Synthetic Assets - DeFi's Coming Of Age Story
Most Decentralized Finance (DeFi) applications look like copies of traditional financial products. You can swap one token for another, borrow or lend a token in a money market, and even trade on an exchange with margin and leverage.
But DeFi can go much further. Blockchains are open, global platforms that carry programmable value at their core. It’s only a matter of time before DeFi produces something unique — with no corollary in the traditional world.
Introducing Synthetic Assets, a.k.a Derivatives.
A derivative is an asset that derives its value from an underlying asset or index.
Suppose a derivative’s value is tied to the value of another asset via a contract. In that case, we can trade the movement of that value using trading products like futures and perpetuals.
How do synthetic assets differ from traditional derivatives like futures?
Instead of using contracts to create the chain between an underlying asset, and the derivative product, synthetic assets tokenize the relationship. This means synthetic assets can impart exposure to any asset in the world — all from within the crypto ecosystem. A synthetic asset is simply a tokenized derivative that mimics the value of another asset.
Suppose one wants to trade AMC Entertainment Holdings Inc (NYSE: AMC) stocks without holding the $AMC asset. Using a synthetic, you can trade $sAMC (synthetic AMC) instead, which behaves like the underlying asset by tracking its price using data oracles such as Chainlink.
Frictionless Transfer: You can move between stocks, synthetic silver and gold, and other assets without holding the underlying asset.
Global Liquidity: Another advantage of synthetic asset protocols is their ‘infinite liquidity.’
No Central Party Risk: There are no central parties with privileged control
Borderless Participation: While there are no specific citizenship requirements to participate in the stock market, there are certain needs that investors must satisfy. Non-US persons must provide identification documents, pass Know Your Customer (KYC) screening, and comply with several laws intended to protect US interests. However, synthetic assets feasibly give investors on any location or jurisdiction exposure to the price action of stocks, commodities, and currencies. To trade these tokens, users would hardly need any requirements to enter the US equities market. This makes synthetic assets a favourable alternative for foreign investors experiencing barriers to entry.
Access to Emerging Asset Classes
Synthetic assets allow investors to invest in new commodity classes. Take BTCST, for instance. Bitcoin mining power has historically been limited to those who can afford expensive mining equipment, but synthetic assets are innovating to bridge this gap.
Through the tokenization of bitcoin mining power or hashrate, anyone can buy into the token and reap the rewards of bitcoin mining without needing to own and operate the machines physically.
Understanding Synthetics Role in DeFi
There are several reasons synthetics are useful to multiple participants in the “decentralized finance” (DeFi) ecosystem.
Scaling assets: One of the biggest challenges in the space is bringing real-world assets on a chain in a trustless manner. One example is fiat currencies. While it’s possible to create a fiat-collateralized stablecoin like Tether, another approach is to gain synthetic price exposure to USD without holding the actual asset in custody with a centralized counterparty. For many users, price exposure is good enough. Synthetics provide a mechanism for real-world assets to be traded on a blockchain.
Scaling liquidity: One of the main issues in the DeFi space is a lack of liquidity. Market makers play an important role here for long-tail and established crypto assets but have limited financial tools for proper risk management. More broadly, synthetic and derivatives could help market markets scale their operations by hedging positions and protecting profits.
Scaling technology: Another issue is the current technical limitations of smart contract platforms. We haven’t yet solved cross-chain communication, which limits the availability of assets on a decentralized exchange. With synthetic price exposure, however, traders don’t need direct ownership of an asset.
Scaling participation: While synthetics have traditionally been available to large and sophisticated investors, permissionless smart contract platforms like Ethereum allow smaller investors to access their benefits. It would also allow more traditional investment managers to enter the space by increasing their risk management toolset.
Synthetic Asset Protocols
Synthetix is an Ethereum-based protocol for issuing synthetic assets. Analogous to derivatives in legacy finance, synthetic assets are financial instruments in the form of ERC-20 smart contracts known as “Synths,” which track and provide the returns of another asset without requiring you to hold that asset. You can trade Synths — from cryptocurrencies, indexes, inverses, and real-world assets like gold — on Kwenta, Synthetix’s decentralized exchange (DEX). Synthetix’s native token, the Synthetix Network Token (SNX), is used to provide collateral against Synths that are issued.
Synths - Synths use decentralized oracles, smart contract-based price discovery protocols, to track the prices of the assets represented, allowing one to hold and exchange Synths as if owning the underlying assets. Synths are different from tokenized commodities, such as Paxos’ PAX Gold (PAXG), which is backed by gold bars. Owning PAXG means owning the underlying gold and that Paxos holds it for you, whereas owning Synthetix’s sXAU means that one does not own the underlying asset — but merely has exposure to the price of gold.
