Synths and the Umoja Protocol incur the following risks:
Synth Unwinding
A Synth's position may be unwound (or halved) if its underlying collateral continues to be equal to or less than 5%. Therefore, users must top up their collateral to maintain their notional exposure.
Learn more about Syth Unwinding here
Synth Collateral Maintenance
Synths aretokenized asset management strategies used by the Umoja Protocol as primitives to build Smart Money. Users provide collateral to use these strategies, either directly through Umoja's interface or soon indirectly via its API for creating new assets.
Depending on Synth's strategy, collateral maintenance may be required to ensure that Synth is as effective as it is supposed to be. Certain Synths, such as that of Synth Options, require a minimum collateral threshold given that its strategy uses leverage.
Note, that all Synth strategies have built-in liquidation protection (for those relevant).
A synth's position may be unwound (i.e., halved) if its underlying collateral continues to be equal to or less than the Synth's minimum collateral threshold. It is important that, if the user wants to maintain their notional exposure, they top up their collateral.
For example, let's say we have a Synth Put Option with the following details:
Synth:Synthetic Put Option
Exposure: Protecting $1M worth of BTC from going down in value.
Current BTC Spot Price: $50,000
Coverage Activation Price (Strike): $49,000
Coverage Length (Term): 1 Week
Synth Min. Collateral: 5%
Required Collateral Deposit: 10%
For instance, if Alice uses $5,000 in USDC as collateral to protect $50,000 worth of Bitcoin from dropping below $49,000, she needs to maintain at least $2,500 in collateral to keep her full coverage. If market volatility leads to high trading fees that deplete her collateral by 50%, her coverage will decrease to $25,000 instead of being completely lost, aligning her remaining collateral with the required 5% for the adjusted coverage amount.
If a user's collateral is below the minimum threshold of the Synth they are using, their notional value (i.e., exposure) will half. To avoid Synth unwinding, users must top up their collateral to ensure it is above Synth's minimum threshold.
Trading Fees
Trading fees are the cost of maintaining Synths, and they increase with higher bidirectional market activity. These fees are deducted from the user's collateral, requiring periodic top-ups to maintain the desired exposure. Each Synth's trading fees are covered by the user's collateral, and if a Synth requires a minimum amount of collateral, the user may need to add more to maintain effectiveness. Failure to do so will gradually reduce the user's exposure as trading fees deplete the collateral. This system ensures that the collateral risk for each Synth is specific to the user who created it through the Umoja dApp or API.
Black Swan Events
A crypto Black Swan event is when crypto prices change erratically and abruptly, preventing the Synths from reasonably adjusting their strategies to adapt to the reality of the market. If a Black Swan occurs, Umoja deploys reserve capital from the Insurance Pool to protect Synth users.
A History of Crypto Black Swan Events
A crypto black swan is an unexpected event that significantly impacts the cryptocurrency market. These are unpredictable, rare occurrences that often have wide-reaching effects on market stability and investor confidence. The term "black swan" refers more broadly to any unexpected event with a major impact, but within the context of cryptocurrencies, it specifically relates to sudden and unpredictable market movements.
Cryptocurrency markets have experienced several black swan events, which are unexpected occurrences that have significant, often adverse, impacts. These events highlight the inherent risks and vulnerabilities within the crypto ecosystem. Black swan events in the realm of cryptocurrency are notable for their unpredictability and substantial effect on market values and investor confidence.
One of the earliest and most infamous black swan events in cryptocurrency history is the collapse of Mt. Gox in 2014, once the world's largest bitcoin exchange. This event marked a significant moment in crypto history due to the theft of approximately 850,000 bitcoins, shaking investor confidence and leading to a sharp decline in bitcoin's price <<4>>.
Another notable black swan event was the Bitfinex hack in 2016, where hackers stole 120,000 bitcoins, causing immediate panic and a significant drop in bitcoin's price <<4>>. This event underscored the security challenges facing major exchanges and the impact of security breaches on the broader cryptocurrency market.
Coinbase, a leading cryptocurrency exchange, experienced a stock crash, further illustrating the financial risks and volatility inherent in the cryptocurrency industry. These stock price movements often reflect broader concerns or developments within the cryptocurrency sector, affecting investor sentiment and market dynamics <<4>>.
Cryptocurrency markets also experienced a black swan event on what is now referred to as “Black Thursday” in March 2020. This date is etched in financial history for the sudden and profound adverse effect it had, demonstrating the high volatility and unpredictable nature of crypto markets <<1>>.
Understanding these black swan events is crucial for investors and participants in the cryptocurrency market, as they highlight the potential for unexpected and dramatic impacts on market prices and investor confidence.
Smart Contract Risk
Smart contract risk refers to the potential vulnerabilities and failures within the code of a smart contract that could lead to unexpected or malicious outcomes. This includes bugs, security loopholes, and design flaws that can be exploited to cause loss of funds, data breaches, or unintended contract behavior. Since smart contracts are automated and self-executing based on the code's logic, any error in the code is irreversible and can lead to significant financial and operational risks. Ensuring thorough testing, audits, and security practices are essential to mitigate these risks.
