UXD: the algorithmic Delta-Neutral stablecoin
Stable-coins are on everyone mouth these last months (Q4 2021-Q1 2022), so much that a denomination to this phenomena came out; The Stable-Coin Wars.
This asset is the most used in all DeFi, thanks to its versatility, flexibility and accessibility (because of the decentralized nature of some of them). Unfortunately or luckily many experiments are being done, above all with algorithmic stable-coins. Many of them fail and people lose money, but they should be taken as lessons, reminder and finally ways to make both market and technology more “mature”.
As you could read in the last days, the UST de-peg occurred, bringing the Terra ecosystem down till a $LUNA (-99%) and $UST (from 1$ to 0.1$) hard collapse. Many people and funds had their money invested in that ecosystem, and they lost almost everything.
Celsius for example was invested in Anchor (500 million $) : https://www.theblockcrypto.com/post/146752/celsius-pulled-half-a-billion-dollars-out-of-anchor-protocol-amid-terra-chaos
So as you probably know, unlike USDT, UST is an algorithmic stable-coin, and it’s backed by NO collateral, so keeping the peg is hard and if people lose trust in the protocol and ecosystem, then the stable-coin and the project are going to face a bank run, so the risk is high because of the design and mechanism fragility.
Now, UXD is algorithmic as well, but it’s 100% backed by a Delta-Neutral position. We will see how UXD gives a solution to the risks linked with stable-coins and algorithmic ones, and how it proposes to solve the Stable-coin trilemma.
But, what is a Delta-Neutral position and what’s a Delta?
So, let’s start by introducing these two concepts.
DELTA
First of all ,we are talking in terms of derivatives products, in fact the Delta is one of the most fundamental concept in that domain. A derivative product operates in a Virtual Market and it’s based on Underlying Assets, that are used as a reference.
Now, the Delta corresponds to “the amount a derivative’s price changes as the referenced underlying asset changes in price”
Yes, a derivative product could vary its price-relationship with the underlying asset, in those cases an arbitrage incentive, called “Funding Rate”, occurs.
The mechanism consists of encouraging people who make the “right” buy/sell order that would bring the Virtual Price back to the correct Market Price .
In other words, if 1 BTC is traded for $30k on the Virtual Market and $29k on the Real Market and one person sells 1 BTC in the Virtual Market (helping therefore the virtual price to follow the market price), then that person will receive $1k as a payment.
So, we could say that Funding Rate Payment = Virtual Price — Market Price
DELTA-NEUTRAL
As previously said, the price of a derivative could differ from the one of the underlying asset, so the Delta-Neutral Strategy could be a solution to be neutral to this variation.
In fact a Delta-Neutral position has the characteristic to be Neutral, and so being independent from an Asset Price. A multiple balancing long and short positions -to get a zero delta-exposure- is usually adopted.
Delta-Neutral therefore ensures STABILITY, that’s why UXD is based on this concept.
The main goal is to always provide a 1:1 redeem/issue between the deposited collateral and the stable-coin
Now that you’ve learned what Delta and Delta-Neutrality are, let’s jump to how UXP protocol integrate them and why.
HOW DOES THE PROTOCOL WORK?
UXD protocol is an algorithmic Stable-Coin built on Solana, 100% backed by a Delta-Neutral strategy that is made for every $ of UXD issued. By doing so, users will always be able to redeem their collateral deposit 1:1 with UXD.
As previously said, UXD could be a solution for the Stable-Coin Trilemma. What does it consist of?
The Stable-Coin trilemma faces three requisites and main values:
- Decentralization: the opposite of centralization, this is important because it eliminates Censorship, Power abuse, Permission and Mono-directional control. What decentralization gives back is the Accessibility (to Finance, in this case), Privacy, Data property, more Liberty and Transparency, all in a collaboration-oriented, inter-operable ecosystem.
