UMA: Priceless Contracts via Data Verification

Universal Market Access (UMA) is an Ethereum-based protocol that allows you to create tokenized financial derivatives with self-executing agreements. On UMA, creating a futures contract for the price of gold becomes as simple as buying or minting an ERC-20 asset called a synthetic token. These tokens can be traded on decentralized exchanges (DEXs) and utilized throughout the decentralized finance ecosystem. For a detailed explainer on how UMA is creating a blockchain evolution for financial derivatives, read our UMA primer here. 

There are two key elements that make the UMA protocol work: its platform for creating synthetic tokens, and a “priceless” contract mechanism, which is a novel model that functions as the platform’s oracle. Blockchain oracles are independent services that provide reliable market data to blockchains and smart contracts. They serve as a bridge to the non-blockchain world for data that becomes the basis for transactions and trades. 

UMA takes a new approach to the role of an oracle in providing data for derivative smart contracts by removing third party oracles from the process almost entirely. Instead of relying on a constant feed of data to be pushed on chain, UMA places responsibility onto its users and community with a system of over-collateralization, economic incentives, and minimalist oracle architecture called the Data Verification Mechanism (DVM), in what it calls “priceless” contracts. Only when there is a dispute are the collateralized positions subject to the data verification mechanism process based on Schelling points. 

Cost of Corruption [CoC] > [PfC] Profit from Corruption

The core assumption of UMA’s priceless contracts is based on the principle that it must be more costly to corrupt the system than it would be profitable to do so. Out there in the unverifiable real world where market data comes from, there are countless vectors for error or corruption so UMA assumes that all oracles are vulnerable to corruption. Only by ensuring that the Cost of Corruption always outweighs the Profit from Corruption, can a system relying on off-chain data be economically guaranteed. In order to create a position on UMA, you must deposit collateral. The system will only let you mint tokens at a “safe” level, which is defined as the average ratio of synthetics to collateral system-wide. After that, sponsors are free to withdraw as much collateral as they like, however, if they withdraw more than the required collateral ratio, they will assuredly be liquidated. This is the basic economic incentive that keeps the synthetics properly collateralized without a price feed.

To ensure the cost of corruption is greater than the profit from corruption (CoC > PfC) the UMA protocol has designed incentives to reward honest participation and penalize any attempts at dishonesty. The system relies on financial incentives and, only when needed, dispute resolution using the Data Verification Mechanism (DVM). The DVM is only used when a liquidation is disputed as being invalid.

Token Sponsors

New synthetic tokens are minted by token sponsors and the counterparty to the derivative trade is the token holder who purchases the token through UMA. To become a token sponsor, you need to set a price identifier and deposit collateral. Let’s run through an example:

Assume there is an existing price identifier for the price of gold on January 1, 2022, and you want to use DAI as collateral to mint new synthetic tokens called GOLD_JAN22. The GOLD_JAN22 token would be an ERC-20 token that, on January 1, 2022, would become forever redeemable for the equivalent value of one share of gold in DAI, a value that is set in stone at the moment of expiry. 

As a token sponsor of the GOLD_JAN22 token, your responsibilities would be to keep track of the price of gold and make sure the value of your DAI collateral remains above the minimum collateral requirement. 

If the value of gold rises too high and causes your collateralization ratio to drop below the minimum requirement, sponsors can either add more collateral or repay some debt by repurchasing some GOLD_JAN22 tokens from the market.

Token Holders

If you were on the other side of the above example and were a GOLD_JAN22 token holder, you have exposure to gold. The value of your tokens will track to the value of the reference asset (gold), although with a ‘funding rate,’ which means it may trade rich or poor against the pegged value. It will always tend to converge to the exact value of the reference asset at the time of expiry, because that is the exact amount of collateral it can be redeemed for at that time.  

Data Verification Mechanism (DVM)

Remember, the DVM process is only triggered if a liquidation dispute is filed on a sponsor’s behalf. If there is no dispute, the DVM stays out of the process.

If the DVM is called upon in our example, the GOLD_JAN22 tokens and DAI collateral are frozen and the DVM begins the following verification process:

• Asks UMA token holders for the correct price of gold at the time of the liquidation.

• UMA holders vote on the correct price. The modal majority becomes the correct price, with a pro-rata weighting based on UMA tokens held by voters. UMA token holders who voted with the majority are rewarded a fee for their service. 

• The incorrect party, either the liquidator or the disputer, has a bond that is slashed as a penalty and disincentive to grief the system.

• If the liquidation is found to be valid, the sponsor forfeits their liquidated funds.

The intent behind the UMA platform is that the DVM is only called into use in rare circumstances. The assumption by UMA is that token creators and sponsors are generally responsible and will rarely dispute a price, because activating the DVM can be costly, and the data — for example, the price of gold on a specific day — is usually easily quantifiable via the price identifier. 

By using this priceless methodology for price identification, UMA removes potentially liable third party oracles from the equation. Instead, a quantifiably provable shared truth is incentivized between token sponsors and holders and is crowdsourced by the DVM mechanism. 

UMA Tokens 

The UMA token powers the DVM and governs the entire protocol. Through the DVM, UMA token holders can vote to verify prices and earn fees for voting. Each UMA token counts as one vote. When using UMA tokens to verify prices, voting correctly — with the majority — means earning rewards proportionate to voting shares. If 100 UMA tokens voted and 10 were yours, you would get 10% of the rewards. If you didn’t vote or voted wrong, you wouldn’t get anything. 

Through the UMA Improvement Proposal (UMIP) process, the UMA token can also be used for systemwide changes, such as approving new price identifiers, activating emergency shutdowns, and modifying code on the protocol. In order to protect the value of their UMA tokens, UMA token holders have the power to change the protocol. If corruption is detected, rewards and punishments can be modified and contracts can even be shut down — making UMA token holders the powerful, final line of defense in keeping the protocol honest.

Derivatives and synthetic tokens are powerful tools capable of creating a limitless array of self-executing financial contracts. This could contribute to a more mature digital asset market, while providing an evolution to financial derivatives as an instrument. UMA’s DVM architecture has the ambitious goal of building an incorruptible infrastructure on which these tools can be built. While the first use case for UMA is to create derivatives native to Ethereum, the core protocol is designed to create a trustless and incorruptible way to verify price information onto the blockchain. By utilizing Ethereum’s system of self-enforcing smart contracts and challenging the blockchain oracle mode, UMA is balancing automation with the wisdom of the crowd in its model for synthetic derivatives.