If Uniswap becomes an oracle, how will it work and capture value?

Original title: "Opinion | Will UNI become an Oracle Token?"

Original author: Ryan Sean Adams, co-founder of Bankless

Original translation: Harris, Crypto Valley

UNI as an Oracle Token: Parsing Vitapk's Proposal

There is never a dull day in DeFi, because of its open source, permissionless and agile nature, the protocol is constantly iterating, improving and evolving.

Vitapk This is reflected in a proposal made by Buterin for Uniswap, who suggested creating an Oracle and using UNI tokens to protect it. At first glance, the idea seems a bit strange and brings up some questions. Uniswap is a decentralized exchange, not an Oracle service. Why would they do this? Why do UNI holders want the token to be used in this way?

Leaving aside the confusion and peeling back the layers, the idea is quite interesting.

First, this is the first time we know of Vitapk getting involved in protocol governance, or sharing his thoughts on how a specific asset can be leveraged. Additionally, while he didn’t mention it explicitly, this proposal introduces a new value accrual mechanism for the UNI token that could fundamentally change its value proposition.

Let’s unpack the proposal and see what this would look like in practice, and the implications for Uniswap and UNI.

Oracle101

Before we dive into Vitapk’s proposal, let’s refresh our memory on what Oracles are, and the role they play in DeFi.

Blockchains are relatively isolated, they only know about events that happen on-chain, they don’t have access to off-chain data. This is where oracles come in, as they provide a way to bridge the gap between the external state of the world and the on-chain state of Ethereum.

Currently, messengers primarily provide price data to DeFi applications so that they can understand the value of the assets deposited within them. This information is critical to the protocol's ability to function properly.

Using Maker as an example, Maker needs to know the value of the underlying collateral used to mint DAI in case the value of the collateral falls below the outstanding value of the DAI debt. If this price data is incorrect, corrupted, or manipulated, liquidations will not work properly and the protocol will be at risk of bankruptcy. Because of this, the Oracles that deliver this price information must be highly accurate and secure.

While they provide a valuable service, in order to maintain the level of security and trust we expect when using applications on decentralized networks, these oracles must also be trustless. If the information a decentralized application needs to function properly depends on a centrally controlled entity, or there is only one source of information, then what good is it? Much like the underlying layer of blockchain, decentralized oracles leverage cryptoeconomic incentives to achieve this level of trustlessness.

Vitapk suggests that Uniswap should create their own decentralized Oracle that is able to obtain off-chain data in order to provide accurate price feeds to DeFi protocols.

This will be a different system from the Uniswap Time Weighted Average Price (TWAP) Oracle on Uniswap V2 and V3.

While TWAPs are difficult to operate, their functionality is limited because they can only pass on-chain data. In contrast, this new feature will be able to trustlessly communicate on-chain and off-chain data, using UNI Token as an incentive mechanism to provide security and coordination systems.

Utilizing UMA's DVM

Vitapk recommends that Uniswap build their Oracle in accordance with UMA's Data Verification Mechanism (DVM).

UMA is a protocol for creating "priceless" synthetic assets and derivatives. Like many DeFi protocols we are familiar with, token creators on UMA will post collateral and use it to mint synthetic assets. When the value of the collateral falls below a certain threshold, it is liquidated.

What makes UMA different is its liquidation process. As discussed earlier with Maker, most DeFi protocols will be tied to price feeds to monitor the solvency of a position in order to know when to liquidate it. However, UMA functions differently because it does not utilize continuous price feeds. Instead, prices are monitored off-chain and positions can be liquidated at any time by third-party participants. Because it only utilizes price feeds during liquidation, derivatives on UMA are considered "priceless."

This might bring to mind an obvious question. Even if my position is still solvent, won’t someone get liquidated? The answer is yes. However, there are crypto-economic incentives to encourage honest behavior. Liquidators are required to post collateral before liquidating a position, and if the liquidation is disputed, a portion of that collateral can be slashed. This is where UMA’s Oracle, the DVM, comes into play. The DVM leverages UMA token holders to resolve disputes and ensure the system is functioning properly.

Here’s how the DVM works.

Raise a dispute and send a voting request to the DVM (fees apply)

UMA token holders vote on the correct asset price

The vote is recorded on-chain and the dispute is resolved

Token holders are incentivized to vote correctly through rewards from UMA. Additionally, an erroneous or malicious vote could cause reputational damage to UMA, causing the token value to drop.

With this in mind, we can see that the cost of compromising the DVM is equal to the value of 51% of the UMA tokens active in voting. If a malicious actor were to obtain this amount, they could hijack the DVM and steal the funds within its purview. Because of this, it is critical that these tokens are worth more than what they secure. If this were not the case, it would become profitable to buy up all of the UMA tokens and launch an attack. This creates a clear incentive for the protocol to keep the market cap of UMA as high as possible. To help achieve this, fees paid to the DVM are used to buy back and burn UMA.

This attack vector is the main reason why Vitapk suggests that Uniswap and the UNI token are a good fit for this design. With over $24 billion in FDV, Uniswap has more than enough economic bandwidth to exploit the security of an oracle.

What is the difference between this Oracle and Chainpnk

Chainpnk is the most popular decentralized oracle service as their price feed helps secure value for over 240 DeFi projects like Aave, Synthetix, SushiSwap, and Curve. This adoption has helped propel the pNK token to a FDV market cap of over $25 billion. While Chainpnk has a dominant position in the oracle market, users of the system bear certain trust assumptions.

