Synthetic Assets often referred to as synths, are a new trend in the crypto market’s Decentralized Finance (DeFi) sector, which is the fastest-growing niche within the crypto space. In the present article, we’ll define synthetic assets in the context of the cryptocurrency market and list the best platforms to create synths.
The Origin of Synthetic Assets
In general, the term ‘synthetic asset’ came before the DeFi boom. It refers to an asset or mix of assets that have relatively the same value as their underlying asset. As a rule, synthetics merge various derivatives, such as futures, options or swaps, to simulate the price of an underlying asset that can come from commodities, company shares, stock indices, forex pairs or interest rates. In this way, investors can speculate on the price of a real-world asset without actually owning it. For instance, rather than buying company shares, an investment company can buy a call option and sell a put option on the same stock. In this way, it tracks the price and return of a stock with a high degree of accuracy.
Synthetic assets enable the investment firm to employ several financial vehicles rather than buying the stock, which gives it exposure to more liquidity, flexibility, and opportunity for arbitrage. If you have some knowledge about forex and commodity trading on online trading platforms aimed at retail investors, you can compare synthetic assets with contracts for difference (CFDs), which are a type of derivatives that tracks the performance of an underlying asset. Nevertheless, synthetic assets are different, more sophisticated, and designed for other purposes.
As you’ll see below, crypto-related synths are totally different. All in all, I find it fascinating that the derivatives market has expanded at an exponential rate since the early 90s, when the Internet changed the way we trade any asset. This demonstrates a growing global public of investors who are eager to speculate on the volatile prices of various assets.
To understand the hugeness of the derivative market, think about the fact that in H1 2019, there was $640 trillion of the notional amount outstanding for derivative contracts, according to data from the Bank for International Settlements (BIS). Other sources claim that the value of all derivatives exceeds $1.2 quadrillion – a number that is way bigger than the combined value of all assets, including all commodities, stocks, and real estate. This is because derivatives are nothing else than bets, which is why their size can easily exceed the actual capitalization or value of an underlying asset.
While derivatives opened the door to more flexible and convenient trading, as it gives customizable exposure to any asset, they are quite dangerous if institutional investors ignore the risks. In fact, the financial crisis in 2008 was triggered by the excessive use of derivatives called collateralized debt obligations (CDOs), which are financial tools that consisted of different debt products sold on the secondary markets, including mortgages, auto loans, credit card debt, and corporate debt. Legendary investor Warren Buffett said in a letter to investors in 2020 that derivatives are financial weapons of mass destruction. He was quoted as saying:
“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
In order to ensure the fair use of derivatives, we need decentralized infrastructures that cannot be manipulated or wrongly exploited by any groups. Blockchain is the technology that makes it possible, as it enables the creation of trustless platforms that have no single points of failure. Now let’s get deeper into cryptocurrency synthetics and see how they work.
What Are Crypto Synthetic Assets?
In a nutshell, blockchain-based synthetic assets aim to provide traders with exposure to a variety of traditional or crypto-related assets without the need to own the underlying asset. They resemble derivatives like CFDs, but are traded on blockchain infrastructures and tend to be more accurate and fair when it comes to simulating the price of an asset. The underlying asset can be anything from commodities like gold or oil, fiat pairs that include the USD, EUR, GBP or JPY, as well as stock indices and company shares like Apple, Tesla, Facebook, or BMW. It can also be another digital asset like Bitcoin or Ethereum.
The crypto synth is a newly created token that represents the underlying asset. It is a blockchain-based digital unit mirroring the price of the traditional or digital asset that it tracks. By employing these synthetic assets, investors hold unique tokens that accurately mimic the price of traditional assets without the need to go outside the cryptocurrency space. For example, they can own oil-related tokens without having to buy actual oil futures. On top of that, crypto synths come with all the perks of decentralization, which means trustlessness and transparency.
Advantages of Crypto Synthetic Assets
Synthetic assets are gaining popularity in the crypto space, and for very good reasons. Here are the most common advantages of synths:
- Decentralization of Traditional Assets – we used to discuss the great benefits of decentralized cryptocurrencies, like Bitcoin, Ethereum or other altcoins and stablecoins, but how about decentralized gold or the US dollar? Thanks to blockchain, these traditional assets can be converted into synths and then traded on decentralized exchanges (DEXs) without the involvement of any third-party, which ensures the security and transparency of deals.
- Better Liquidity – the DeFi space cannot boast the same liquidity level as the traditional financial market, which provides a wide variety of investment tools. The point is that if a market has more investment vehicles, then it experiences a higher trading volume and hence brings more liquidity. Thus, by minting tokens to collateralize traditional assets, the synths bring in more assets to the DeFi market, thereby boosting liquidity.
- Diversification – Obviously, the more assets you invest in, the better for your portfolio. This is because diversification is the single most important hedging approach that can protect you against volatility and potential price crashes. Traditionally, crypto investors could choose only between cryptocurrencies and ICO tokens, which didn’t provide enough diversification options, especially when most of the crypto space follows Bitcoin. Crypto synths allow investors to diversify their portfolio by getting exposure to conventional assets.
