The Capital
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The Capital

Synthetic Derivatives

Active traders tend to be speculative investors and aren’t as prominent among those who take a “buy-and-hold” approach.

In this post:

Overview of synthetic assets

What are they, and how are they used in traditional financial markets?

Why are synthetics important to the crypto markets?

Synthetics in DeFi and the Role of Oracles

Synthetics are used to simulate particular instruments while altering some key characteristics. This allows investors to gain exposure to underlying assets without necessarily having to hold them.

Digital Representation

In the cryptocurrency space, tokens are a digital synthetic representation of any other asset, including those in the real world, such as stocks, commodities, or fiat currencies. Crypto synthetics can also be used to gain exposure to cryptocurrencies and tokens. A simple example could be some of the “wrapped” assets used in Ethereum’s DeFi applications.

Wrapped Bitcoin (WBTC) has succeeded over recent months, which is a testament to the appetite for such assets, having risen from a market cap of around $1.1 billion in September to $4.7 billion at the peak of Bitcoin’s recent rally above $40,000. The recent release of a synthetic version of Monero could help would-be investors get around the exchange clampdown on privacy coins. It offers investors exposure to Monero (XMR) without having to navigate the ongoing delistings, while also providing an opportunity to stake Wrapped Monero (WXMR) in the various Ethereum-based decentralized finance applications.

Speculation

The most common use-case of crypto assets is speculation, this is not necessarily a bad thing. Speculation has been a key driver in the development of traditional financial markets.

Some speculators base their investing decisions on social media groups and memes. This was, and still is, the primary driver behind the surge in stock price for companies like GameStop and AMC Theaters. Both companies were mired in financial trouble and, at different points, rumored to file for bankruptcy prior to 2021.

At present, it still plays a major role in the industry today. This is because the price movement of securities is frequent and volatile. It is normal for participants to take advantage of fluctuations in the market.

The best way to predict the future is to create it — Peter Drucker

The crypto asset market today majorly suffers from a lack of depth in liquidity. In contrast, assets within the traditional financial system have built a baseline of liquidity over multiple decades. Insufficient liquidity limits the utility of the underlying protocols. This has been the case with decentralized exchanges and meme coins. Much of the liquidity is only moving from one asset to another.

What are synthetics?

A synthetic position is a way to create the payoff of a financial instrument using other financial instruments. A synthetic position can be created by buying or selling the underlying financial instruments and/or derivatives.

In other words, the risk/reward profile of any financial instrument can be demonstrated using a combination of other financial instruments.

Synthetics are comprised of one or more derivatives, which are assets that are based on the value of an underlying asset and include:

Forward commitments: Futures, forwards, and swaps

I won’t predict anything historic. But nothing is impossible. — Michael Phelps

Contingent claims: Options, credit derivatives such as credit default swaps (CDS), and asset-backed securities.

What are synthetics good for?

There are a variety of reasons why an investor would choose to purchase a synthetic asset. These include funding, liquidity creation, and market access.

Below I will provide an overview and examples from traditional finance for each of these reasons. Note that these are not mutually exclusive.

Funding

Synthetics can lower funding costs. One example is a Total Return Swap (TRS) that is used as a funding tool to secure financing for assets held. It allows the party to obtain funding for a pool of assets it already owns and the swap counterparty to earn interest on funds that are secured by a pool of assets. Used in this way, the TRS is similar to a secured loan because:

The party that sells the securities and agrees to buy them back is the party that needs financing, and the party that buys the securities and agrees to sell them bank is the party that provides the financing.

Liquidity creation

Synthetics can be used to inject liquidity into the market, which reduces costs for investors.

One example is a credit default swap. A CDS is a derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a series of cash payments to the seller and receives a promise of compensation for credit losses resulting from a “credit event”, such as a failure to pay, bankruptcy, or restructuring. This gives a CDS seller the ability to synthetically long an underlying asset and a CDS buyer the ability to hedge their credit exposure on an underlying asset.

In this paper, the author demonstrates that CDS markets are more liquid than their underlying bond markets. One of the main reasons for this is standardization: the bonds issued by a particular firm are usually fragmented into a number of different issues, which differ in their coupons, maturities, covenants, etc. The resulting fragmentation reduces the liquidity of these bonds. The CDS market, on the other hand, provides a standardized venue for the firm’s credit risk.

