1654581008 UXD stablecoin stable or just another pipedream in the works

UXD, stablecoin stable or just another pipedream in the works?

With the fall of the algorithmic stablecoin UST, the quest to find the most resilient stablecoin continues… Will the features of UXD prove itself to be a good stablecoin?

It is with no doubt that the design of a good, working stablecoin is one of the toughest challenges to solve in crypto. There are currently so many stablecoin out in the market. How would we know which one is the most suitable to use?
Today we will be looking at a stablecoin in the Solana ecosystem called UXD.

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UXD stablecoin stable or just another pipedream in the works
Photo by Bonnie Kittle on Unsplash

UXD protocol was formed during 2020, was previously called Soteria but was rebranded into UXD.
There are 2 tokens within this protocol,

  • UXD — Native stablecoin
  • UXP — Governance token for the DAO

UXD is a trustless, algorithmic stablecoin on the Solana blockchain. The unique feature about it is that it uses delta neutral positions to back its stablecoin. The stablecoin is also able to generate yield from those perpetual futures position that it has.

UXD is pegged to USD and is 100% backed. Users will always” be able to redeem 1 UXD for 1 USD of assets. In the event where UXD moves away from its peg, it will also rely on the arbitrageurs to bring it back to peg.

UXD is also capital efficient where there is no need to over-collaterized or monitor for liquidation from market conditions due to its delta neutral positions.

I believe a good stablecoin does not need to have a overly complex design which requires a lot of deep understanding. While there are some new concepts that needs to be understood for UXD, the underlying fundamentals of how it work remains to be quite intuitive.

So a quick summary of the terms for better understanding before we continue…

  • Delta, Delta Neutral — the amount of price change, derivatives, compared to the underlying asset. If neutral, the value is not affected by the price changes of the underlying asset.
  • Derivatives — an instrument which allows the betting of the price of an asset without actually owning the asset (reference asset)
  • Perpetual futures — a contract between 2 parties to buy/sell an asset at an agreed price but with no expiry date (contract doesn’t settle)

UXD maintains its stability by balancing long and short positions. When you mint UXD on the protocol, you will be depositing your collateral into it. The smart contract will use this collateral to open a delta neutral position on Mango markets (an equivalent short position).
If the price of the collateral moves up by 1$ (profit), the short position will move down by 1$ (loss). Therefore the overall value has not been changed even though the value of your initial collateral has changed.

This is how the stability is achieved via Delta-neutrality.

When the user want to retrieve their collateral, they can deposit back the minted UXD and the smart contract will unwind the position in Mango markets and return the collateral to them. They might receive back more/less qty of their collateral but the $ value will remain the same. (Stablecoin)

Deposit collateral (SOL) and you will be able to mint UXD

1654581001 46 UXD stablecoin stable or just another pipedream in the works

Due to the nature of the perpetual futures, interest is being generated. Since the futures is not actually trading the actual asset in the market, the virtual price of the it will change depending on where the demand for the buy/sell is at.

Because we need the virtual price of the futures to track the actual market price of the underlying asset, there is a mechanism in place so that the virtual price does not deviate too far from the market price of the asset.

Introducing funding rate. (Funding rate = Virtual price – Market price)
When there are too many people buying the futures, this increased demand will push the price of the long futures higher.
The funding rate is a periodic payment from the popular position to the less popular position. (In this case, the buyers of the futures= popular position)

Since Mango markets has an hourly funding rate, if the virtual price remains to be higher than the market price, an user going long will need to pay the funding rate every hour.
The purpose of this is to incentivize people to take up the opposite side of the trade so that the price can rebalance itself back to the market price.

Funding rate — When the funding rate is positive, the interest will be given to those who stake UXD and to the insurance fund (popular position is BUY)

Insurance fund — When the funding rates is negative, the protocol will pay the negative funding rate via the insurance fund. (popular position is sell)

When the insurance fund is depleted, the protocol will auction off its UXP tokens to replenish the insurance fund.
In the event of an exploitative hack which causes the under collateralization of UXD, the insurance fund may be used too.

1654581001 889 UXD stablecoin stable or just another pipedream in the works
Photo by Justus Menke on Unsplash

While there are a number of risk ever present for stablecoins, I would like to point out a few which I think are more crucial compared to the rest while under the assumption that the oracle fetching the price for the futures DEX is still holding up regardless of the current market conditions.

1Insurance funds running out or completely depleted
In a bear market, there will usually be more short sellers than long buyers. This will cause the funding rate to be negative. The insurance fund will be used to pay for the negative rates.
If this happens indefinitely and once the insurance funds runs out, the negative rates will cause those who are holding on to UXP to be undercollateralized. (because those negative funding rates will still need to be paid)

When the users try to redeem, they will not be able to redeem their 100% of their initial collateral back a full value.
Effectively, the stablecoin would have lost its peg.

