Overview of UXD Protocol
What is UXD?
UXD Protocol is a decentralized stablecoin protocol built on Solana. It was founded in 2020 as Soteria and more recently rebranded to UXD. The protocol is currently being built — the devnet app was launched on October 4th, and the mainnet launch is expected in November.
UXD is the native stablecoin of the protocol, pegged to $1USD.
UXP is the protocol’s governance token, which controls the UXD DAO.
UXD Stability Mechanism
UXD employs a novel stability mechanism that differs substantially from existing offerings in the crypto space. The key innovation from UXD is the use of on-chain perpetual futures contracts (also known as perpetual swaps) to create an on-chain delta neutral position that is stable in dollar terms. UXD stablecoins are issued in proportion to the dollar value of the position, and are backed by the position itself.
The protocol holds a collateral asset (like SOL or BTC) and simultaneously shorts the same asset via a futures contract. It holds a long position and a corresponding short position on the same asset, meaning it has no exposure to price movements of the asset itself. This type of position is called delta neutral and is stable in dollar terms, regardless of the asset’s price movement. This position is then tokenized to create a stable crypto-dollar.
How It Works
In order to mint UXD, users deposit crypto collateral into a smart contract that creates a delta-neutral position on a Solana DEX (Mango Markets to begin).
For example, if a user deposits SOL into the contract, the UXD protocol then takes that SOL and opens a delta-neutral position on the DEX. The protocol will be long spot SOL, and short future SOL to create a hedged position whose value will always be stable in dollar terms.
Let’s say that the price of SOL is $150. The user deposits 1 SOL into the contract, which then mints 150 UXD to the user.
On the back end, the contract uses the SOL to open a delta-neutral position on Mango Markets. The protocol will hold 1 SOL as collateral, while simultaneously opening a 1 SOL short position — there is no exposure to SOL price movements, and the value of this position will always be $150. The value of that position is what backs the 150 UXD that have been put into circulation.
The user can close out the position by depositing the 150 UXD back into the contract. This will trigger the unwinding of the DEX position, and the user will receive $150 worth of SOL in return. If the price of SOL falls during the time the position is open, the user will receive more SOL than they initially deposited. If the price of SOL goes up, the user will receive less SOL than they put in. In either case, however, the dollar amount of the collateral they receive back will be equal to the dollar amount they put in.
Perpetual swaps also involve the use of something called the funding rate. From this guide:
Funding rates are periodic payments to long or short traders based on the difference between the perpetual contract market and the spot price.
Supply and demand force between bids and asks on the derivative and spot marketplaces will never be identical, because they operate independent orderbooks. Thus, price will never be in perfect equilibrium. This same dynamic can be observed on spot exchanges; rarely will the price of BTC on Coinbase and Binance be identical. Arbitrage ultimately keeps these markets relatively in tune. If the price of BTC on Coinbase explodes relative to the broader market, traders will buy ‘cheap’ BTC on Binance and send it to Coinbase, sell it at a premium, and pocket the spread. This increase of ‘inflow’ BTC to Coinbase will add sell pressure to their orderbook, causing the price to come down. Simultaneously, the buy pressure of these arbitrageurs on Binance will cause the price to go up. Ultimately, the two prices converge back towards equilibrium.
In an ideal world, we want our derivative contract to replicate price exposure to the underlying (spot) as tight as possible. The problem is we lose the natural arbitrage feature when intertwining derivatives books to spot books. If the price of BTC on Coinbase goes way higher than Mango, we can’t buy a ‘cheap’ Mango BTC derivative, transfer it to Coinbase and sell it, as it’s not an accepted collateral by Coinbase.
Funding is the solution to this dilemma. There exists some oracle module, called the index, which serves as the anchor price. Typically, the index is a weighted average price feed of multiple spot exchanges. The derivative contract will periodically assess its last-traded price in relation to the index. If the derivative price trades at a premium, longs will pay a periodic interest rate to their short counterparties. If the derivative trades at a discount to the index, then shorts will pay longs. The interest rate creates an incentive mechanism for counterparty liquidity to step in and take the opposite end of the imbalance, converging the derivative price back into parity. Many strategies exist where delta-neutral traders can hedge the directional exposure of their positions in secondary markets, isolating that interest payment for a risk-free arbitrage. These delta-neutral liquidity providers play an important role in trending market environments where organic counterparty liquidity in the derivative market may be scarce (no one wants to be short BTC in a bull market).
In other words, one side of the market is always paying the other side of the market. This helps balance out supply and demand.
Positive funding rates imply that many traders are bullish and long traders pay funding to short traders. Negative funding rates imply many traders are bearish and short traders pay funding to long traders.
