The idea of using perpetual contracts to hedge against collaterals has been recognised as a valid approach to creating a delta-neutral stablecoin mechanism. Judging from their recent moves, UXD Protocol might become the first one that’s going to make it happen on Solana!
Love the idea, the choice of Solana, and also appreciate that their whitepaper gives a clear illustration of the design. However, I believe there is some room for improvement! As the whitepaper specifies, the insurance of the protocol will have to pay fundings when there are negative funding rates on the derivative exchange they’re hedging.
As the protocol grows larger, this flaw might become a target if someone deliberately manipulates the funding rate to make the insurance suffer from constant payments.
Originally I proposed to sell the spot and open a long position of the equal size with perpetual, instead of shorting, when there is a negative funding rate. However, it turns out to be wrong, thanks to the explanation of the founder Kento on Discord!
Let’s go with a song that has the same animation style as UXD Protocol!
1. Stabelcoin Overview & UXD Protocol
The comparison between different types of stablecoin is quite an interesting but complicated topic. For those interested, can check out their first article: Why Soteria? (the project has rebranded).
A brief summary is:
- Fiat-backed stablecoins are not transparent, which means trust is involved and they are no different from any fiat. Not to mention the centralisation risk:
- Cryptocurrency collateralised stablecoins have huge potential price risk, especially on a not-so-performant (only speed-wise) blockchain like Ethereum.
- Non-collateralised stablecoins also involve trust in the system. Once it is lost, the value has a potential downside to nothing. Like Fei Protocol, what a miracle (pegging without a pegging mechanism)!
What UXD Protocol proposes is a stablecoin backed by a delta-neutral position using non-stable cryptocurrencies as collaterals. By going short on the collateral with perpetual contracts, the value of the position remains stable, if excluding the funding rate from consideration.
For example, if a user deposits 1 BTC, a short position of 1 BTC will be opened with that 1 BTC as the collateral.
If the price goes up by 1$, the collateral gains 1$ of value while the short position goes down by 1$, achieving delta-neutral.
A stablecoin made possible by using the composability characteristic of DeFi* is truly exciting and inspiring!
*According to their previous post, due to the lack of a cross-collateralisation decentralised derivatives exchange, the hedging is currently done on FTX.
2. The Potential Issue
As there exists a funding mechanism on perpetual contracts, UXD Protocol does take that into consideration and states their stablecoin to be usually interest-bearing, but might still have times that have to pay for the funding payments, using the insurance fund.
To me, this is a flawed assumption only holds due to the nascency of the market. When the crypto market becomes as efficient as the traditional financial world, the chance of positive and negative funding rates should be equal.
Furthermore, since the funding rate of a market is visible to everyone, anyone with the fund to manipulate the funding rate and familiar with the hedging mechanism of UXD can control the market to make the insurance fund suffer from consistent loss.
3. A Failed Improvement Proposal
Originally, I proposed that when there is a negative funding rate, instead of shorting, we sell the non-stablecoin collateral and get stablecoins such as DAI or USDC. With the stablecoins in hand, we use them as the collateral to open a long perpetual contract of the equal size.
Thus, the position has the same one long and one short exposure, while now we won’t be paying funding payments.
For example, when a user deposits 1 BTC, the vault immediately exchanges the 1 BTC on a DEX for DAI and uses the DAI to open a long position of the size of 1 BTC.
If the price goes down by 1$, the 1 BTC the vault owes the user is 1$ cheaper, which means the vault has a profit of 1$. The long position of the perpetual contract, however, has a 1$ loss. Overall, the vault still has 0 pnl.
However, this is where things go wrong. When the price goes down, even though the vault can afford to pay out the collateral to the user, the value of that collateral is still lower and makes the stablecoins issued under-collateralised.
For example, when BTC is 40000$, the protocol issues 40000 UXD to the user. If the price drops to 30000$, the position the vault holds a delta-neutral position of 1 BTC instead of 40000$. Thus, the 40000 UXD is backed by 1 BTC, which is of 30000$ value only, making it under-collateralised.
This is the major difference between my failed proposal and the original approach: the original approach is delta-neutral on USD value, while my proposal is delta-neutral on the collateral. Obviously, only the first one works for creating a stablecoin, not the second one. I failed :(
This is a record of me thinking that I came up with an improvement proposal but was later proved to be wrong lol
As usual, feel free to leave a comment down below and please point out errors if there’s any!