For example, there is currently no direct mechanism to punish bad actors. While this will change in the future once pNKStaking goes live, for now the system does not require node operators to stake pNK tokens. This means that Chainpnk is currently secured through implicit incentives. This includes node operators losing revenue due to reputation damage, as malicious actors will be less likely to receive future data requests, and potential declines in pNK tokens.

One trade-off to consider is that the UMAOracle design has more latency compared to Chainpnk. While Chainpnk's price feed operates via "heartbeats" that continuously update at specific intervals, the UMA DVM's dispute period lasts for 48 hours. As a result, Chainpnk's design may be better suited for more use cases than UMA's.

While Chainpnk’s oracle is battle-tested, Vitapk believes Uniswap can fill a gap by serving as the oracle for protocols willing to tolerate increased latency in exchange for having an “automated mechanism” to punish malicious behavior. While the two oracles appear to complement each other, if Uniswap’s design gains traction, it raises the question of whether it will cannibalize Chainpnk’s market share.

How This Helps UNI Accumulate Value

Now that we know more about Vitapk’s proposal, it raises the question. Why would Uniswap and UNI holders do this?

Uniswap’s oracle proposal offers clear financial benefits to UNI holders.

As of now, the only rights UNI holders have are over the governance of the protocol. UNI token holders can vote on a pool-by-pool basis to flip a “fee switch” that shifts 10-25% of liquidity provider fees to the protocol. These revenues can then be passed on to UNI holders through traditional means, such as dividends or buybacks and burns. While these mechanisms would turn UNI into a productive asset, they would also reduce liquidity provider revenues, meaning these cash flows could come at the expense of hindering the growth of the protocol.

This puts Uniswap in a dilemma. Continue to maintain a non-dividend-paying governance token in the eyes of the market, or accrue value to the token while risking competitive positioning.

UNI as an Oracle Token adds a novel value capture mechanism on the asset.

Let’s review how the UMA protocol accrues value for its token.

Participants in the DVM receive inflation rewards

Fees paid to the DVM are used to buy back and burn UMA

Sound familiar? That’s because these value accrual mechanisms are the same as those of Ethereum. After the merger of EIP-1559 and PoS, ETH depositors receive inflation rewards, while fees paid to the network are used to buy back and burn ETH.

These mechanisms make ETH a highly productive asset, and these same value capture mechanisms can also be used for UNI, with Uniswap as a microcosm.

Uniswap’s token supply already has a 2% perpetual inflation, and Uniswap’s governance could use that to reward participants in the DVM. In fact, token holders have a strong incentive to do so, as it would create a positive feedback loop for the price of UNI.

Let’s take a look.

UNI holders, who do not want their share of the supply diluted, will be incentivized to participate in the DVM vote

More participation will increase the cost of corrupting the DVM, as an attacker would need to acquire more tokens to control it.

This increased security will lead to greater trust in the DVM, increasing the likelihood that it will be exploited.

The higher the adoption of the DVM, the more fees will be paid to it.

The more fees the DVM collects, the more UNI is burned and the greater the net buying pressure on the token

As we can see, this is a game changer for UNI's value proposition. The UNI token will go from being a capital asset that charges fees, to one that also has a buyback and burn value capture mechanism, without affecting Uniswap's core competitiveness as a decentralized exchange.

Is this feasible?

While Vitapk's proposal has the potential to fundamentally change the competitive dynamics of the Oracle market and UNI's value proposition, this can only be achieved if the proposal is managed through Uniswap.

So far, this has proven to be easier said than done.

Of the three proposals that have made it to the official vote, only one, the creation of a Uniswap grants program, received the necessary voter turnout (40 million UNI voted in favor, or 4% of total supply) to pass. While the other two proposals received overwhelming support, including one to lower that threshold to 3%, neither reached a quorum and therefore could not pass.

In recent days, however, things have begun to change, as the number of people involved in Uniswap governance has exploded. Spurred by a post on the Uniswap governance forum about deploying Uniswap on Arbitrum, five “temperature checks” (the first stage of Uniswap governance) have been voted on in Snapshot since May 26. At the time of writing, three have received enough votes to reach the second stage of governance, known as “consensus checks.” This increase in activity suggests that if the time is right, Vitapk's proposal may have a greater chance of passing governance than previously thought.

The passing of a proposal is one thing, but its successful implementation is another. Creating and implementing an oracle is a massive undertaking, even if it is based on an existing design. That said, if there is any project with the resources to pull it off, it's Uniswap. The protocol's treasury is massive, worth over $4 billion at current market prices, leaving them well-funded to accomplish this task.

It's also worth pondering the specifics of Uniswap's approach. Will they hire an additional development team? Will they acquire another project or protocol? Could they even call on the community to develop a project through a grant program?

As we said at Bankless. DAOs have the money, and wjgs need the labor.

Could someone provide labor to Uniswap by creating this oracle, perhaps in exchange for a very substantial reward?

Conclusion

As we can see, Vitapk's proposal has broad implications for the Oracle perspective, Uniswap, and the UNI token. Not only will Uniswap create a highly secure and professional oracle, but it has the potential to completely change the value proposition of the UNI token.

Crypto is called programmable money for a reason. There are endless ways to leverage tokens and accrue value. Through the merit-based melting pot we call DAOs and protocol governance, we are only beginning to get a glimpse of what is possible.

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