent, the possibilities are unbounded. A derivatives contract representing any metric of any asset can feasibly be tokenized, as long as it has a large and healthy-enough market to reach fair consensus on its market value. The way most blockchain projects approach this is with an oracle, software that acts as an intermediary to translate data from the real world to smart contracts on the blockchain, and back again.

UMA is building what is referred to as priceless contract infrastructure. Priceless contracts operate with the rule that prices only need to come on-chain if there is a dispute. This method effectively removes oracles from the equation unless there is a dispute about the outcome of the agreement, in theory opening up derivatives to non-traditional asset classes.

According to UMA, synthetic tokens and priceless contracts are just the first proof of concept for a much broader infrastructure. Already, UMA has made great strides in the ambitious task of evolving financial markets and enabling blockchain derivatives trading. As the infrastructure of interconnected decentralized finance platforms continues to grow at pace, blockchain technology is poised to present a radically improved, streamlined, and more equitable framework for financial markets.

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