Despite recent attacks on stablecoins following the collapse of TerraUSD, they continue to serve an important purpose in supporting the DeFi ecosystem. Therefore, it is critical to understand the structural differences, objectives and potential flaws for some stablecoins we see today. Stablecoins come in many different forms in an attempt to optimize for stability, efficiency and decentralization. Typically there are tradeoffs that happen across these key features which is known as the “stablecoin trilemma”. As a result of not being optimized across all three features, stablecoins often fall into one of three sub-categories: 1) fiat backed, 2) collateralized debt position or 3) algorithmic stablecoins. The UXD protocol attempts to optimize for all three through its novel approach using derivatives and presents a unique opportunity to make decentralized assets more productive.
UXD is a stablecoin protocol native to Solana (soon to be multichain) that is backed by a delta-neutral position using perpetual swaps on decentralized derivative platforms. As a result of being fully collateralized and pegged to the US dollar using derivatives, users will be able to redeem 1 UXD for 1 USD worth of assets with any deviations from the peg arbitraged away by traders. There will also be no risk of liquidation or significant loss as the protocol will not require over-collateralization. Additionally, stakeholders in the stablecoin will receive an attractive yield when the perpetual futures funding rate is positive (contango) and conversely, there will be an insurance fund to pay when the yield is negative (backwardation). By design, these features and components offer the protocol a competitive edge to some of the dominant stablecoins in the market today.
A delta-neutral position is when the value of the position doesn’t rely on the value of the asset. In short, this is typically achieved using derivatives where you would balance both a long and short position to effectively have zero delta exposure. In the case of UXD, when a user deposits $100 of BTC, the protocol would open a corresponding short perpetual future position and effectively maintain $100 BTC value. The protocol would then issue $100 UXD stablecoin which would represent the delta-neutral position and it would be redeemable anytime for $100 of crypto assets.
When dealing with perpetual future positions, the delta-neutral position backing the stablecoin generates interest depending on market conditions and the funding rate may be positive or negative. When the funding rate is positive, the protocol has been structured in a way where the interest would be distributed to UXD protocol stakeholders and the insurance fund. Conversely, when the funding rate is negative, the insurance fund will be used to pay out the negative funding rate so UXD holders do not have to bear the burden in such scenarios.
The insurance fund will be managed by the DAO and will be used to not only pay out the negative funding rate as mentioned above but any situations that may cause the under collateralization of UXD’s stablecoin (e.g. exploitative hack). Although the insurance fund is well capitalized at around $57M there may be the rare instance it gets depleted. In such situations, the protocol will have a backstop and hold an auction for UXP tokens to replenish the insurance fund. As the stability of UXD is correlated to the health of the insurance fund, the team has done extensive research to better understand the historical funding rates and to stress test the insurance fund in different markets across centralized and decentralized exchanges. Understanding historical and projected funding rates will be critical in understanding the sustainability of UDX as a stablecoin.
In addition to smart contract risk and market risk, there are several counterparty risks specific to the protocol that may cause the stablecoin to be undercollateralized. When attempting to make the insurance fund more productive in asset management strategies there may be exploitative hacks causing UXD holders to be undercollateralized. Another possibility can be insufficient liquidity in the underlying derivatives exchange and the counterparties trading on margin. In such scenarios, stakeholders may not be able to redeem their crypto assets and UXD may be forced out of its positions.
Tokenomics and Mechanism Design
The native UXP token serves as a governance token and is required to make decisions for the protocol through its DAO. As mentioned earlier, UXP token holders will also receive cash flow from the delta-neutral positions while serving as the last reserve to back the insurance fund in case it gets depleted. The total token supply has been adjusted to 7B following a 30% burn proposal that was introduced and passed by the community early this year. The proposal was put in motion to bring a degree of “tightness” on the DAO with respect to having complete flexibility on issuing future token supply from the “community” allocation shown in the diagram below. As a result, the proposal aimed to create a more sustainable ownership structure by bringing the fully diluted value metric down. Unfortunately the burn has increased the concentration of ownership of all UXP holders including institutional holders at the cost of its community.
Despite current macro conditions, the stablecoin market continues to remain fairly healthy with a total market cap of $143B and trading volume of up to $100B a day. Stablecoins have found a clear product market fit by facilitating crypto trading pairs, cross-border payments, e-commerce and more. However, more than 90% of the market cap in stablecoins is composed of centralized stablecoins. Centralized stablecoins are at high risk of being censored by hostile third parties, therefore having a decentralized stablecoin that is uncensorable, stable and capital efficient will greatly benefit the crypto ecosystem as a whole.
The market cap for the UXD stablecoin is at $20M which is significantly small compared to the likes of USDC or DAI. However, the novel approach addressing the stablecoin trilemma has gained significant interest since its recent launch as the number of holders has grown to 1,300 this year.
Further adoption may happen in the future as the protocol goes multichain, integrates with various perpetual swap protocols and accepts a wider range of cryptocurrency assets as collateral to back the stablecoin. It will be interesting to continue monitoring such activity and see if UXD can truly deliver on solving the stablecoin trilemma.
Further Reading and Sources
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