At initiation, this delta-neutral position is 100% backed by decentralized crypto assets, such as SOL, ETH and BTC. The below section is intended to explain some of the intricacies involved in the dynamics of the delta-neutral accounting, and scenarios in which UXD may become partially and temporarily collateralized by USDC.
Suppose there is 1,000,000 of UXD outstanding, which was created on average when SOL was $100. This means the UXD asset depository holds 10,000 SOL and is short 10,000 SOL-perp on a relevant derivative exchange. Each UXD is backed by an equivalent dollar amount of SOL.
Suppose SOL moves to $90. Then:
- 1.UXD's depository still holds 10,000 SOL, which is now worth $900,000.
- 2.UXD's short SOL-perp position accrues a +$100,000 PnL
Each UXD is still backed by an equivalent dollar amount of "assets", but the composition of assets has changed slightly. Now, 1 UXD is backed by 90% SOL and 10% "paper profits", which are the unsettled PnL profits from the derivative exchange (note: paper profits are themselves collateralized due to margin maintenance requirements, significantly reducing any sort of counterparty risk).
The existence of UXD's +$100,000 paper profit implies that another party has a -$100,000 paper loss, in unsettled PnL. If this profit remains unsettled, UXD remains 100% backed by "decentralized" assets, because the paper PnL is a formal accounting structure on a decentralized derivative exchange.
However, for decentralized exchanges like Mango Markets, PnL settlement may only occur in USDC. Therefore, if UXD's counterparty wishes to settle the -$100,000 PnL, they are allowed to do so by sending USDC only. Immediately after settlement, UXD is still backed 100% by assets, but the composition has become: 90% SOL, 10% USDC.
Since UXD is not intended to ever have permanent USDC backing, there needs to be a mechanism for bringing UXD back to 100% backing by decentralized crypto assets. Note also that if the counterparty never settles the negative PnL, then UXD never holds any USDC, though eventually would be required to do so.
The solution is a "rebalancing" mechanism that "resets" the delta-neutral position to have zero PnL. Using the above example, in one atomic transaction rebalancing works as follows:
- 1.UXD settles the $100,000 PnL and receives $100,000 USDC.
- 2.The USDC is atomically swapped into SOL, BTC or ETH through a spot-market purchase. In the above example, UXD purchases ~1,111 SOL at $90/SOL.
- 3.Atomically, a corresponding short SOL perp position is established for ~1,111 SOL.
The end result is as follows:
- 1.UXD's depository now holds ~11,111 SOL, worth $1,000,000 at $90/SOL.
- 2.UXD's short SOL-perp position has 0 PnL, as the PnL has been settled.
After this operation, UXD is 100% backed by decentralized crypto assets once again.
In UXD's current beta state, it has not been possible to implement rebalancing due to a technical limitation regarding the number of accounts involved in a single atomic transaction and the current 200k computing units limit. As a result, UXD does not currently have a rebalancing mechanism.
However this proposal, once implemented, will allow for continuous rebalancing of UXD's position. Moreover, since the rebalancing operation incurs fees (trading slippage + taker fees), the DAO may find it preferable to set a USDC backing %, above which rebalancing occurs.
Currently, as of 2/08/2022, UXD is not backed by any USDC because the short perpetual futures global depository is in a negative PnL, and so there is no positive PnL at risk of settlement.
However, UXD Protocol is working on temporary solutions to help mitigate the rebalancing issue until such a time as UXD Protocol can implement a full rebalancing solution. These will be communicated over public communications channels such as Twitter and Discord.
In the (viewed as unlikely) scenario that assets in the depository consist almost entirely of positive PnL, then UXD may become temporarily backed by a corresponding amount of USDC if this PnL is settled. Currently, there is no direct mechanism for redeeming UXD for USDC, so redeemability may be temporarily not possible for 100% of outstanding UXD, though such UXD would still remain fully collateralized.
UXD Protocol has developed a temporary solution in this case that would allow for UXD to be redeemed for USDC:
1.UXD Protocol would mint UXD using insurance fund converted to the desired collateral as a temporary buffer.
2.Add Liquidity in USDC from the insurance fund on Saber USDC-UXD pools if the pool has <= 30% USDC.
UXD Protocol believes a combination of these two solutions will allow for sufficient exit liquidity should a user wish to exit their UXD Position. Such a solution has not been deployed on mainnet, but will be implemented very soon.
Moreover, our next audited update will include an audited rebalancing-lite instruction, that has been designed to circumvent the current technical limitation. This will be replaced by the full automatic rebalancing mechanism in the future.