Synthetic Assets on Ethereum - UMA Protocol
Hey DEFI TIMES community,
In last week's token analysis, we talked about Synthetix. Synthetix lets you create synthetic assets on the Ethereum blockchain. Here's a quick recap:
With Synthetix, you can create assets that reflect the price of:
"Fiat currencies: sUSD, sEUR, sKRW
Commodities: synthetic gold and synthetic silver, both measured per ounce
Cryptocurrencies: sBTC, sETH, and sBNB
Inverse Cryptocurrencies (the price of inverse Synths rises when the price of the underlying asset falls): e.g. iBTC
Cryptocurrency Indexes: sDEFI and sCEX"
You can create an asset with a market in the real world, right on the Ethereum blockchain. A synthetic asset on Ethereum is not a right to claim the underlying asset. It only reflects the price of it.
Today, we would like to introduce a similar protocol on the Ethereum blockchain: UMA. UMA is the main competitor of Synthetix and, therefore, also lets you create synthetic assets on the blockchain.
The market for synthetic assets is often considered to be worth over $1 quadrillion. That's why UMA and Synthetix could be two of the most valuable protocols in the future. As both go after this insanely valuable market, it is crucial to examine both of them closely.
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How UMA works
With UMA, you can create synthetic assets on the Ethereum blockchain. Synthetic assets are collateral back tokens (>100% backed), which reflect the price of an underlying asset.
Some examples of synthetic assets include:
- Synthetic real-world assets (eg: gold or Amazon stock)
- Synthetic cross-chain crypto assets (eg: Bitcoin, LTC)
- Tracking tokens for various non-tradable indices (eg: Tokens that track the future usage of DeFi projects; Tokens that track the number of downloads of a Chrome extension; Tokens that track the success of trade ideas on r/WallStreetBets)
"Priceless synthetic tokens are synthetic tokens that are securely collateralized without an on-chain price feed. These tokens are designed with mechanisms to incentivize token sponsors (those who create synthetic tokens) to properly collateralize their positions."
UMA's priceless synthetic contract templates use an optimistic oracle, called the Data Verification Mechanism (DVM).
The oracle solution tracks the prices of the underlying asset. When the prices fall, synthetic asset creators need to ensure proper collateralization. When prices fall below a certain threshold, creators need to deposit additional collateral. Otherwise, their positions will be liquidated.
The liquidation mechanism ensures that every single synthetic asset is always backed sufficiently.
An Oracle solution is always needed to keep the synthetic assets sufficiently collateralized. Oracle solutions are services that bring real-world data on the blockchain in real-time.
Let's assume that you have created a synthetic asset that reflects the price of gold. You have backed it with collateralization of 125%, which is the minimum backing ratio. Somehow, the blockchain needs to know when the collateralization ratio drops below 125%. When that happens, your position will be liquidated.
That's why UMA needs a service to bring the gold price in real-time on the Ethereum blockchain. Several Oracle solutions exist today, but the UMA protocol decided to launch its own Oracle solution.
The UMA Oracle is designed so that the cost of manipulating the Oracle is higher than the return that can be achieved by doing so. It is a "provably honest design." This concept is important because, in theory, any synthetic asset creator has an incentive to manipulate the oracle to keep the positions from being liquidated.
When the "Cost of Corrupting" is higher than the "Profit of Corrupting," you eliminate any incentive to manipulate the system. No malicious actors will enter the protocol in the first place.
UMA is the native token on the UMA protocol. It is mainly used as a governance token. Token holders vote on critical protocol parameters, such as liquidation ratios.
The token was started in an Initial Uniswap Listing, which was the first time a significant DeFi token was listed on Uniswap.
UMA token holders are not eligible for receiving protocol dividends.
The UMA protocol goes after the biggest market in the world: derivates and synthetic assets. Like its main competitor, Synthetix, it has managed to build a great product, where people can launch tokens that reflect an underlying asset's price.
Users need to back the synthetic assets sufficiently (125% collateralization ratio). An internal Oracle solution brings real-time price data to the blockchain.
UMA lets its users create any asset in the world on the blockchain. There are no limits:
- Bitcoin dominance
- DEX market share
- Perpetual swaps
- Metamask Downloads
- Usage of DeFi projects
- Private Pension Plans
UMA has a significant advantage over Synthetix: Users can use ETH and DAI to collateralize their synthetic assets.
All in all, UMA is a great step in the right direction: it is building yet another DeFi lego, which can be used to build an open and permissionless financial system.
All information presented above is meant for informational purposes only and should not be treated as financial, legal, or tax advice. This article's content solely reflects the opinion of the writer, who is not a financial advisor.
Do your own research before you purchase cryptocurrencies. Any cryptocurrency can go down in value. Holding cryptocurrencies is risky.