UMA Project — Yield Dollar 101

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As the UMA project continues to grow, so do the number of new community members seeking to participate in Synthetic Asset creation, specifically — yield dollars. Though yield dollars resemble something like a stable coin, there are a few key differences that must be understood in order to safely use them. Namely, these differences are collateralization, expiration, and redemption. In this article, we are going to discuss the differences between yield dollars and stablecoins and look at a few key examples of the various ways to use them.

Let’s get started.

What is a yield dollar?

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Chart of yUSD-OCT1/USD, taken from CoinGecko.

Don’t let the chart fool you! Though the price of a yield dollar is usually around the $1 mark, it is not a pegged asset in the way that most stablecoins are. Rather, it is an asset that will approach the $1 mark as we get closer to expiration. Think of $1 more as an end goal, rather than a “peg” that the asset is always tethered to (as is the case with stablecoins such as USDC and USDT).

However, some stablecoins (such as DAI) are collateralized assets, meaning that their value is maintained by the value of another (usually volatile) asset. This is the case with yield dollars. To “mint” a yield dollar, a user has to deposit collateral, which they will then use to “back” their yield dollars. When yield dollars are created, a “debt” is recorded that must be paid before the user can withdraw their collateral. This debt can only be paid back with yield dollars.

Yield dollars also have an expiration date. After this date, no more yield dollars can be minted — however, they can be redeemed for $1 worth of their backing collateral. We refer to this process as redemption. The amount of collateral paid back per yield dollar is determined at the moment of expiration by the UMA Oracle (DVM). For example, in the case of yUSD-SEP20 (which used ETH collateral), the “resolved price” was 0.0023 ETH per yUSD. So, if you were holding $1 yUSD at the time of expiration and wanted to settle with the smart contract, you would receive 0.0023 ETH ($1 worth of ETH as of Sep 1) as compensation.

As a quick round-up, let’s define our terms thus far.

Collateral refers to the funds that must be held in the smart contract in order to create new yield dollars. The smart contract allows users to mint yield dollars at a certain ratio (e.g. collateralization ratio) of yUSD to collateral. Note: your collateral must always be at least 1.25x the value of outstanding yUSD debt, or liquidation might occur.

Expiration is the date at which a settlement price is determined (aka the amount of collateral each yield dollar can be redeemed for).

Redemption is the process of exchanging an expired yield dollar for its settlement value in collateral.

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Next, we are going to go through a number of key examples of the various ways to use yield dollars. Users are able to buy or mint yield dollars and may either hold these through expiration or sell on the open market. Note: These are hypothetical scenarios.

Key Examples

Example #1 Minting yUSD and holding through expiration.

Let’s say a user named Alice deposits 5 ETH into the UMA smart contract. At the time, ETH is trading at an even $400, so her deposit is valued by the contract at $2000. The collateralization ratio for this hypothetical asset is 2.5, so she can only mint 1 / 2.5x the amount of yUSD compared to the collateral she deposited. That works out to 800 yUSD. (Note: the GCR for yUSD-OCT20 is currently 2.4203. The asset described in this article has a CR of 2.5 to keep the math simpler).

Over the course of the next month as yUSD nears expiration, the value of ETH is declining. Alice decides that she is going to hold her yUSD through expiration. As the date approaches, ETH is trading at $300. The settlement price of yUSD is determined as .00333 ETH per yUSD. Alice settles her 800 yUSD with the smart contract and receives 2.664 ETH in return. She also retrieves her remaining collateral, which has now been unlocked, worth 3 ETH, giving her a total of 5.66 ETH. In this example, Alice has gained approximately 13.2% against ETH.

Example #2 Minting yUSD and selling prior to expiration.

Let’s go back to our previous example, but this time Alice decides to sell her yUSD after minting. She notices that yUSD is trading at a premium of $1.05, so she receives $840 for her $800 yUSD. The day before expiration, the price of yUSD drops to $1 in anticipation of the settlement price. Alice then buys back her $800 yUSD and repays the smart contract, unlocking her 5 ETH of collateral, and pockets the extra $40. This works out to an APY of around 24%.

Example #3 buying yUSD and holding through expiration.

In this example, Alice does not want to remain exposed to ETH at all. Instead, she sells her $2000 worth of ETH for 2060 yield dollars, which she holds through expiration date. ETH stays rather flat over the life of the token, and at expiration, it is still trading at $400. She redeems her yield dollars for .0025 ETH each and is left with 5.15 ETH after settlement. At this point, if she is still bearish on ETH, she can sell for stablecoins or more yield dollars. Rinse and repeat.

Example #4 using yUSD as a low-interest loan.

Let’s say that Alice is bullish on ETH, but Christmas is approaching and she needs money to buy her family gifts. Instead of selling her ETH and losing all exposure, she decides to mint yUSD and sells it on the market, intending to pay it back over the following month. She mints her 800 yUSD, which are trading for $.995 at the time, and sells them for $796. Over the next month, she saves enough money to buy back her yUSD at $1 each and repay her debt. She has effectively borrowed $800 from herself, and only had to pay $4 to do so over a one month term. This represents about a 6% interest rate — a rate far more favorable than most small, short term lenders or credit cards.

But wait, there’s more! Alice’s hunch that ETH would be bullish over that month was correct. Now, ETH is trading at $500! Paying off her 800 yUSD debt allows her to retrieve her 5 ETH, now worth $2500!

Example #5 using yUSD as a leveraged long.

In our final example, Alice is extremely bullish on ETH but does not have enough funds to buy more. Instead, she mints 800 yUSD, sells it on the market at $.99 each, and uses the proceeds to buy 1.98 more ETH at $400 each. At the end of the month, ETH is trading at $500 each. She sells 1.6 ETH, pays back the 800 yUSD debt, and retrieves her collateral. Combined, she now has 5.38 ETH, netting her about 20% return in one month against ETH (but even more against USD)!

Now, most exchanges that offer leveraged/margin trading have some sort of “funding rate” that must be paid in order to borrow funds. Selling yUSD to create a leveraged position in this manner has an effect similar to a funding rate — with the rate determined by the price of yUSD at entry. Since Alice sold her yUSD at $.99 each, but then paid back yUSD at $1 each after 30 days, this is an implied funding rate of 1% per month (12% APY).

It becomes even more interesting when yUSD is trading at a premium. Effectively, this is the same as a negative funding rate (meaning the lender pays you) for borrowing money.

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To conclude, Yield Dollars are a tool that investors can use as a hedge, leverage, or fixed-rate loans. They are similar to collateralized stablecoins, with the added feature of expiration. If there is an example not covered in this article, feel free to ask in one of our community chats!

Discord: https://discord.gg/snHxfSJ

Twitter: https://twitter.com/UMAprotocol?s=20

Website: https://umaproject.org/

Blockchain Blogger. DeFi Degenerate. Passive Income Investor.

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