How Synthetic Assets Will Change the Financial World
Trading something without owning the underlying asset is nearly as old as the financial markets themselves. In traditional markets, they are referred to as ‘derivatives’. The derivatives market is the bread and butter of the global financial system — and is estimated to top one quadrillion globally (although the number is frequently dismissed by some analysts).
With the advent of the blockchain, and the ability to take advantage of efficiency gains and fungibility inherent within it, there is now a further step: synthetic assets.
But what are these ‘synthetic’ assets? And how will they change the world?
What are Synthetic Assets?
Synthetic assets are a tokenized derivative of an asset that exists on the blockchain and can be used within the DeFi ecosystem and employed on other DLTs. It allows for the creation and representation of notional value on the blockchain in the form of crypto tokens. Tokens have been created for gold, silver, stocks, bonds, and more.
These tokens track and mimic the price of the underlying asset. Stablecoins are the most obvious and essential example of synthetic assets, and we’ll cover them in depth lower down.
Yet because derivatives can track not only the price of individual commodities but also the price of entire positions (say, a ten-year short against the value of a basket of stocks set against the value of gold over the same timeframe), it’s perfectly possible to create a synthetic of that entire position. The possibilities to then fold those tokenized positions in DeFi protocols makes for a dizzyingly complex set of possibilities — the potential of which has barely been explored.
Finally, synthetic versions of other cryptocurrencies can be created. There are plenty of protocols that offer synthetic BTC, for example. How and why you’d want to do this we’ll discuss later on.
How Do Synthetic Assets Work?
Depending on the protocol, synthetic assets can work in a variety of ways. Like stablecoin collateralisation though, they’re broadly split into two camps. There are synthetic assets that are backed by financial value stored off-chain, and those which are collateralised by on-chain methods.
The simplest way to guarantee the value of a synthetic asset is by owning its corollary asset off-chain. Paxos Gold is an example of a protocol that issues tokens that track the price of gold, with the gold physically held in off-chain vaults.
If a synthetic token of a bond is created, it’s possible for the individual or institution who created it to own the bond off-chain and allow it to be redeemed in exchange for the tokenized asset when it is returned to them. Of course, these methods lack the multiplicative effect that is possible with synthetic assets, but they are a surefire way of guaranteeing their value.
Of course, on the blockchain (and in traditional finance), you can also peg value using other assets as collateral. In crypto terms, this means using crypto-collateral and locking it within a protocol which would then, in turn, issue the synthetic asset you require.
The first and most famous example of this is Synthetix, who first conceived the idea. With Synthetix, you can buy and deposit their native token which is then used, at an over-collateralized ratio to protect against market shocks, to mint synthetic versions of commodities like gold and silver.
Other protocols like Comdex, which is built on Cosmos, allow users to mint synthetics based on the prices obtained from price oracles, which may then be traded on their DEX via the cAsset app. The protocol has also adopted the CDP model, wherein users can lock their crypto assets as collateral when minting synthetics. Moreso, Comdex is able to aggregate liquidity from multiple DeFi ecosystems, thus bridging the gap between CeFi and DeFi and allowing these assets to be traded through IBC-enabled chains. As expected, liquidity is paramount to the success of synthetic assets, and Comdex has several means of incentivising it with liquidity mining.
Why Are Synthetic Assets Useful?
The chief usefulness of synthetic assets lies in their composability with DeFi and the ability to move any type of commodity or derivative trading on-chain where it is traceable, transparent, and fast.
Furthermore, deployment of synthetic assets on the blockchain can result in specialised yield by engaging in DeFi. Finally, and perhaps most importantly, the synthesization of assets creates a much more fluid and fungible economy as notional value can be exchanged and traded with ease.
If I wanted to swap the notional value of an Italian 10-year government bond I was holding for its equivalent in gold, then through traditional finance methods, this would be slow and cumbersome. I may have to outright sell the bond for a dollar or other fungible token before buying gold, incurring fees along the way.
Synthetic assets allow for the possibility of direct swaps and financial interaction between previously siloed commodities, derivatives, and assets. Although the ecosystem for this is nascent, it’s growing and is one of the key reasons institutions (who hold a lot of these types of assets) are interested in the blockchain.
Are Stablecoins Synthetics?
Yes, and albeit being arguably different to other synthetics like stocks, bonds, or commodities, stablecoins still track the underlying value of off-chain fiat currencies.
Stablecoins are poised over the coming years to muscle into the world economy at large and become one of the de facto payment systems of the modern Web 3.0 enabled world.
Their speed, fungibility, and decentralisation makes them an excellent store of value, and are the first attempts at a new money since we digitised finance with the advent of computers. Stablecoin issuers and stablecoin protocols have grown immensely over the last year, as more market participants realise the value they bring.
Onomy Protocol is bringing the most flexible, decentralised, and fastest stablecoin minting facility into reality. Users will be able to mint Denoms to synthetically represent any national currency they require. It opens up the possibility, in time, of creating the entire Forex market on-chain. A tokenized version of the Forex market would be fairer, faster and more inclusive than the one that currently exists. Of course, this does not undermine the sheer potential of stablecoins to be used as means of payment, to access credit markets, or simply provision liquidity in exchange for yield, opening new opportunities for people to access the currencies they need, when they need them.