Introduction
In this article, we will summarize the “Delta Neutral Stablecoin”.
Simply put, the “Delta Neutral Stablecoin” is an algorithmic stablecoin that uses the delta neutral position mechanism.
What is a Stablecoin?
A stablecoin is a type of virtual currency that is characterized by its relatively stable value.
While common virtual currencies (e.g., bitcoin) can fluctuate widely in price, stablecoins are typically designed to be roughly equivalent in value to a legal tender such as a dollar or a euro.
The main uses of stablecoins are as follows
- Price stability
- Stablecoins are stable in price and can be used for everyday transactions and payments. This increases the probability of avoiding significant fluctuations in the price of virtual currencies.
- Trading on virtual currency exchanges
- Virtual currency exchanges commonly use stable coins to trade among virtual currencies. This is convenient for traders because it reduces the risk of price fluctuations.
- Remittance
- Stablecoins are also used for international money transfers, sometimes competing with banks and money transfer services. It is a fast and low-cost way to send money internationally.
- Smart Contracts
- Can be used by developers of decentralized applications (DApps) to make payments and transactions.
Stablecoin is supported in a variety of ways to provide price stability.
Types of Stablecoins
Stablecoins are broadly classified into the following three categories
Legal tender-backed
Stable coins whose value is backed by legal tender such as US dollars or Japanese yen, and typical examples are USDT and USDC.
The price is stabilized by providing a mechanism to always exchange 1:1 with legal tender legal tender such as US dollar.
It is also important to note that the issuer holds assets equal to or greater than the stablecoin issuance fee to ensure that redemptions are executed.
Virtual Currency-Backed
DAI is a typical example of a stable coin whose value is backed by a virtual currency.
Because of the volatility of virtual currencies, many stable coins are “overcollateralized” so that they can retain their value even if their price falls.
They may be required to put up additional collateral funds if the minimum collateralization rate falls below the minimum, and if they fail to put up additional collateral funds, they may be forced to settle.
Unsecured (Algorithmic)
A stablecoin that has no underlying assets and its value is maintained by an algorithm.
The value is maintained by controlling market supply and demand.
Prerequisite Knowledge
Futures Trading
A “futures contract” is “a contract to buy or sell a specific commodity or asset at a specific future date at a specific price.”
We will use a specific example to illustrate.
For example, a farmer produces wheat, and the wheat harvest is supposed to take place in the fall. However, due to weather and market fluctuations, future wheat prices may be unstable. At this time, farmers may want to use futures contracts to reduce their exposure to wheat price fluctuations. The farmer enters into a contract to sell an expected quantity of wheat at a certain fixed price at a future harvest. This price is called the “futures price.
Let’s consider a specific number.
Let us assume that the farmer has a harvest of 1,000 tons of wheat scheduled for next fall. Then, let’s assume that the wheat futures price at the current time is $100 per ton.
In this case, the farmer enters into a contract to sell 1000 tons of wheat at $100 per ton at some future time. If the price of wheat rises to $120 per ton at some future point in time, the farmer has the right under the futures contract to sell at $100 per ton, thus avoiding the risk of a price increase.
On the other hand, if the price of wheat falls to $80 per ton, the farmer can still sell at $100 per ton under the futures contract, thus avoiding the risk of a price decline.
Thus, through “futures trading,” the farmer can manage the risk of future price fluctuations and secure a stable income.
Similarly, futures contracts are used in the financial markets to help investors and companies control their exposure to future price fluctuations.
Perpetual Futures
Perpetual Futures are trading that can be entered into and settled at any time without a specific expiration date.
Unlike “futures trading” that have expiration dates, “indefinite futures trading” allow for more flexible trading.
Let us explain with a concrete example.
Consider a trader who trades the virtual currency Bitcoin. This trader aims to profit by taking advantage of the price fluctuations of bitcoin. However, the price fluctuations of bitcoin are very rapid and, depending on market conditions, the price can change dramatically in a short period of time.
Traders want to control their risk exposure to bitcoin price fluctuations while ensuring flexibility in their trading. Therefore, they consider using “indefinite futures trading”.
A trader enters into an indefinite futures contract for bitcoin on an exchange. This contract allows the trader to take a position at any time and close it at any time. The trader expects the price of bitcoin to rise and the current price is $10,000 per bitcoin.
