The first derivatives ever created were clay tokens that represented claims over goods such as loaves of bread in ancient Sumer before 5000 BC. Sumero is a modern digital manifestation of this innovation.
Sumero is a decentralised finance (DeFi) application for creating synthetic assets. It will be governed by a decentralised autonomous organisation (DAO) coordinated around a governance token called Clay. Sumero will enable anyone to create and trade financial derivatives, by selecting from a basket of underlying protocols (Layer 1 blockchain, oracle service, eligible collateral, etc) that can be seamlessly combined to create and exchange financial risk without a financial intermediary. It will act as a single portal to the world of synthetic assets, offering users of DeFi a superior choice and user experience.
Sumero is different to current synthetic asset protocols in that it will enable anyone to create their own synths via a censorship resistant minting process that will prevent minters from acting maliciously. Only a few parameters from pre-audited contract templates will be amendable.
A Sumero World
As thing stands financial assets exist in silos. If you want to save money you store your money in a bank. If you want to buy stocks you send money to an online brokerage. If you want to send money abroad, you send money to Transferwise. Sumero will sit on a financial system that sets financial assets free. Let’s say you’re sat in a pub and your friend tells you about some hot Nigerian tech startup that has yet to go public. You love the concept and want to invest. These days it’s generally impossible to get exposure to a company like this. Either shares don’t trade or if they do the effort in signing up to an OTC platform, figuring out the mechanics of trading and the general hassle of traversing the siloed financial system prevents most from even attempting to gain exposure. To be honest, minimum trade amounts preclude the vast majority from investing in the first place anyway.
On an open financial system things are very different. In the future when someone hears of an investment opportunity like this, they can simply search for it on SumSwap. If there isn’t a synthetic asset, one can declare their interest in gaining exposure on Sumero, creating the opportunity for a freelance financier acting like an investment bank to mint a token that tracks the predicted future value of its IPO launch price. Then, without having to sign up to any financial intermediary, one can simply swap another asset they own for this token and gain exposure. There are no minimum amounts so nobody is priced out. Trading is 24/7 so it can be done on the spot in the pub no matter the time in Nigeria. Since the asset exists on an open financial system, its owner can even put it work in further ways. For example, it could be lent out to traders looking to make leverage bets in return for a fixed income on top of the expected return from price appreciation. I’m not even scratching the surface of the possibilities here. The beauty of Sumero and other open financial applications is that you can do all these things without having to worry that their counterparties will screw them over because the way the system is designed they can’t screw you over. That’s the power of blockchains.
One of the financial markets in DeFi’s sights is the $1.2 quadrillion (notional value) derivatives market. Since the global financial crisis, much of this liquidity is mandated to be cleared at centralised clearing houses so that regulators can both view the market and mitigate risk. The Bank of International Settlements estimates that the OTC market continues to account for about half of all trades with a notional value of $608 trillion (gross market value of $15tn) in June 2020. It is our belief that a huge chunk of the derivatives market will move to the blockchain where trusted execution and price oracles can automate a substantial amount of human labour. The OTC market in particular is ripe for disruption as institutions are often forced into using brokers in order to preserve their anonymity when accumulating a position. Blockchains, on the other hand, could allow for settling these types of bespoke bilateral or multilateral contracts the OTC market caters for without either side needing to expose their identity.
Given their open permissionless nature, blockchains can even make possible new markets coordinated around derivatives that don’t currently exist. In fact, we’re already beginning to see novel synthetic assets that don’t exist in traditional markets. These synthetic assets will enable individuals to hedge all forms of risks they may face in life without having to engage a financial intermediary, along with enabling humanity to make much better predictions about the future. Furthermore, we don’t see this market being limited to speculation, prediction and hedging. For example, we see a future where it’ll be possible to take one side of a derivative contract and engage a smart contract that renders your position delta neutral enabling people to pick up the “risk free” rate. In a world of sustained low interest rates, a low risk/return strategy like this can become an alternative to the savings account. Such strategies have, up until now, only really been available to financial professionals but DeFi will enable non-professionals to access such earning potential, much like the internet enabled us all to become content producers.
In sum, we expect a much richer, more competitive, less concentrated and less intermediated derivatives market to proliferate on the blockchain.
The Emerging Technology and Product Stack
The process of decentralising finance is well under way. The key elements necessary are foundational blockchains for data storage and compute, pricing sources, and synthetic financial assets that live on-chain.