These risks can be significantly minimized by engaging smart contract auditors for every version release of the protocol. Auditors meticulously review the contract code to identify potential issues before they can be exploited. This proactive approach ensures that the smart contracts are secure and function as intended, safeguarding the protocol and its users from potential vulnerabilities.
Umoja faces exchange failure risk when using centralized finance (CeFi) exchanges or CEXs for derivatives trading to hedge digital asset collateral. This risk emerges if an exchange becomes suddenly unavailable, similar to the FTX incident, potentially impacting Umoja's Synth functionality. The protocol minimizes exposure by never depositing users' collateral directly on exchanges, instead using "Off Exchange Settlement" providers. This approach limits the protocol's vulnerability to any single exchange's failure, ensuring operational continuity and asset safety even in the event of an exchange collapse.
Learn more about Exchange Failure Risk
Umoja Labs employs derivative positions to create certain Synths, like Synth Put and Synth Call Options, trading them on centralized finance (CeFi) exchanges including Binance, Bybit, Bitget, Deribit, and Okx. Therefore, should an exchange unexpectedly go offline, similar to the FTX incident, Umoja faces the challenge of addressing the fallout. This scenario is known as "Exchange Failure Risk."
Starting Beta V3, Users' collateral is NEVER deposited to exchanges and always resides with "Off Exchange Settlement" providers. Umoja has made every step to minimize exposure to exchange failures.
What happens in the event of a failure of an exchange?
Starting Beta V3, Umoja maintains full control and ownership over assets through Off-Exchange Settlement providers, ensuring no collateral is directly deposited on any exchange. This strategy significantly reduces Umoja's risk associated with unique events at any single exchange, limited only to the unrealized profit or loss (PnL) during settlement cycles with these providers.
In case an exchange fails, Umoja can swiftly move the collateral to a different exchange to manage any risks previously covered by the failed exchange. Such an event would lead to the closure of derivative positions, freeing Umoja from any further obligations to the exchange.
With a strong emphasis on capital preservation, Umoja prioritizes safeguarding the integrity and functionality of Synths, even under adverse conditions, ensuring the platform's resilience and the protection of its users' interests.
How is the exchange failure risk managed?
Umoja Labs maintains a neutral stance towards all providers at every stage of its internal processes, ensuring flexibility and impartiality. To reduce the risk and minimize the potential fallout from exchange failures, Umoja diversifies its operations across several exchanges. The company is consistently seeking new liquidity sources to decrease reliance on any single provider.
Furthermore, Umoja Labs actively engages with the broader ecosystem, including investors, advisors, and industry peers, to stay ahead of potential risks. This proactive strategy allows for timely adjustments to exchange exposures as the risk landscape evolves.
Custodial Risk
Umoja mitigates custodial risk from using OES providers for asset custody by diversifying across multiple providers and managing concentration risk. The main challenges include ensuring operational reliability for asset transactions, handling operational duties amidst exchange failures, and guarding against custodian operational failure. Umoja addresses these by frequent settlement of profits/losses and holding assets in segregated accounts, ensuring minimal impact on Synth functionality and stability.
Learn more about Custodial Risk
Given that Umoja relies upon OES provider solutions to custody protocol backing assets for users leveraging Synths that require CEX trading strategies, there is a dependence upon their operational ability. This is the "Custodial Risk" we're referring to.
Counterparty risk is a prevalent issue throughout crypto and has never been more important than it is today. We're confident in the trust we are placing in custodians, whose business models are built on the safeguarding of assets vs. the alternative of leaving collateral sitting on a centralized exchange.
Using an Off-Exchange Settlement provider for custody presents three main risks:
Accessibility and Availability: Umoja's ability to manage funds, including deposits, withdrawals, and delegations to/from exchanges, is crucial. Any disruption in these functions could affect the trading operations and the functionality of certain Synths dependent on centralized exchanges.
Performance of Operational Duties: Should an exchange fail, Umoja relies on the cooperative and lawful actions of the exchange to swiftly transfer any pending profits or losses (PnL). To minimize this risk, Umoja regularly settles PnL with exchanges, as exemplified by Copper's Clearloop, which settles PnL every four hours.
Operational Failure of Custodian: Though large-scale crypto custodian failures are rare, they are possible. Assets are kept in segregated accounts to protect against custodian insolvency, which could otherwise impact the creation and use of CEX-dependent Synths. Solutions like bankruptcy-remote trusts or MPC wallet solutions ensure custodians or their creditors can't claim these assets.
Starting in Beta V3, Umoja mitigates these risks by diversifying collateral across multiple OES providers and managing concentration risk, ensuring no single provider holds a disproportionate amount of collateral. This approach, alongside using several OES providers for the same exchanges, helps to reduce the aforementioned risks effectively.