The trader purchases an indefinite futures contract of 1 bitcoin for $10,000. If the price then rises and 1 bitcoin becomes $12,000, the trader closes the position for a profit. The profit will be the difference in price, $2,000.
Conversely, if the price falls and 1 bitcoin becomes $8,000, the trader will suffer a loss. The loss will be the difference in price, $2,000.
Thus, “Perpetual Futures” allows traders to manage their risk for bitcoin price fluctuations while still allowing for flexibility in the market.
Delta Neutral Position
The term “delta-neutral” refers to “a state in which the risk of price fluctuations is minimized by keeping the delta (a measure of the impact of price fluctuations on underling assets) close to zero in an investment portfolio.
We will explain this using a specific example.
For example, there is an investor who trades stocks. This investor is interested in a particular stock and wants to reduce the risk of future price fluctuations. The investor is considering an options trade related to this stock.
The current price of the stock is $100 and the investor expects the stock price to rise, but at the same time wants to minimize the risk of price volatility. The investor considers establishing a delta-neutral position.
First, the investor purchases 100 shares of stock. The delta of this stock is 1 (a $1 change in the price of the stock changes the value of the portfolio by $1). Next, the investor trades a sell option contract with a delta equal to 100 shares. The delta of this option contract is -1 (a $1 change in the price of the option changes the value of the portfolio by $1, but in the opposite direction when the price rises).
Thus, a delta-neutral position can be constructed by combining the stock and the sell option contract.
Investors can stabilize the value of their portfolios without being affected by delta, even if the stock price rises or falls.
With minimal risk from price fluctuations, investors can execute a more stable investment strategy.
Let’s look at a specific example in virtual currencies.
Consider a trader who trades the virtual currency Bitcoin. The trader aims to take advantage of bitcoin price fluctuations to profit, but at the same time wants to mitigate price volatility risk. The trader will consider building a delta-neutral position.
The current bitcoin price is $10,000 and the trader expects the price to rise. However, to minimize risk from price volatility, a delta-neutral position should be constructed.
The trader starts by purchasing 1 bitcoin at $10,000. The delta of this position is 1 (a $1 change in the price of bitcoin changes the value of the portfolio by $1).
Next, the trader trades a sell option contract such that the delta is -1. The delta of the sell option contract is -1 (a $1 change in the price change of the option changes the value of the portfolio by -$1). This will result in a delta of 0 for the trader’s portfolio.
In this way, the trader’s portfolio value is not affected by the delta when the price of bitcoin rises or falls, and the value of the portfolio remains stable.
Funding Rate
The “funding rate” is the mechanism used to coordinate the exchange of funds between traders holding positions in a virtual currency perpetual swap contract (indefinite futures contract).
It corrects the discrepancy between the market price and the contract price and can correct market bias.
We will illustrate this with a specific example.
Consider that you are trading a perpetual swap contract for the virtual currency bitcoin. The contract price deviates slightly from the current bitcoin price, and if market participants attempt to take advantage of this deviation over time, market bias may occur.
Funding rates are a mechanism to correct for this market bias. For example, if the market price is higher than the contract price, traders with long (buy) positions must pay a certain amount of money to traders with short (sell) positions. This payment, called the funding rate, is a factor that corrects the discrepancy between the market price and the contract price and corrects for market bias.
Conversely, if the market price is lower than the contract price, the trader with the short position will pay funds to the trader with the long position.
Consider a specific situation.
Suppose the current bitcoin price is $10,000 and the contract price of the perpetual swap contract is $10,050. If the market price is higher than the contract price, the trader with the long position pays a certain amount to the trader with the short position as a funding fee. This funding fee payment corrects the discrepancy between the market price and the contract price, thereby maintaining market equilibrium.
Funding rates are calculated at regular time intervals and may vary depending on market conditions.
Traders should closely monitor changes in funding rates and understand market trends and biases as they trade.
As you can see from the graph above, there are more buyers when it comes to bitcoin.
Therefore, when the rate goes up, the long position side pays more interest to the short position side in order to adjust the price.
Derivatives DEX
The Derivatives DEX is a type of decentralized exchange (DEX) and a platform for trading derivatives.
Derivatives are contracts derived from the price fluctuations of assets such as stocks, virtual currencies, and commodities.
