UMA Range Tokens
The convertible bonds of DeFi
Hi friends, welcome back. This week I’m going to do a quick explanation of UMA’s range tokens. You can think of them as a crypto-native version of a convertible bond.
Also, “convertible bonds” might make this post sound super boring. I promise it’s not; range tokens are one of the most useful DAO tools out there today so stick with me!
Let’s break it down 👇🏻
How Does a Convertible Bond Work?
Convertible bonds are financial instruments that occupy the space between bonds and equities. Bonds are just forms of debt issued by companies; lenders earn interest on top of their loans. Bonds tend to have limited upside and also limited downside (since, in the case of a bankruptcy, bondholders are paid before equity owners). Equities are just stocks. They’re higher risk but also tend to have higher returns than bonds over time. They have a claim on the economic profits of the company.
A convertible bond is a hybrid bond-equity. That is, it has properties of both bonds and equities. It takes the limited downside feature of a bond and combines it with the high upside feature of an equity and packages the two payoff features in one instrument. The instrument has fixed payments (interest) but can also be converted to equity if the stock price rises enough.
First, let’s look at the bond-like features of a convertible bond (sometimes referred to as a ‘convert’). Investors who purchase a newly issued convertible bond are lending money to the issuing company to use at its discretion. In return, the lender will receive interest payments on the loan. If the investor wanted to, he or she could simply hold this bond until maturity, collecting the interest payments along the way.
But instead of holding the convert to maturity, the investor could also choose to “convert” the bond to equities. Why would he or she do this? An investor would convert the bond to equity if the share price of the equity has increased. From Investopedia:
Ideally, an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of remaining interest payments.
Each convertible bond is able to convert to a certain number of shares. For instance, one convertible bond could convert to 100 shares of common stock.
Combining debt-like and equity-like features into one instrument gives the investor downside protection while still giving them exposure to the stock. If the stock price decreases, the investor will be left with a guaranteed return (the interest earned on the bond). If the stock price increases significantly, the investor will be left with the upside exposure to the stock price. Because the instrument offers higher upside than normal bonds, the interest earned on the bond portion of the security is usually lower than plain vanilla bonds.
A typical convertible bond payout might look something like the image below. Notice how the price is flat until the stock price approaches the price at which the bond is convertible to equity. From there, the bondholder is able to earn an asymmetric return as the price of the stock increases.
UMA Range Tokens: Crypto Convertible Bonds
UMA has built a crypto version of a convertible bond which they call a range token.
Why Range Tokens Are Useful
Before we explore the nuances of the range token, let’s consider who might want to sell a range token. Perhaps there’s a new crypto project or DAO that has recently launched a token; they likely have a lot of “native” tokens* in their treasury account (balance sheet).
*An example of a native token would be the $UNI token that was launched by Uniswap. It trades openly on both centralized and decentralized exchanges, and its price can fluctuate quite a bit.
Let’s imagine we have a project called DragonDAO (totally making this up here) that’s launched a $DRAGON token. Their treasury (balance sheet) contains only $DRAGON tokens that are worth $50 million. Meanwhile, they may need cash or USDC to pay their employees and contributors.
Also, the $DRAGON token tends to be highly volatile in the short term. Like the $UNI chart above, it can swing up and down very rapidly, making it hard for DragonDAO to create budgets for their upcoming projects. How can DragonDAO get the stability and cash they need to pay their contributors?
Well, one option is that they could simply sell $DRAGON tokens from their treasury on the open market. This isn’t ideal for two reasons:
It puts downward selling pressure on the token and keeps the price suppressed. It’s also not the best signal to be selling your tokens as it can demonstrate a lack of confidence in the valuation.
DragonDAO happens to think that their token is particularly undervalued. They don’t want to sell tokens today if they think they’re not being compensated for the true value of the token.
Perhaps DragonDAO could take out a loan on a decentralized platform like Aave, using their $DRAGON tokens as collateral. That also poses a problem. Given how volatile the $DRAGON token is, DragonDAO will face liquidation risk. If the token drops too much too quickly, the loan platform will sell the $DRAGON tokens in order to pay back the lender. Vanilla loans don’t provide enough stability.
Instead, DragonDAO can issue UMA range tokens. Let’s explore an example to see how they work.
How Range Tokens Work
First, the range token is collateralized. In this case, DragonDAO will collateralize the range token with $DRAGON tokens, which are currently trading at $10. To keep things simple, let’s assume that 1 range token is collateralized with 1 $DRAGON token.
A range token has an upper and a lower bound. This is the range of the token. Let’s say the upper bound is $15 and the lower bound is $5. There are 3 payout scenarios:
Between the range - When $DRAGON is trading between $5 and $15, the investor will earn a stable yield. What’s the mechanism for this? The range token will automatically adjust the number of $DRAGON tokens that the investor earns based on the price of $DRAGON. When $DRAGON is at $5, the investor will receive 1 $DRAGON token as yield. When the token is at $10, the investor will earn 0.5 $DRAGON. See how between the range, the yield is always $5? The number of tokens shifts to ensure that the investor earns a stable yield between the range.
Below the range - when $DRAGON trades below the range, the investor is short a put option. If that doesn’t make sense to you, don’t worry about it for now. Basically, the investor is worse off if $DRAGON drops; the most $DRAGON that they can earn from 1 range token is 1! So if $DRAGON goes to $3 (below the lower bound of $5), the investor’s yield has gone from $5 to $3!
Above the range - when $DRAGON trades above the range, the investor is long a call option (has upside exposure) . The most $DRAGON the investor will earn is set by the upper bound. In this case, that’s 0.33. As the price of $DRAGON rises, they’ll earn more and more in U.S. Dollar terms. For instance, if $DRAGON traded at $50, the investor would earn 0.33 $DRAGON (worth $16.5). That’s an extra $11.5 in yield for the investor.
You can see a payout chart here:
Let’s take note of a few things about this chart:
When $DRAGON is between $5-15, the investor earns $5 of yield.
DragonDAO has issued 1 range token for 1 $DRAGON. The most $DRAGON tokens the investor can earn is 1. This happens in the below the range scenario.
The least number of $DRAGON tokens that the investor can earn is 0.33. This happens in the above the range scenario. In that case, the investor is better off since the price of 1 $DRAGON token is higher.
In the below the range scenario, the investor can actually earn less than $5. In our initial convertible bond payout diagram, there was no “dropoff zone.”
If you’d like to play around with my (simple) model on range tokens, you can find it here. Just make a copy of it and you can tinker with all the assumptions.
Why Would Investors Want Range Tokens?
Now, let’s think about it from the investor’s perspective: why would someone want to buy a range token? Well, first, perhaps the investor has a different risk profile that makes them hesitant to buy $DRAGON tokens outright. The interim volatility could be too high for them to hold $DRAGON tokens.
Most investors who purchase range tokens are long-term believers in a project; they may believe the token price will appreciate and are happy to accept a yield in case it doesn’t. If the token rallies a lot, they’ll have exposure via the embedded call option in the range token.
There are also lots of interesting things that you can do with range tokens. If someone wanted to have exposure to a pure yield instrument, they could hedge out the risk in the downside and upside scenarios by buying a put option and selling a call option.