#1 What Is A Crypto Synthetic Asset?

To best understand synthetics I think it is best to start with the idea of counter party risk. OK, let’s go!

Say you have one physical gold coin in your possession. You have 0 counter party risk. You have the gold, no one has a claim on it, and you have it in a safe place under your control. While this is the best way to hold an asset, it is very limited in use. You do not gain interest, it is hard to store and keep safe, hard to fractionalize etc etc. But, as you have no counter party risk, you rely on no one else to keep you stored value safe. You are like your own bank.

Now, let’s move a step forward and create a synthetic asset from that gold coin. The internet defines a synthetic asset as:

“The combination of securities and/or assets in such a way that they produce the same financial effect as the ownership of an entirely different asset would.”

That is a crazily complicated way of saying you collateralize something by locking it into a contract, and then use a data feed to speculate on something else. It is actually very simple:

To create a synthetic asset you take something of agreed upon value, lock in into a contract thereby collateralizing it, then extract that value to use on something else.

Let’s go back to our gold coin. How can I make a gold coin synthetic asset? You probably have figured it out by now! Take it to a gold storage vault, deposit the gold coin, get a certificate that is valid for claiming one gold coin and there you have it! With that paper in hand you have just created a gold backed synth.

The value of that synth(gold certificate) is now dependent on the DATA FEED of the generally agreed upon price of gold. So, if you think the price of wheat will go up but the price of gold will stay stable or go down vs wheat you use that gold certificate to buy some wheat. If the price of wheat in gold terms goes up, you can sell the wheat for more fractions of gold certificate to claim more gold. Importantly, you are not making more gold, you are making more CLAIMS on the gold at the gold storage facility.

Remember the idea of counter party risk? This where it comes into play.

By placing your physical gold at the gold depository you are taking on the counter party risk of that gold being lost/stolen/damaged etc. When you sell that gold certificate you are giving that counter party risk to the buyer. When you buy it back, you take that counter party risk back on yourself.

Creating and using synthetic assets always relies on some amount of counter party risk. To create a synth, something has to be collateralized (locked into a contract) and with that comes risks. Here is where blockchain and crypto assets truly shine a beacon for future innovation!

With the above example of the counter party risk for the gold coins, we can already guess some HUGE risks. Theft, fire and many other risks to the physical assets exist. Most common however, is fraud. How can you know that your gold certificate can actually be redeemed for physical gold? How can you ‘audit’ all the physical gold and all the gold certificates to make sure they match 1:1? You can’t of course, and the problems caused by fraud of this sort have caused much suffering throughout history.

How can blockchain fix this? Decentralized blockchain distributed ledger technology makes auditing possible constantly, in real time, and visible to anyone. It is easy to check, in every moment, exactly how much collateral(gold in the above example) is locked in a contract and how much issued synthetics (gold certificate) is in circulation. There is no guessing. There is a much smaller risk of fraud or theft.

For example, let’s use bitcoin as the same as gold in the example above. First, you deposit a bitcoin in a protocol (lock in a contract), then you withdraw half of it’s value in synthetic Bitcoin coins(sBTC in this example). The sBTC can then be sold for another speculative asset(wheat). At every moment you would know how much sBTC is in circulation and how many Bitcoins are locked into the contract. There is still counter party risk for the bitcoin and sBTC holders(the code of the smart contract) but it is much less than with the physical gold example above.

The ‘bank run’ phenomenon risk (where people lose assets when more synthetic collateral exists than actual collateral) would then be mitigated, and theoretically eliminated, by two factors:

1. The sBTC is over-collateralized (there is two times as much gold as gold certificates in circulation)

2. The amount of both locked collateral BTC(gold coins) and sBTC(gold certificates) are publicly visible reducing the risk of people losing trust in the protocol and withdrawing assets.

There are hundreds of other examples of current and possible future uses of crypto synthetic assets that we will get into in the future. If you have any questions or comments about this, please don’t hesitate to get in touch!

For the next post we will look at the importance of data feeds for synthetics and how that might look in the future.