Derivatives DEX allows you to trade these derivatives.
We will use specific examples to illustrate this.
Example: Bitcoin Perpetual Swap
Let’s say you want to trade a derivative contract based on the price changes of the virtual currency Bitcoin. The derivative DEX may offer a bitcoin perpetual swap contract. This contract allows you to take a position based on changes in the bitcoin price.
1. Choosing the type of contract
Traders first select the type of derivative contract they wish to trade. For example, they may choose a Bitcoin Perpetual Swap contract.
2. Taking a Position
The trader acquires the derivative contract on the DEX in the quantity he/she wishes to trade in the contract. At this time, a certain amount of margin must be deposited. For example, to acquire a perpetual swap contract for 1 BTC, 0.1 BTC is deposited as margin.
3. Position Against Price Fluctuations
Perpetual Swap Contracts allow you to take positions in response to changes in the price of Bitcoin. For example, if the price of bitcoin rises, traders with long positions will profit. Conversely, if the price falls, they will lose profits.
4. Closing and Profit Taking
A trader can close a position at any time and receive a profit or loss depending on the current price. For example, if you close a long position when the price of bitcoin rises, you will receive the difference as profit.
Unlike centralized exchanges, the Derivatives DEX is a decentralized platform that allows users to deposit their own assets into the DEX’s smart contracts to conduct transactions.
This allows traders to trade derivatives while maintaining control over the custody of their own assets.
UXD Protocol
Overview
Solana Always Built Decentralized Stable Coin Protocol provides a mechanism for 1UXD = 1USD.
On-chain indefinite futures (Perpetual) are used to create a stable dollar-based delta-neutral position on-chain.
At the same time as holding the collateral asset, the same asset is shorted in an indefinite futures contract.
The above creates a delta-neutral position by holding equal amounts of long and short positions, creating a stable dollar-based stablecoin that is not affected by any price fluctuations of the asset itself.
How it Works
Physical Bitcoin or Solana is deposited into the smart contract and UXDs of the same amount are issued to the user.
The physical Bitcoin or Solana deposited in the smart contract is then used as collateral to take a short position in an indefinite futures contract on the derivative DEX.
This creates a delta-neutral position with a long position in cash and a short position in futures, allowing you to have a stable position with zero profit or loss.
However, because of the short position, the Fundingrate mechanism allows the user to receive interest income in many cases.
The user can also close the position at any time by returning the UXD to the contract and retrieve the physical tokens that were deposited.
At this time, the price may go up or down compared to the price at the time of deposit, but it is equivalent in dollar terms.
Let’s look at a concrete example.
The user deposits 10,000USD worth of BTC with UXD Protocol.
UXD Protocol will then issue 10,000UXD.
UXD Protocol creates a delta-neutral position in the derivative DEX using the 10,000USD worth of BTC deposited as collateral.
This will allow you to earn interest income based on your funding rate without losing money at 100% funding efficiency.
Interest income is deposited into UXD Protocol’s insurance proceeds fund, and interest income deposited into the insurance proceeds fund is used to pay the long position side when prices fall.
In the event that the insurance fund is depleted, the governor’s token, UXP, is sold at auction to secure funds.
UXP
This is the native governance token of the UXD Protocol.
When the insurance fund is depleted, new UXP tokens are automatically issued and auctioned to replenish the funds in the insurance fund.
ALM
Abbreviation for Asset Liability Management.
Stablecoin should have minimal price volatility relative to legal tender.
To accomplish the above, a structure must be created that allows anyone to exchange 1 UXD for 1 USD.
The Asset Liability Management Module (ALM) combines low-risk strategies for backing stablecoins.
Delta Neutral Position
As mentioned earlier, a delta-neutral position is created by holding a short position in an indefinite futures contract against a cash asset.
The gain or loss will be zero, but you will earn interest income based on your funding rate.
Financing
Similar to MakerDao’s D3M, you deposit stable coins into a financing platform to earn yield on an overcollateralized basis.
The UXD protocol controls the interest rate and generates yield by injecting UXD tokens into other overcollateralized lending markets.
In addition, newly issued UXDs will not circulate in the market unless they are deposited with overcollateralization.
- MakerDAO
- MakerDAO is a decentralized finance (DeFi) project and a platform for issuing and managing DAI, a stable coin.
