A deep dive into stablecoins, the trilemma problem, the UXD Protocol and a few tidbits on deltas, perpetual swaps and funding rates along the way.
Stablecoins are cryptocurrencies with stable value regardless of the market conditions. Compared to the high volatility of crypto assets, these stablecoins are well suited to be a store of value, often forming the link with traditional financial systems. Stablecoins have the potential to become global, digital cash. As such, their total addressable market can be considered to be M1 i.e. banknotes and coins, plus overnight deposits. The total M1 supply for USD is nearly 20.5 trillion dollars as of Sep 21, which gives an enormous market to stable coins ripe for disruption.
Stablecoins have been one of the fastest growing sectors of DeFi. In the below chart, I have tried to estimate the market size of stable coins by 2030, which I estimate to reach around USD 13 trillion with steady state growth rate of around 30%.
To further understand the stablecoin market and some of the major challenges, let us first understand how the “stability” of stable coins is maintained. Broadly this is done in one of the four ways — fiat-backed, crypto-backed, commodity-backed, or Algorithm-backed.
- Fiat-backed Stablecoins are backed 1–1 by fiat currency often USD such as Tether. The peg is maintained by a central institution, which holds the fiat currencies in bank accounts.
- Commodity-backed Stablecoins are similar, except the peg is maintained to a physical asset such as Gold. The challenge with this method is reliance on issuing entities, which can fail to fulfil their obligation.
- Crypto-Backed Stablecoins are generated on-chain by depositing cryptocurrency such as BTC/Ether. Since the price of cryptocurrencies is volatile, one often needs to deposit more than the amount of stablecoin received, for e.g.: Depositing $ 150 worth of BTC for $ 100 with of DAI. While this has the benefit of decentralization, the process isn’t capital efficient as users lock a higher amount of capital.
- Algorithmic Stablecoins in contrast, do not use fiat or crypto collateral; instead rely on the use of algorithms and smart contracts to manage the supply of tokens in circulation. While they optimize for decentralization and capital efficiency, the stability of the peg is still vulnerable to risks/assumptions while developing the algorithms.
This leads us to the stablecoin trilemma, which states that there will always be a trade-off between
- Stability — The peg is always maintained
- Decentralization — Issuance & trading doesn’t rely on a central entity
- Capital efficiency — How much $ of assets for 1 $ eq of stable coin. For eg: if 150 $ of BTC is needed for 100 $, the coin is over collateralized and capital inefficient.
UXD is an algorithmic stablecoin, backed 100% by delta neutral position. By using financial products like perpetual futures, UXD optimizes for all 3 parts of the stablecoin trilemma.
How does it work?
Let’s suppose you want 100 $ worth of the stable coin, but you only have 100 $ of some cryptocurrency, say SOL. So ideally, you could deposit 100 $ worth of SOL into the protocol and get a loan against it. Now, most exchanges will give you a loan of less than 100$, often only up to 50 $, whereas you gave up SOL worth 100 $. The protocol does this to protect itself against volatility.
So if the price of the SOL deposit falls to 70 $, and you refuse to return the 100 $ worth of loan, the protocol has some buffer to protect itself. However, this method is capital inefficient as you are locking up more $ value worth of collateral. UXD solves this problem by creating a delta-neutral position against your deposit.
So what’s delta neutrality?
Delta refers to the change in the price of a financial derivative with respect to a change in the price of underlying. So, if say a BTC-linked product has a delta of 50%, its price will change by 0.5 $ for every 1 $ change in the price of BTC. So, if something is delta neutral, it means that irrespective of the change in the price of underlying, its value doesn’t change.
Coming back to our first example, the main reason why exchange gives you a loan less than the collateral is because of its exposure to the underlying coin, but if the exchange could eliminate this exposure, then it would be delta neutral. Since this would reduce its risk, it can give you a higher loan for the same collateral, i.e., become more capital efficient.
Enter UXD
UXD employs on-chain perpetual futures contracts to create this delta neutrality. Futures are financial contracts that allow users to buy (go long) or sell (go short) at a predetermined price.
So, to mint UXD, users first need to deposit collateral. For this example, suppose I deposit 10 SOL worth ~1200 $. Once, the deposit is received, UXD shorts equivalent dollar amount of futures on a Decentralized exchange. Users can deposit this borrowed UXD to redeem their SOL from protocol. UXD in turn shorts 1200 $ worth of perpetual SOL futures on a Decentralized exchange like Mango Markets.
Perpetual futures & Funding Rates- Futures contracts are agreements to buy or sell an asset at predetermined price at a specific time. Perpetual futures as the name suggests do not have an expiration date and as such have price very close to market price of underlying asset. In the below chart, blue line is SOL index price while red line is the price for perpetual future. The more efficient the market, the lesser the difference will be.
Funding rates, help link futures price to that of underlying asset and are updated periodically. When the price difference in perpetual contract is higher than market price, participants who are long, pay the ones who are short. Conversely, a negative funding rate indicates that perpetual prices are below the mark price, which means that participants with short positions pay those with long position. The funding rate mechanism helps to keep contract prices in line with the underlying.
As we discussed earlier, higher the market efficiency, lesser the difference and hence lower the funding rate. However, these rates can spike significantly in times of market dislocations.
When the funding rates are positive, UXD passes them onto users after deducting a small amount for its insurance fund. This insurance fund is created to negative funding rates since they aren't passed onto customers. More reason to convert, eh? The fund was initially capitalized at $57,086,131 on 14th Oct 2021. This means that at its initial value, UXD’s insurance fund could withstand -11.4% funding rates on $500 milllion of UXD for an entire year. If the fund is depleted, UXD would issue UXP tokens to cover it. UXP Token is the governance token to control decisions made through UXD DAO. Governing the insurance fund is the responsibility of the UXP DAO. The two main revenue sources for the UXP protocol are take from positive funding rates and active management of insurance funds
UXP was offered in a public IDO ending November 14th that raised over $57M from 3,676 investors. Funds raised in the IDO are directed towards the insurance fund. In addition to IDO funds, UXD raised a $3M seed round from investors like Alameda Research, Multicoin Capital, Defiance Capital, CMS Holdings, Solana Foundation, Mercurial Finance, Saber DEX founder Dylan Macalinao and Solana Founders Anatoly Yakavenko and Raj Gokal.
The main risks for UXD are-
- Smart Contract Risk — Bug in smart contracts of UXP protocols / underlying exchanges.
- Negative Funding Rates: If the funding rates are negative long enough to cause full depletion of the insurance fund.
- Insurance Fund Asset Management Risk: The insurance fund is expected to be deployed in active asset management strategies which might have various investment risks.
- Insufficient Liquidity to Exit UXD Positions: If the underlying derivative exchanges lack liquidity to service UXD unwind orders.
- Supply/Demand Imbalance: Due to unrestricted access to mint/redeem, significant crypto assets, there could be a situation where there is imbalance between supply and demand, which in turn could cause UXD to trade off its peg.
Stablecoins seek to combine the stability of developed market fiat currencies with the advantages of the blockchain. While Tether & Circle have already proved the importance of stablecoins to the ecosystem, UXP protocol with its scalable, decentralized, and stable operating mechanisms might just be the next step in the evolution of a true global, digital cash.
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