Mirror Protocol enables users to issue synthetic assets, which are crypto tokens that track the price of real-world assets, such as stocks. Synthetic assets can be quickly traded for other synthetic assets or stablecoins on automated market makers (AMMs) such as Uniswap or Terraswap.
Mirror Protocol is built on the Terra network, though its synthetic assets — referred to as Mirror Assets (mAssets) — are also available on Ethereum and Binance Smart Chain (BSC) via bridges. Mirror Protocol is governed by the holders of Mirror token (MIR), its native governance token.
mAssets - Synthetic assets on Mirror Protocol are called mAssets. To mint (or create) a mAsset, you must first deposit collateral to the protocol (amounting to more than 150% of the current value of the real-world asset). The protocol accepts TerraUSD (UST), a stable coin issued via Terra - now lost its peg post-crash of May-June 2022, and mAssets as collateral. If the value of the real-world asset rises to exceed the value of the collateral you deposited, your collateral will be liquidated to ensure the system is solvent. If you wish to redeem your collateral, you must first burn the mAssets issued to you. One can also trade mAssets by interacting with liquidity pools on AMMs such as Uniswap and Terraswap. Though mAssets can be traded 24/7 (like most cryptocurrencies), they can only be minted during real-world market hours (in keeping with the stocks and bonds that serve as their underlying index value).
Synthetify is the synthetic asset exchange built on Solana. Solana is notable for numerous reasons but mainly because of its massive transactions per second (TPS) metric, which increases as computing power increases. Given that the fees are <$0.01 per transaction, this seems to be the perfect place for institutional money and high-frequency trading firms to work their way into cryptocurrency. This is already happening.
These firms want exposure to DeFi, of course, but they also want to be able to do what they have done with traditional financial products – but better. A decentralized synthetic asset exchange like Synthetify will enable them to do just that. Using oracles that bring off-chain price feeds on-chain, Synthetify will be able to offer any asset to be traded on Solana. Sure, other synthetic platforms exist like those listed in this article and more, but none of them is built on Solana. As a result, Synthetify has lots of potential.
Synthetify utilizes a unique model where traders deposit collateral to enable them to trade synthetics against a collective debt pool. The supported collaterals are USDC, SOL, SNY, and renBTC. SNY stakers earn a proportional share of exchange fees associated with the debt pool. These fees are currently capped at 0.3% per trade.
Understanding Varied New Crypto Assets
Synthetic representations of real assets are an essential first step, but the design space for derivatives in crypto is massive and largely untapped. Dimitry Berenzon from 1Kx, in an article, talked about a few derivatives that can actually up the synthetic assets game.
These include traditional derivatives that are structured for the various participants in the crypto-asset markets and “crypto-native” derivatives that have not previously existed in conventional financial markets. Some of these derivatives are:
Hash-Power Swaps: The idea is to have miners sell a portion of their mining capacity to a buyer, such as a fund, for cash. This gives miners a steady income stream that does not rely on the underlying crypto asset price and gives funds exposure to a crypto asset without investing in mining equipment. In other words, miners can hedge market risk because they do not have to rely on the market price of the crypto asset they are mining to remain profitable. This is also being structured and offered by BitOoda via their physically settled “Hash-Power Weekly Extendable Contracts”.
Electricity Futures: This is a product that has been available in traditional commodity markets for quite some time but could be offered to cryptocurrency miners. The miner enters into a futures agreement to purchase electricity at a given price at an agreed time in the future (e.g. three months). This allows the miner to hedge their energy risk since a sharp rise in electricity costs could make mining unprofitable. In other words, the miner turns their electricity costs variable to fixed.
Airdroptions: This would be an option to purchase a crypto asset with a strike price equal to its airdrop. The option buyer receives a payout structure similar to that of a deep-in-the-money call option, with a premium that equals the market price of that airdrop. If the airdrop performs well, the buyer exercises the option, and the seller delivers the crypto asset. If the airdrop does not, the buyer doesn’t exercise the option, and the seller receives the premium.
Synthetic digital assets are revolutionizing decentralized finance by offering access and liquidity to investors. Through tokenization, individuals can access investment opportunities that might otherwise be impractical for their situations, democratizing finance and providing increased access to the promising investments of the future.
Synthetics and derivatives are essential for building mature markets — i.e., markets that have reached equilibrium — by facilitating price discovery and helping hedge against volatility. Since transactions are handled entirely on the digital blockchain and facilitated through self-executed smart contracts, entering and exiting from investments with near-instantaneous liquidity has never been easier.
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