Funding rates have historically been positive for BTC, and the crypto space in general, considering that over the long run, it is easier to be long scarce/deflationary assets against perpetually inflationary fiat currencies. This positive funding rate will provide cash flow to the UXP Protocol. This is an interesting advantage that can be used in a number of ways (explained further in the token section).
One important use of the funding rate will be to continuously capitalize the protocol’s insurance fund. Should the funding rate turn negative at any point, the protocol will need to pay it. These payments will be drawn from the protocol’s insurance fund so that UXD holders never have to pay.
The UXD Protocol’s insurance fund will initially be capitalized through a token sale. When the funding rate is positive and the protocol is bringing in funds, a portion of these will be directed to the insurance fund to ensure it remains safely capitalized.
There are a number of key advantages that UXD has relative to other stablecoin protocols.
Resilient Stability Most stablecoin protocols rely on collateral assets to back the value of the stablecoin. Many of them require over-collateralization to protect against large price movements in the underlying collateral. If the collateral value moves too much too quickly, the stablecoin can become under-collateralized and loose its peg. Others rely on “algorithmic” stability that is prone to bank runs, attacks, and loss-of-confidence death spirals. A purely algorithmic (i.e. unbacked) stablecoin does not currently exist, and may never materialize.
UXD isn’t actually backed by collateral assets in a vault contract*.* Rather, it’s backed by an auditable on-chain delta neutral position that is itself designed to maintain a stable value even in the case of price swings in the underlying asset. I believe this to be a more robust stability mechanism than anything that currently exists on the market.
In addition, the existence of an easy arbitrage opportunity for any deviation from the peg will help to further reinforce stability. If UXD is trading above $1, traders can create new UXD and sell it at premium. If UXD trades below $1, they can redeem UXD for the underlying collateral and sell the collateral at a profit. This will ensure that the price of UXD remains tightly pegged.
Capital Efficient Because UXD doesn’t rely on over-collateralization, it’s more capital efficient than comparable decentralized stablecoins like Maker.
$100 of SOL or BTC deposited into the UXD Protocol creates exactly 100 UXD. This is comparable to centralized systems like USDC, where tokens are backed 1:1 with collateral. Systems like Maker can only issue stablecoins for a portion of the deposited collateral value. This creates inefficiencies and barriers to scale.
In many ways UXD combines the best of both worlds. It’s as capital efficient as the most successful centralized stablecoins on the market (USDC, Tether), and as robust in the most successful decentralized stablecoin (Maker). It also avoids the inherent risks that come with unbacked or partially backed “algorithmic” stablecoins that don’t utilize collateral.
Decentralized While centralized custodial stablecoins like Tether and USDC have seen impressive growth, they’re an entirely different asset than decentralized stablecoins like UXD. Centralized stablecoins carry a very high regulatory risk — new legislation could result in them being banned, whitelisted, or having other changes that drastically affect their utility. If major regulatory action is taken against a centralized stablecoin provider, it will serve as a positive catalyst for the adoption of decentralized alternatives like UXD.
Decentralized stablecoins have been called the holy grail of crypto because they provide price stability along with the other most important property of cryptocurrencies — censorship resistance.
UXD exists entirely on-chain and doesn’t require intermediaries. It’s censorship-resistant, verifiable, auditable, and has no single point of failure. True decentralized finance is only possible with decentralized stablecoins, and these tokens will continue to grow in importance over time.
Other decentralized stablecoins like Maker, FRAX, and others are largely backed by centralized assets like USDC. This increases their attack surface and makes them less genuinely decentralized.
The funding rate from the on-chain position provides a cash flow to the UXD Protocol (provided the funding rate is positive). This cash flow can be used in a number of ways:
- It can provide a native yield to UXD holders
- It can provide cash flow for UXP holders
- It can help to continuously capitalize the insurance fund
UXP becomes more attractive as an asset, since it will have both governance utility and cash flow (via direct returns or a buy-and-burn program).
Important note: If the funding rate is negative, the insurance fund will be used to pay the funding rate so that UXD holders aren’t penalized.
The UXP Token
The UXP token is the native governance token for the UXD Protocol.
In addition to being used for governance decisions, the UXP token also serves the important role of providing a reserve of last resort for the protocol’s insurance fund. If the insurance fund is ever depleted, the protocol will automatically mint new UXP tokens and auction them off to restock the insurance fund. UXP holders assume this risk.
