The present financial system is supported by the availability of derivatives and other kinds of synthetic assets, and of course, financial contracts are not left out. The financial derivatives market is currently leading the others as it can boast of more than $540 trillion.
As DeFi becomes more popular together with the unrestricted way of doing things, it won’t be a surprise if the availability of derivatives and its likes pushes people to enter the DeFi space.
Not long ago, another protocol known as UMA came on board. It is gaining a lot of followers because its synthetic assets require no permission to create.
About UMA Protocol
The full meaning of UMA is Universal Market Access. It uses Ethereum to form financial assets that are accepted and easy to get by anyone in the world. Its aim is to make out synthetic assets using Ethereum through the following means:
- Creating a structure for creating financial contracts quickly.
- Use of oracles to be sure of economic gains.
These may not look so clear but as you keep reading this review, your understanding about how UMA works and how useful the protocol is will be more appreciated.
Creating a structure for creating financial contracts
In the conventional financial system, people get to use financial contracts in two ways: 1) the use of collateral to make adjustments to the fluctuations in contracts. This is otherwise called margin. 2) Filing a case in court if a buyer or seller feels there is a breach in a signed contract.
When Ethereum and other decentralized networks requiring no KYC are involved, it is difficult to succeed in taking the other party to court because you cannot really say where the person lives. Apart from that, the process involved in filing a case requires so much money that only rich individuals or establishments can succeed in it. The good news is that UMA and Ethereum smart contracts built their decentralized system in such a way that parties are encouraged to participate only because of the incentives they see. This is necessary because it takes away the need to depend on the court to fight the other party who has broken the terms of a contract but instead upholds the use of margin as the ultimate weapon to make contracts succeed.
Bearing all these in mind, UMA saw the need to create a protocol that is open-sourced where buyers and sellers can choose the kind of financial contracts they want.
There are five major attributes of a UMA contract:
- Where the buyers and sellers can be located
- Margin accounts for the buyer and seller
- A formula for deriving what each contract holds
- Methods to keep margin balances in check
- Oracle to serve as reference/guide
Let’s now use a typical example as shown on their website to illustrate how things happen at UMA. There is going to be a transaction between Alice and Bob.
Alice and Bob are predicting on the outcome of Bitcoin’s price one year from now. As for Bob, Bitcoin’s price will fall while Alice believes the contrary will happen based on the fact that there was Bitcoin halving in May.
The two parties will create the financial contract by themselves. The two also choose 10% as the least required margin and set their penalty fee at 5%. Now, they are ready to put their stakes in the contract. Bear in mind that the penalty fee, margin requirements, and BTC price are given in USD but the payment for margin is calculated based on what ETH gives. (more explanation coming soon).
As the months go by, Bitcoin’s price appreciates so Bob has to add another ETH so that his margin will be raised and he won’t incur the penalty. Bob is expected to keep adding more ETH as Bitcoin’s value appreciates. At the end of one year, Bitcoin’s value rose by 50% thereby making Alice’s prediction come true. Alice will get what he deserves since Bob continued to maintain the margin on his own side.
Assuming Bob faltered in balancing his margin by failing to add more funds such that his collateral was not enough at any time during the contract, it would be required of him to hand over the penalty fee.
Use of oracles to be sure of economic gains
The possibility of creating financial contracts quickly on UMA is facilitated with a dependable oracle that can ensure quick costing, bargaining, and resolution of conflict. But finding the right oracles have been the bane of progress in the DeFi space right from time. If the right oracles are not used, it would be difficult to send data to a lot of DeFi systems and this will affect open positions because it would be difficult to determine collateralization ratios. For this reason, the likes of ChainLink have decided to work on creating decentralized oracles because it is better than the centralized ones that are bound to bring total collapse if one point fails.
As a result, UMA tried to come up with a design for an oracle that can improve on the quality of decentralized financial contracts. UMA, in the design, thought that it was possible for someone to influence the oracle to suit his/her financial goals.
Hence, UMA saw the need to make it senseless for anyone to influence the oracle by increasing the cost of doing so (Cost of Corrupting or CoC). It will be of no benefit to think of such since the profit (Profit from Corrupting or PfC) that will be derived is always less than the cost of doing so. You can get more information about this in simpler words by looking at the whitepapers from UMA.
Priceless Synthetic Assets
Not long ago, UMA has been making efforts to see that it creates some priceless synthetic assets. The first of its kind from UMA is the ETHBTC synthetic instrument used to relay data about how the two currencies perform in the market.
UMA Governance Token
One of the cornerstones of the protocol is the UMA token which is also used for governance. Owners use it to oppose data that is fed and also decide on changes the protocol should make. UMA’s publicity was made big by listing it on Uniswap.
What the future holds for UMA’s decentralization
As it is easy to create contracts and there is an oracle designed to a high degree of efficiency, it is now possible for users to tokenize prices so that anyone can access them. This makes it undemanding for interested investors in any part of the world to find any asset that is available. Of more benefit is the opportunity given to its users to invent new products and turn assets into tokens that are not common in the old financial systems. Some of UMA’s latest innovations are:
- US & Global Equities
- Cryptocurrency Dominance
- DeFi Total Value Locked
- DEX Market Share
- Perpetual Swaps
- Tokenized Yield Curves
- Private Pension Plans
- Insurance and Annuity Products
Even though investors can see the asset, they are not able to handle it. For instance, someone in Japan that buys Apple’s stock that was changed to tokens with the help of UMA hasn’t any Apple stock in reality. However, he has the same business to do with those who have the stock.
Similarly, someone buying the ETH/BTC token knows how the two currencies relate with each other even though there is no real ownership of the two.
UMA’s aim is to increase DeFi’s adoption by making financial contracts more available to as many that need them. It is true that UMA has competitors such as Synthetix but UMA is more preferred because its collaterals can be ETH or DAI unlike Synthetix that uses a less popular asset called SNX.
There is a great hope for DeFi and open finance will also be established soon. The years ahead have several interesting packages from the stables of DeFi.