The Defiant

What is UMA?

A Step-by-Step Guide to Tokenization of Off-Chain Assets

What is UMA?

Universal Market Access (UMA) is an Ethereum-powered protocol that tracks off-blockchain assets such as gold and tokenizes them into synthetic on-chain assets. 

Thanks to this bridging between real-world and digital assets, UMA enables automated trading without banks and other intermediaries.

As an open-source platform for creating financial products, UMA is one of the building blocks for equitable decentralized finance (DeFi).

UMA Origin and Purpose

Populations in the developing world lack access to basic banking services or financial markets. Less than 5% of the population in India and Brazil, for example, participate in the stock market, according to Finshots

The reason for this is simple. Financial markets require advanced institutional infrastructure, technology, education, and regulatory frameworks. 

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Seeing this problem, two former Goldman Sachs traders, Allison Lu and Hart Lambur, launched UMA in 2018. They recognized the Ethereum blockchain network as an excellent opportunity to create a protocol that replicates traditional financial products for the masses.

Because Ethereum is both global and permissionless, UMA eliminates localism and gives all global citizens the chance to participate in stock trading. 

Whether it is futures, options, or contracts for differences (CFDs), the UMA protocol tokenizes these financial derivatives and transforms them into on-chain, self-executing digital assets.

How Does UMA Work?

Let’s say a trader wants to use UMA to create a futures contract for silver as the underlying asset. These types of contracts, typically traded via CME Group exchange, are binding agreements to sell or buy commodities/securities at a given price point in the future.

Because futures have expiration dates, investors use them against depreciation or appreciation, depending if the trader locked the price for selling or buying. 

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For instance, farmers typically use futures contracts to lock in the prices of their products ahead of time. If anything unexpected happens in the market that depreciates them, farmers can sell their products above the current market value.

UMA’s Priceless Financial Contract Designs (PFCD) makes it possible to create such contracts in a user-friendly way, generating synthetic tokens that represent traditional derivatives. PFCD uses smart contracts to bind both parties and lock their funds, which are released or liquidated until conditions are met.

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As with lending dApps like Aave, to prevent liquidation, synthetic tokens are over-collateralized to safeguard against crypto volatility. Users can create synthetic tokens in the following steps:

  • Deposit a collateral for a new synthetic token, typically ETH or DAI.
  • Create a price identifier, determined by UMA token holders, to track the underlying asset’s price.
  • Set the contract’s expiry date.
  • Mint synthetic tokens, following Ethereum’s ERC-20 standard.

Once created, synthetic tokens can be put into circulation on a number of dApps for trading. UMA is supported by dozens of dApps across the Ethereum ecosystem.

The UMAverse. Source: UMA

If the synthetic token’s collateral is kept above the liquidation threshold, it expires. Then, the token becomes redeemable for whichever underlying asset it tracks, at the specific price when it expired. 

The underlying asset could be a commodity like Bitcoin or gold, security like Tesla (TSLA) stock, or an event outcome speculation.

Of course, if a synthetic token appreciates higher than the current market value, the trader can sell it for a nice profit. Otherwise, the trader suffers a loss.

How Does UMA Track Underlying Assets?

While UMA’s PFCD serves as a template for creating synthetic tokens, it is entirely another matter to tie their prices to off-chain assets. This is where the second part of UMA’s protocol comes in — Decentralized Oracle Service.

An oracle is an intermediary software that formats real-world information into data that is readable by blockchain’s smart contracts. Nevertheless, UMA’s priceless contracts have an embedded rule dictating that off-chain prices are imported only when there is a price dispute, which is why it is called optimistic. 

Vitalik Buterin proposed this concept in 2014 to allow for intervention in an otherwise automated process. In other words, UMA combines the human touch with self-executing smart contracts.

To resolve potential price disputes of underlying assets, UMA’s Decentralized Oracle Service consists of two parts — Optimistic Oracle Service (OOS) and Data Verification Mechanism (DVM). 

The latter handles disputes and liquidations, in addition to settling synthetic tokens after their expiry dates.

Source: UMA

The key UMA network actors are sponsors, liquidators, and disputers. As their names imply, sponsors are in charge of creating synthetic tokens, liquidators handle liquidations, and disputers initiate voting and probe liquidators’ decisions.

The protocol’s UMA tokens represent the voting power, proportional to UMA holdings.

UMA Governance Tokens

In charge of UMA protocol is the Risk Labs Foundation, run by CEO and co-founder Hart Lambur, with Allison Lu co-founder as the only employee. When they launched UMA tokens, they initially minted 100M UMA. Out of that, 48.5M UMA are in the hands of Risk Labs founders.

For dApp developers that have integrated the UMA protocol, Risk Lab allocated 35M UMA. On a weekly basis, this amounts to 50,000 UMA distributed to teams who use UMA to mint synthetic tokens on their dApps.

The rest of the UMA pile, 14.5M, is reserved for future funding via token sales. As of September 2022, 68% of UMA tokens are in circulation. At its highest price point, UMA got to $43.37 in February 2021.

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As the protocol’s governance and utility token, UMA is critical to secure its smart contracts and maintain optimistic oracle’s price verification. Moreover, the protocol’s DVM relies on UMA tokens to prevent data corruption, as one would need to obtain 51% of UMA tokens to do so. This is the balance between the cost-of-corruption (CoC) and the profit-from-corruption (PfC).

For this reason, the protocol encourages using UMA as a collateral, generating an inflationary reward, at about 0.05% of UMA’s total supply. Against this slight inflationary pressure, UMA’s price-appreciating demand depends on the protocol’s dApp integration.

When UMA token voting takes place, it is usually discussed beforehand on the UMA Discord server, while Voter dApp is used for voting itself. Such voting proposals, dubbed as UMA Improvement Proposal (UMIP), range from emergency shutdowns and price disputes to approving new cryptocurrencies as contract collaterals.

Most importantly, if a corruption vector is detected, UMIP voting allows the protocol to grow more robust by tweaking the balance between rewards and sanctions.

UMA’s Future

At the end of 2021, the size of the global derivatives market grew to $12.4T, according to the Bank for International Settlements (BIS). This is the pool available for UMA to recreate onto the Ethereum ecosystem.

For this reason, UMA relies on the success of Ethereum, and its future scaling upgrades. In the meantime, UMA is getting onboarded to every EVM-compatible chain, with Polygon paving the scalability road. This includes even competitive Layer 1 networks, such as Avalanche, because it employs an EVM (Ethereum Virtual Machine) layer.

Central bankers represent the only formidable obstacle to UMA’s growth. They clearly see decentralized assets as a threat, as showcased by the European Central Bank president Christine Lagarde.

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.

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