Today there are now many smart contracting blockchains or what are known as Layer 1 protocols. Ethereum is by far the most widely used but there are other competitors such as Polkadot, Solana, Tezos, and Avalanche. There has also been a proliferation of oracle services including Augur, UMA, Chainlink, Band Protocol, API3, and more. All of these involve different approaches and security trade-offs. Augur and UMA are “priceless contracts” in the sense that they don’t engage an external data feed but rather create the incentives for the price to track the underlying asset using the threat of an expensive dispute resolution mechanism. The others involve regular payments for a data feed to keep the price information accurate. There has also been a proliferation of synthetic assets (tokenised derivatives) that employ some of these blockchains and oracle services. Synthetix is the leading provider of these. It secures $1.6bn of synthetic assets and has a network valuation of $3.2bn. It lives on Ethereum and uses Chainlink price feeds to track the price of various stocks and commodities. Mirror Protocol is a noteworthy competitor on the Cosmos interchain network with cross-chain bridges to transfer assets between blockchains.
The building blocks for the future I outlined in the introduction are certainly falling into place. That said, there is still some way to go to enable people and institutions to seamlessly contract with each other.
When a derivatives contract is deployed on the blockchain it will work as it was coded to work. However, if it has a bug, there will be no way of remedying the problem, resulting in a loss for one or all parties. Consequently, code audits are of paramount importance. As things stand, each individual contract needs to be audited by all parties. Either each contracting party must have coding experience or employ a third-party auditor. The other option is to approach one of the synthetic assets DAOs and request a new product. However, there are limitations here too. These DAOs have their own rules. For example, if you want to mint a Tesla synth on Synthetix, you need to over-collateralise it on the short side to the tune of 500% with the protocol’s native asset SNX. Since the SNX futures markets are thin, hedging one’s exposure is very difficult. You are also forced to use Chainlink as an oracle and Ethereum as the settlement layer. In the case of Mirror, those on the short side are forced to collateralise with a USD derivative called Terra USD (UST). This is a synthetic asset whose resilience in adverse market conditions is completely unproven. One is also forced to use Terra’s oracle and rely on their chosen settlement systems. Given that the entire raison d’etre of the OTC derivatives market is for bespoke offerings precisely tailored to the needs of the contracting parties, this situation is not a viable path forward for it.
The Solution: Sumero Protocol
The goal of Sumero Protocol is to remove the requirement to audit code by contracting parties or to rely on designs and product offering choices offered by DAOs. Sumero will put complete control into the hands of individuals and firms seeking to gain exposure to financial risk in order to grant the similar flexibility as offered by the OTC derivatives market in traditional finance today.
Although Sumero will provide users with the tools to make these design decisions themselves, it will remove the need for them to trust each other by automating the asset creation process on censorship resistant infrastructure. In Sumero there will of course be collective governance – every protocol needs it – but it will be only be used to expand the tools and feature set available to users. Users themselves will decide which products are minted at Sumero and how they’re secured. The protocol will be designed so that users can mint synthetic assets that anyone can trust without needing to be able to code. The contracts will also be trustlessly issued on a blockchain and engaged with an oracle. If a price identifier needs to be approved with the oracle provider, Sumero will also handle this process on behalf of the user. Anyone interacting with the contract will know any asset that bears Sumero’s stamp will have been created via this trustless execution protocol and will therefore be able to rely on the original security audit without having to examine each individual contract in the knowledge the audited template it was created from could not have been amended outside of specific parameters.
Since users will have complete control in specifying contracts to their needs, Sumero will enable users to recreate the bespoke OTC derivatives market on the blockchain but with much less cost and friction and without requiring a broker to remain anonymous.
In offering users complete control, they will not only be able to choose between competing options, but they will also be able to combine them. The minter of a synthetic asset could issue an asset on Polkadot and have it secured by both API3 and Chainlink. An attacker would thus have to compromise both oracle providers. The issuer could also distribute liquidity – and therefore risk – across multiple blockchains. If the security of one blockchain fails, only part of the position will be lost. Market participants can also build on each other’s creations. Issuer D could take issuer A’s USD on Ethereum secured by Band Protocol, Issuer B’s USD that is secured by Augur and Issuer C’s USD that is secured by Chainlink and use them all as collateral to mint another meta-USD token greatly reducing risk to those exposed on the long side. This would be somewhat analogous to reducing one’s exposure to bank liquidity or solvency risk by having many bank accounts without the friction of dealing with many bank accounts. Again, of all these risk mitigation choices will be made by individual users as opposed to centrally planned governance in a DAO.
How Does it Work?
The Sumero protocol will store independently audited contract templates approved by the Sumero DAO. It will also store and compute censorship resistant scripts that will enable users to parameterise these templates to their requirements without introducing any bugs intentionally or otherwise. The process via which the contract is deployed on the blockchain and engaged with an oracle will also be conducted via an automated censorship resistant process.
When Sumero is deployed anyone, anywhere, will be able to mint their own synths which will be governed by their preferred rules. Anyone that wishes to gain exposure to them can trust they are secured how they are claimed to be secured.