Major Token Utilities
- voting on protocol decisions (governance)
- potential cash flow from funding rate payments (either direct payments or buy-and-burn)
- reserve of last resort for the protocol insurance fund
The UXP Protocol is still very early. Little is known about how the DAO will be structured or how governance will actually work. On-chain governance frameworks on Solana are quite a bit less developed than those on Ethereum, and investors should expect some growing pains. Valuation frameworks for these types of tokens are also in their infancy. That said, comparable tokens in other ecosystems include $MKR ($2.26B), $SPELL ($503M), $TRIBE ($291M), and $FXS ($165M).
3% of the UXP token supply will be sold in an upcoming Initial DEX Offering (IDO). The team has not yet announced a specific date, but they have said that it will take place in October or November. More info will be announced via Twitter and Discord.
While details are still sparse, the team has said that the sale will function similarly to the token sales conducted by Parrot and Mango Markets. In these sales, a fixed number of tokens were put up for sale. Users put $USDC into a contract, and then were awarded a pro-rata share of the tokens based on their contribution.
I’ve identified two key market advantages for UXD.
First of Its Kind UXD is the first ever stablecoin backed by an on-chain delta neutral position. This is a novel innovation for stablecoins and one that is uniquely enabled by Solana’s scalable architecture and existing DEX infrastructure.
The novel stability mechanism pioneered by UXD could prove to be more robust, scalable, efficient, and decentralized than competitors. If so, UXD will be able to capture a large portion of the decentralized stablecoin market (currently a multi-billion-dollar and growing opportunity).
First to Market on Solana Solana is the first smart contract platform to legitimately challenge Ethereum, and the ecosystem is developing at an impressive pace.
A number of centralized stablecoins are available on Solana. Ethereum-native stablecoins can be bridged over using Wormhole. However, there are no Solana-native decentralized stablecoins, and UXD will very likely be the first to market.
Competition among stablecoins is fierce, and there’s a huge advantage to being the first to market. And because Solana is such a growing ecosystem, there’s a huge opportunity for UXD to be the decentralized stablecoin of Solana and to benefit from the enormous growth the ecosystem will likely have over the next few years.
There are a number of important risks to consider.
UXD is built on Solana, a new and emerging platform that is technically still in beta. September’s network outage was a reminder that the network still carries a degree of risk for high-stakes projects like UXD.
Should Solana suffer further technical issues, or should it be eclipsed by other platforms, it could hinder UXD’s chances of success.
Smart Contract / Protocol Risk
UXD Protocol is currently under construction. All new protocols and contracts carry some inherent risk. Bugs or exploits in the contracts of either UXD or Mango Markets (and other integrated DEXs) are always a possibility that needs to be considered.
Oracles traditionally constitute a high-risk point of failure for stablecoin protocols. UXD gets all of its price info from the Mango Markets DEX, which relies on outside oracles (including one that had a notable recent failure).
The community should encourage formal audits and measured growth to help prevent these possibilities from becoming existential threats.
There are some rare but possible market conditions that could result in UXD positions losing value such that UXD tokens become un-backed.
From Mango Markets:
If an account still has liabilities but no more assets for liquidators to take, the account is bankrupt and insurance fund starts paying. Socialized loss only kicks in after the insurance fund owned by Mango v3 is depleted. We hope this is a rare event.
For losses among perp market participants, the losses are spread equally among all other participants in that perp market.
When a margin account has negative equity, the losses are socialized among the lenders. There is obviously the risk that a user loses his margin account to a liquidator when his account goes below the required maintenance collateral ratio (MCR) of 110%. But there is an even bigger risk to the ecosystem when a margin account falls below 100% collateral ratio. At this point, the value of the account’s liabilities are larger than the value of assets. In this situation, the liquidator is provided a 1% incentive to liquidate and lenders collectively take the negative equity of the account. In rare circumstances, this could even trigger a liquidation cascade where the socialized losses trigger more accounts to fall below 100% collateral ratio.
How can an account achieve negative equity if the liquidation engine is properly operational? The engine itself does not assume the liquidated position; rather it attempts to offload the position into the orderbook at a fill greater than or equal to the bankruptcy price (max theoretical limit the position can support before going negative). However, liquidity can dry up in rare circumstances of extreme volatility, with no guarantee that the engine will be able to offload this position without incurring slippage on the execution that puts it into negative equity. The insurance fund exists to cover the gap. If the insurance fund is fully depleted and negative equity is still outstanding, the balance is socialized amongst lenders (shorts). Such manifestation would result in a ‘bleed’ of the UXD delta-nuetral position, resulting in a collateral backing less than the desired 1:1 rate.
In this scenario, both the Mango Markets insurance fund and the UXD insurance fund would have to be entirely depleted before UXD holders were penalized. Sophisticated users would be able to see this activity on-chain and might choose to close out their positions, but most likely would not. This would be a very rare occurrence, and the existence of the insurance funds provides a buffer against this risk.