Market access

Synthetics can open up the marketplace to relatively free participation by recreating the cash flow of virtually any security through a combination of instruments and derivatives.

For example, we could also use a CDS to replicate the exposure of a bond. This can be helpful in a situation where the bond is difficult to obtain in the open market (e.g. perhaps there weren’t any available).

Let me provide a concrete example using Tesla 5-year bonds, which are yielding 600 basis points over Treasuries:

Tesla Model Y arrives in Europe

Buy $100,000 of 5-year Treasuries and hold them as collateral.

Write (sell) a 5-year, $100,000 CDS contract.

Receive the interest on the Treasuries and get a 600 basis point annual premium on the CDS.

If there’s no default, the coupons on the Treasury plus the CDS premium will give the same yield as the 5-year Tesla bond. If the Tesla bond defaults, the portfolio value would be the Treasury less the CDS payout, which amounts to the default losses on the Tesla bond. So, in either case (default or no default), the payoff from the portfolio (Treasuries + CDS) would be the same as owning the Tesla bond.

What makes a good synthetic?

In some instances, synthetic product development has only been possible once a critical mass of liquidity has been attained in the underlying. There is little point in creating a synthetic if the underlying is too illiquid since it is likely to reduce the economic benefits.

Total return swaps are a good example of this process. Though the credit derivative market began to form in the early 1990s, total return swaps were not widely quoted or traded for several years. In fact, investors or speculators seeking exposure to a specific corporate bond or bond index were more likely to purchase or short the reference bond or index directly.

As market makers began managing their credit portfolios more actively and quoting two-way prices on a range of credit derivatives, activity began to build, and opportunities for investors to participate in synthetic credit positions via total return swaps improved. As a robust two-way market began to form, bid-offer spreads on the synthetic compressed, attracting more end-users eager to assume or transfer credits synthetically. The market is now able to support a broad range of credit references because the underlying credit derivative market is liquid, active, and well supported.

Why synthetics and DeFi?

There are several reasons why 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-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 having to hold 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 both long-tail and established cryptoassets, but have limited financial tools for proper risk management. Synthetics and derivatives more broadly 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.

Synthetics in DeFi

There is actually already widespread use of synthetics in the DeFi space. Below I will provide several examples of projects utilizing synthetics along with simplified diagrams of what the asset creation flow looks like.

The Evolution of Oracles

In the past, many decentralized applications (dApps) have been financial. This is starting to change with projects turning to Oracle networks for different event-based outcomes. For instance, Oracle networks can power insurance contracts by delivering data that triggers the settlement of insurance claims. That is when the conditions stated in the contract are made then the activities take effect. Projects like Etherisc are using hybrid smart contracts to enable farmers to protect themselves against risks associated with weather. The protocol aims to make insurance purchases more effective with decentralized insurance applications.

In the past year, two-thirds of global weather damages were not covered by insurance programs. Arbol uses smart contracts and climate data to give farms and businesses that would not have access to weather insurance the ability to leverage a policy covering their land against risks associated with weather. In this particular scenario, chain link oracles report when a certain level of rainfall has taken place. This triggers the execution of the smart contract and the client are paid without the need for a subjective assessment or a long claims process.

Another important use case for oracles is in futures and derivatives. Last year derivatives exchange FTX offered users the opportunity to buy futures contracts. Dedicated prediction protocols have sprung up which allow users to trade in the outcome of various events. According to Chainlink’s Sergey Nazarov, data delivery is just an initial phase for Oracle networks. Oracle networks are moving beyond data delivery into the off-chain computation. They are going to power any sort of decentralized service that a blockchain cannot do on its own. These include generating privacy, scalability, randomness, and so on or behalf of smart contracts.

Chainlink has started to rollout computational functionality for its Oracle networks with features like keepers that help to automate smart contract functions when agreed conditions have been satisfied. The verifiable randomness function (VRF) which generates provable fair random numbers has been used by NFT projects that need to verify random NFT drops. This has helped to ensure a fair distribution of NFTs when during airdrops.

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Abiodun Ajayi

Abiodun Ajayi

Abiodun Ajayi has more than 6 years of experience in Security and IT architecture. He consults and helps form strategies, perform project feasibility studies.