- What is the Direct Deposit Module (DDM)?
- MakerDAO’s Direct Deposit Module (DDM) is a mechanism for users to deposit ETH (Ethereum) as collateral and borrow DAI based on it.
- This allows users to generate DAI with stable value using cryptocurrency as collateral.
Concrete example.
- Depositing ETH
User A has 1 ETH and decides to deposit this ETH into MakerDAO’s DDM. - Setting the Collateralization Rate
User A must set a specific Collateralization Ratio when depositing ETH as collateral. For example, User A chooses to deposit ETH at a Collateralization Ratio of 150%. - Borrowing from a DAI
After User A deposits ETH into the DDM, he/she can borrow DAI based on the corresponding Collateralization Ratio.
For example, we have decided to borrow 100 DAI for 1 ETH. - Use of DAI
User A can use the borrowed DAI for other transactions or store it; since DAI is a stable coin, its price is relatively stable. - Collateral maintenance and repayment
User A must maintain an appropriate collateralization rate for the deposited ETH.
If the collateralization rate falls below a set standard, User A may lose some or all of its collateral.
In addition, borrowed DAI must be repaid, which may incur certain interest charges.
Excess Collateral Loan
Allows users to borrow UXD by depositing crypto assets.
This allows traders to gain leverage and the UXD protocol to earn borrowing fees.
In addition to traditional overcollateralized borrowing/lending platforms, the UXD Protocol will deposit some UXD storable coins with third-party platforms such as Maple Finance.
Maple Finance has three roles.
- Liquidity Providers (LPs)
LPs deposit funds into the Liquidity Pool to fund loans and earn a return. In return, they receive an LP token representing their share of the pool. - Pool Delegates
Pool delegates are responsible for managing their respective pools.
They must agree on contract terms with borrowers through smart contracts and stake MPL-USDC 50–50 Balancer pool tokens into the pool in case of default.
This ensures that incentives are aligned with liquidty providers. - Borrowers
Borrowers request capital from the platform, create a loan, hold collateral, and receive funds.
Based on the terms and conditions agreed with the pool delegate, borrowers can withdraw funds for a specified term, at a fixed interest rate and fixed collateral level.
The UXD Protocol acts as a Liquidity Provider, providing lending assets to the Liquidity Platform, which then acts as a lender of funds.
RWAI
Abbreviation for Real World Asset Investing.
The RWA investment platform allows UXD Protocol to create loans secured by real world assets.
As specific examples, the document discussed the following credit structured products
Credit Structured Products
Credit Structured Products are financial instruments created by combining different types of debt instruments, such as bonds, loans, or other types of credit securities.
These products are designed to provide access to a variety of credit risks and risk profiles.
Risk Tranching
In the context of credit structured products, “tranching” refers to the process of dividing a pool of assets, such as bonds or loans, into different classes or “tranches” based on their level of risk and expected return.
For example, in the case of a Collateralized Debt Obligation (CDO), the asset pool is divided into several tranches with different levels of risk and expected return.
The tranche with the highest risk and highest expected return is usually called the “equity” tranche, while the tranche with lower risk and lower return is called the “senior” tranche.
Tranches are structured in such a way that losses on the underlying asset are first absorbed by the equity tranche and then affect the senior tranche.
Such tranches of credit-structured instruments provide appropriate investment opportunities for investors with different risk profiles and diversification of risk.
Credix
Credix is an example of a credit structuring product that provides capital to underdeveloped markets (e.g., South America) in an efficient manner.
Specifically, Credix’s first market, the Credix FinTech Market, focuses on providing credit to FinTech lenders in LatAm (Latin America) with quality and high growth potential.
All borrowers have passed a rigorous multi-tier due diligence process, are backed by real world assets, and have generated returns.
UXD Protocol will begin its partnership with Credix by providing liquidity to this “Credix FinTech Market”.
And there is potential to develop partnerships with Credix in the future.
In summary, Credix will provide credit to LatAm FinTech lenders with high quality and growth potential, and that credit will be backed by real world assets.
UXD Protocol will evolve this partnership by providing liquidity to Credix’s “Credix FinTech Market”.
This will facilitate the provision of capital and expansion of credit to underdeveloped markets.
Finally
In this issue, we have discussed stablecoins and UXD under the title “Delta Neutral Stablecoin”.
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