Best Platforms for Crypto Synths
Now that you have basic knowledge of crypto synthetic assets, let’s briefly analyze the three most popular platforms that allow users to create and trade the tokenized versions of any traditional asset. Here they are:
Synthetix is not the oldest platform that enables the issuance of synths, but it has become the most popular one right now thanks to the DeFi boom. It provides an issuance platform and an exchange that allows users to mint and trade synths. Users have to lock up collateral to create synths and then need to repay their loan to reclaim the collateral. All synths are ERC-20 tokens.
Initially, Synthetix began as a stablecoin project known as Havven. It was founded by Kain Warwick, who is currently the CEO of the entity behind Synthetix. The rebranded organization has become one of the biggest DeFi projects, with over $700 million worth of SNX tokens locked up in the protocol as of September 2020.
Synthetix employs a multi-token infrastructure that leverages a complex system of collateral, staking, fees, and inflation. The main types of tokens are the Synthetix Network Token (SNX) and synthetic assets, called synths. The system resembles MakerDAO’s one, which we’ll discuss below. The difference is that MakerDAO users have to lock up Ethereum to create DAI. In Synthetix, you have to lock up SNX to create sUSD (synthetic USD) or any other synthetic asset through Mintr dapp.
The Synthetix ecosystem is made up of three dapps:
- The Synthetix Exchange – it enables users to exchange the newly minted synthetic assets without direct counterparties.
- Mintr – this is the platform where users can stake SNX to earn fees and mint synths.
- Dashboard – it provides an overview of the entire Synthetix ecosystem.
Obviously, one of the most important things for a platform that provides synths monitoring traditional assets is to make sure the price is accurate. Synthetix used to rely on centralized price feeds or oracles, but they were prone to manipulation. Thus, the price of synthetic British pound or Apple could deviate from the real price. This problem has been addressed thanks to a partnership with Chainlink, which is currently the most popular decentralized oracle system that brings information to the blockchain space without the need to trust centralized groups.
Besides creating Synths, SNX holders prefer to stake their tokens to get rewards, as Synthetix uses a unique inflationary model that incentivizes stakers. This is why more than 80% of the SNX is now locked up for staking.
Abra is one of the oldest blockchain platforms that enable the creation of synths. The project started as a crypto exchange and wallet service, but it added the option to invest in company stocks, commodities, exchange-traded funds (ETFs), and commodities using Bitcoin and Litecoin.
When the user deposits funds into their Abra wallet, the funds are instantly converted to Bitcoin or Litecoin (depending on his/her choice) and shown as USD in the Abra app. For instance, if you deposit $1,000 into your Abra wallet and the price of Bitcoin is $10,000, you will receive a deposit of 0.1 BTC that will show up as $1,000. The platform can achieve this by maintaining a BTC/USD peg that ensures you can redeem $1,000 no matter the price fluctuations in either BTC or USD.
Next, Abra immediately mitigates its risk so that it could enable the smooth trading of the newly created synths. Thus, when you fund your wallet, you are actually taking a short position on Bitcoin and a long position on the hedged asset, whether it’s a stock or commodity. On the other side, Abra is taking a long position on Bitcoin and shorting the hedged asset.
So in practice, if you want to buy $1,000 of Google synths on Abra, the platform would peg $1,000 to your BTC against the price of Google’s stock. If the stock price goes up or down, Abra would add or subtract the equivalent amount of Bitcoin from your contract.
While this approach is a bit sophisticated and difficult to explain, users don’t have to think about it at all. They just buy fractions of shares in the listed companies, ETFs or commodities and try to generate profits on price fluctuations.
Universal Market Access (UMA)
UMA is a decentralized platform designed for financial contracts that employs a “probably honest oracle mechanism” and blockchain-powered smart contracts to enable users to create any financial product.
The platform enables users to mint synths based on the ERC-20 protocol and create tokenized derivatives that offer exposure to real-world assets the same way as traditional ETFs do.
On UMA, any two counterparties can come together to build financial contracts that are secured via economic incentives (collateral), and enforced via smart contracts on Ethereum.
UMA is a fast-growing ecosystem, with the native UMA tokens being the 30th largest cryptocurrency by market cap as per Coinmarketcap data. In mid-September, UMA broke above $1 billion in market cap for the first time.
Why Are Crypto Synthetic Assets Important?
Synthetic assets powered by smart contracts may have a great impact on the traditional financial industry. These new cryptocurrency-collateralized tokens may provide crypto holders with the ideal instruments to trade conventional assets and their derivatives while staying within the digital ecosystem.
As you may guess, decentralization opens the door to a global community of retail and institutional investors. There are no borders, no useless rules that vary from jurisdiction to jurisdiction, and no central authority that can impact the market. Before platforms such as Synthetix, Abra, or UMA, only a few professional investors could get exposure to derivatives. Today, anyone with a smartphone and some basic understanding of trading and synths can access these lucrative investment vehicles.
This is only the beginning. In the near future, we can see the cryptocurrency market expanding at the expense of traditional finance, and even gradually replacing fiat currencies. As for synthetic assets, they will grant investors many opportunities by leveraging derivative-like, blockchain-based products.