DeFi Project Spotlight: Degenerative Finance and uGas Ethereum Futures

uGas is the first project launched by Degenerative Finance, itself a partnership between last summer’s popular DeFi platform, YAM Finance, and UMA Protocol.

The uGas offering will be the focus of this week’s Project Spotlight feature. 

uGas offers decentralized gas futures for users within the Ethereum ecosystem. For the uninitiated, every transaction on Ethereum costs gas. Sometimes the network can be so congested that the cost to transact can make even simple operations prohibitively expensive. 

There have been many examples of such limiting conditions. Each example has also been used to promote alternative blockchains and speed up development for various Layer-2 solutions.

The CryptoKitties boom in 2017 is perhaps the first severe case of extremely high gas fees, but the meteoric rise of DeFi in 2020 has proven to be as notable. 

Ethereum average gas fees in 2020. Source: Etherscan

This is becoming a growing issue for the number two network and may limit the asset’s potential if not solved. Speculators are not the only demographic affected, however. Developers, users, and those looking to build companies on top of Ethereum must consider the high cost of operating. 

Naturally, Ethereum developers have been hard at work to dissolve this pain point. The launch of Ethereum 2.0’s Beacon Chain last year and the “soft” launch of Optism’s Layer-2 solution have given the community hope. 

These solutions, however, may take much longer than anticipated. 

Instead of rebuilding Ethereum’s technical components, many emerging projects attempt to solve the scaling issue through economics. Archer DAO is one example of this; instead of eliminating Ethereum’s “Dark Forest” of predatorial arbitrage bots, the project illuminates the network’s mempool and rewards those who help identify attractive arbitrage opportunities. 

More information on Archer DAO and its value proposition can be found here. 

This approach accepts the limits of the network and the environments they create as inevitable. From this point, they build accordingly. uGas is not dissimilar. 

Instead of solving high gas fees, they create a futures market for crypto’s hottest commodity: Ethereum gas.

This allows users, builders, and speculators to properly hedge for inevitably high gas costs. 

What Are Futures?

Readers who are already aware of futures, how they work, and what they are used for, should skip this section. A deep dive into uGas and how it works follow below. 

Futures allow holders to lock in the price of an asset for a specific moment in the future. They are also different, albeit only slightly, from options. 

Comparison between futures contracts and options. Source: The Balance

There are futures markets for commodities like wheat and frozen orange juice and markets for currencies. Each futures contract comes with an expiration date, at which point the contract is settled via the physical delivery of the underlying asset or settled in cash. Futures contract holders can buy and sell contracts all the way up until the expiration date. 

Naturally, this market attracts speculators, but it can also be an important hedging tool for those interacting directly with the underlying asset. To better understand how futures work in action, it will be useful to unpack a specific example and examine the various relevant agents. 

The easiest futures market to understand is that of water futures in California. 

Despite its abysmal reality, that of betting on the scarcity of resources necessary for life, California officially opened water futures trading in December 2020. Interestingly, Michael Burry, the market savant that predicted the sub-prime mortgage crisis in 2008, also predicted the arrival of such products in 2010.

Because water is critical for just about every industry, there is a much wider range of market participants beyond speculators. 

Almond farmers in California, for instance, will likely be key players in the water futures market. That’s because almonds demand an exorbitant amount of water to grow. This fact, plus the state’s water scarcity concerns and the global popularity for California almonds, make agriculturalists a prime agent in the water futures market.

Thus, with so many almond farmers concentrated in an area with historically limited access to water, water futures offer a means of softening financial downside. 

If, for instance, a farmer suspects that the 2021 summer will be an arid season, they may buy water futures contracts that expire in June. Because water is more abundant during the cooler winter months, the cost of water is slightly cheaper. A farmer can thus “lock-in” the cost of water now so that when prices inevitably skyrocket, they can continue to pay winter prices. 

The above offers a broad definition of how one specific futures market works. Though agriculturalists are the largest party in this market, they are not alone.  

Market agents and their respective trading volumes of water futures. Source: Nasdaq

The Nasdaq Veles California Water Index futures (NQH20) are traded on the world’s largest derivatives exchange, the Chicago Mercantile Exchange (CME). They are settled financially rather than via the physical delivery of water. 

For more details about NQH20, readers are encouraged to visit CME’s explainer.

With the above example in mind, it’s not difficult to extend futures markets to other assets besides commodities. Jack Tao, the CEO of derivatives exchange Phemex, told Crypto Briefing: 

“What started as a practice centered around agricultural producers to hedge the price of their goods against unfavorable conditions, has now transformed into a vital component of financial markets.” 

He explained how futures could assist in risk transfer and price discovery for well-established markets like currencies and stocks, too. Ultimately, Tao said that: 

“Hedging or price discovery goals can be achieved in a much cheaper, faster, and efficient way through futures. It is simply much easier for a user to perform sell transactions as they do not need to possess the underlying asset first.“ 

Instead of holding physical bars of gold, bundles of euros, or buckets of water, futures allow interested parties to quickly buy and sell these commodities with ease. Futures contracts also open up leverage tools for margin trading. 

Needless to say, these tools and markets also apply to cryptocurrencies, concludes Tao. 

Instead of holding Bitcoin, CME traders can buy and sell Bitcoin futures on a fully-regulated derivatives exchange. The exchange has also announced the launch of Ethereum futures in February 2021. 

These products are only the tip of the crypto finance iceberg, however. 

Introducing Degenerative Finance

Like Nasdaq’s water futures, uGas offers futures on Ethereum gas. And for an industry rife with pure-play speculation, gas futures offer real utility for those building and working within the Ethereum network. 

uGas is the first product of an alleged suite of crypto products created and managed by a partnership between YAM Finance and UMA Protocol. 

UMA is one of the first crypto protocols to allow users to mint synthetic assets backed by any mixture of other crypto assets. Examples of their work include the launch of a so-called “yield dollar” and a synthetic asset that lets holders short the price of Compound’s COMP token. 

1/ Synthetic $COMP (yCOMP) is live on mainnet.

It is now possible to permissionlessly short $COMP.

— UMA (@UMAprotocol) June 26, 2020

The partnership between YAM and UMA is called Degenerative Finance. It is essentially an experimental design space for novel derivatives products. Documentation on the tie-up reads: 

“We hope to fill a market need that allows for new forms of speculation and hedging in DeFi that can cater to individual and institutional investors alike.”

uGas is the first example of the partnership’s ambitions. UMA first created it before YAM took over the project’s maintenance. The latter will oversee the uGas interface, branding, and manage risk bound in the uGas product.