1654581002 413 UXD stablecoin stable or just another pipedream in the works
BTC funding rate over a 30 day period on Mango markets
1654581002 671 UXD stablecoin stable or just another pipedream in the works
ETH funding rate over a 30 day period on Mango markets
1654581002 549 UXD stablecoin stable or just another pipedream in the works
SOL funding rate over a 30 day period on Mango markets

Although its just a short representation (30 days) of how the funding rates is like on Mango markets for the 3 types of collateral, we can at least get a rough idea of how it is going to be like.

We can see that most of the big fluctuations happened during the the early period of May where the market started to show signs of entering a bearish state and also the UST depegging incident. Other than that, the rest of the charts doesn’t have much big changes with the funding rate.

2Selling of UXP tokens to raise funds
As mentioned above, when the insurance fund is depleted, the protocol will sell off those staked UXP tokens to get the funding. We’ll take a quick look at the tokenomics and the utility of the UXP token.

1654581002 305 UXD stablecoin stable or just another pipedream in the works

For the Team and investors, their UXP would be locked in till the end of the cliff, at 14 Nov 2022 and the rest of the amount released monthly (linearly). So we might be seeing some action around that period, depending on their objectives.

1654581002 278 UXD stablecoin stable or just another pipedream in the works
USDC raised from the 3% sale of UXP tokens

Use cases for UXP (not exhaustive)

  • adding new derivative exchanges
  • adding other forms of crypto collateral for the delta neutral position
  • changes to the positive funding rate
  • introducing new strategies for managing the insurance fund

The question to ask is, in a prolonged bear market, how correlated would UXP be with the rest of the market? and would the sale of the token bring in sufficient capital? Through governance, new proposals being added in relation to how the protocol get more protective funding and actual use cases for UXP would play a role in guiding and protecting the growth of the stablecoin.

1654581003 282 UXD stablecoin stable or just another pipedream in the works

As we can see, the insurance fund is put into good use, earning APY instead of just sitting in the “vault” doing nothing. While its generally a good idea to accumulate more funds for a rainy day, it does introduce new risks into the equation like whether those sources are indeed safe and reliable.

The growth of the insurance fund would need to be in line with the growth of UXD, else the stablecoin may not be able to remain collaterized when funding rates changes to negative for a prolong period of time.

3Insufficient liquidity from the derivatives DEX/es
When there is not enough liquidity and a large number of users are trying to redeem UXD at the same time, they might not be able to complete the redemption immediately.

1654581003 798 UXD stablecoin stable or just another pipedream in the works
Photo by John Cameron on Unsplash

When panic and fear kicks in due to the “failed redemptions”, its very likely that it will lead to a bank run with more people trying to flee to the exits.
One of the way to exit would be to swap their stablecoin to another token on Dex-es, that is if they still can.
I’ve only shown example of stableswaps, its still possible for one to swap it to another token. So it would be useful to note the liquidity available on those platforms.

1654581003 191 UXD stablecoin stable or just another pipedream in the works
1654581003 251 UXD stablecoin stable or just another pipedream in the works

While talking about the liquidity of the derivatives, another way to look at it is that, part of the growth for UXD might be limited to how much the DEX can offer. After all we need our delta neutral positions to keep it stable.

This can be solved by using multiple DEXes which provides the same derivatives but again it would add on to the existing risks. We will now have to consider the robust-ness of the other DEX as well.

But this isn’t a huge or critical issue that needs to be address now since its still in the early stages for UXD.

4 Solana
Given the recent network halts and the frequency getting more, this has become one of the risks to consider as well.
During peak periods where there are many txns happening, would the same event happen again where the user will not be able to exit or add more collateral successfully? What if some malicious actor just want to see the world burn and purposely send in massive amount of txns to flood the network to try to halt the network when we need it the most?

All this would really depend on Solana on how it solves this issue. Its built to be fast but all that is pretty pointless if nothing can go through. Even so I remain to be optimistic on Solana since this is a crucial issue that they will need to solve if not eventually people will just move on to another chain which is just as fast and cheap but with better uptime.

1654581004 66 UXD stablecoin stable or just another pipedream in the works
Photo by JESHOOTS.COM on Unsplash

While UXD is not the first stablecoin to appear in the Solana chain, it’s unique feature does make it stand out from the rest, at least for me. (thus the article)
Although it claims to have solve the stablecoin trilemma, I’m still not sure on stability part yet. This is due to the insurance fund being a crucial part to its stability (Mango markets too).

1654581004 708 UXD stablecoin stable or just another pipedream in the works

According to my quick calculation, if we hit the max supply cap of 180M UXD now, where the insurance fund and the average funding rates remains to be the same. It would take around 1.34 years for the insurance fund to be completely depleted.

0.002709% * 24 * 365 = 23.73%
23.73% of 180M = 42,715,512 (fees to be paid due to the negative funding)
57,086,131.8292 / 42,715,512 = 1.34 years

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