- Price Stability: a stable-coin by its nature needs to be pegged to the given and projected price, with an underlying asset reference linked with it. Also due to high crypto market volatility, a stable asset is needed, to be used as a safe-heaven asset too, for example during bear markets.
- Capital Efficiency: if more capital than the actual equivalent is required as collateral to create one unit of a stable-coin and to make it secure, then the system is inefficient.
Now, the UXD stable-coin is created through the set-up of a delta-neutral position on a decentralized derivative exchange, so the protocol don’t utilize Oracles, because it takes advantage of the fact that Derivatives Exchanges already use them, this is obviously an optimization, but it could result in a risk too, because you are basing your efficiency on another protocol trust (we will talk about this in the Risk section).
The delta-neutral position is 100% backed by decentralized crypto assets, such as SOL, ETH and BTC, in fact for UXD to be issued, a user only has to deposit a collateral, a Short position on a derivative DEX (Mango Market) will then be created, so that if for example you deposited SOL, and this one does -20%, the collateral will decrease by the same %, but the short position is going to be +20%, therefore a stability is reached with a net PnL of 0.
But let’say that a de-peg occurs..
Then arbitrage opportunities will occur as well in order to profit on them, and by doing so bringing the price back to the peg.
UXD HOLDERS AND FUNDING RATE
UXD holders will receive a yield under the shape of the Funding Rate, that when Positive is going to accrue value in order to:
1) Distribute rewards to UXD holders
2) Fill an Insurance Fund
When Negative the insurance fund comes in to help the situation to be restored. The insurance fund by the way, has been initially funded with 57M$, this to have a solid starting point that can cover a -11,4% deficit of negative funding rates on 500M$ UXD for a whole year.
What if the Insurance Fund can’t cover a Shortfall event?
First of all the Insurance Fund is going to be managed by the UXP DAO, and so by UXP Governance.
If the insurance fund is empty, then UXD will hold an auction of UXP tokens in order to refill it.
The Insurance Fund doesn’t represent the only risk this protocol could face, there are others which are common to stable-coins.
RISKS
These are the primary risks faced by UXD stable-coin, but since DeFi is in a constant development, many new risks could come out
· Smart Contract Risk: A token or a Stable-Coin is created through a smart contract. So it should be easy to notice that if a smart contract written by UXD Protocol, or an underlying derivative exchange contains a critical bug, user funds may be lost and UXD may be under-collateralized.
· Negative Funding Rates: This risk is the one we’ve mentioned above. If funding rates ( that are an integrated part of Perpetual Futures) are negative for a period long enough that sees, as a result, an empty insurance fund, UXD holders may become under-collateralized.
· Insurance Fund Asset Management Risk: The insurance fund management may face hacks or other malevolent attacks.
· Insufficient Liquidity to Exit UXD Positions: As mentioned before, using Derivatives Exchanges could bring risks and benefits. If, for instance, there is a significant illiquidity in the perpetual futures markets, and at the same time a large number of UXD holders are attempting to redeem UXD for crypto assets, there may be insufficient liquidity to immediately redeem UXD for crypto assets.
· Supply/Demand Imbalance: front-end application bugs for the mint/redeem process, or a variety of other market conditions caused by an imbalance of supply/demand.
UXD INVESTORS
CONCLUSION
UXD protocol could really be a solution for stable-coins to solve the trilemma because the algorithmic design has surely some interesting features, that even if simple, are actually effective.
UXD has to face some stress tests yet, so its success still needs to be determined, but risks have been evaluated so it should be curious to see how the protocol is going to react once a shortfall event will occur.
Two important positive attributes of UXD are that decentralization is priority, in fact the protocol has integrated itself in the DeFi ecosystem, (DeFi on Solana in this case), using an external derivative DEX, which in turn utilizes decentralized Oracles.
The second important thing is that thanks to its capital efficiency, UXD like a Primitive Concepts Thinker, cuts costs at the base, this results therefore in whole DeFi operability improvement and optimization, that could set a new standard for the Solana Ecosystem and seeing an increase in UXD adoption.
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