Generally, synthetic assets, also known as derivatives, refers to a mixture of assets that reflect the value of another asset. In a traditional market, synthetic assets consist of various financial products such as futures, options, and swaps whose value is tied to an underlying asset – either stocks, bonds, commodities, currencies, or interest rates.
As such, instead of directly buying an asset, say; stocks, an investor can decide to enter into a futures contract of the same stock. This way, the investor will enjoy unique benefits offered by synthetic assets such as high leverage and liquidity, which aren’t provided by a traditional asset alone. Also, trading synthetics means that you are essentially mimicking the returns of an underlying asset without necessarily owning the asset itself. This is safer and can be used to hedge against risk as opposed to directly buying and selling the underlying asset.
What are Crypto Synthetic Assets?
In a similar vein, crypto-based synthetic assets strive to give investors exposure to various assets without physical attachment to the underlying asset. In this case, an investor is protected from transfer risks, price fluctuations, and arbitrage trades.
From the term ‘crypto synthetic assets,’ you may be tempted to think that the assets in question are primarily digital currencies. Although this idea isn’t entirely wrong, it is essential to note that this derivatives product isn’t made up of digital assets alone. It also consists of fiat currencies such as the US dollar or the Japanese Yen, commodities such as gold and silver, and index funds, as well.
What separates synthetic crypto assets from the traditional derivatives is that investors get to hold tokens that track the value of the underlying asset. Thanks to these tokens, the decentralized nature of the crypto ecosystem is maintained, which also makes it possible to deploy smart contracts.
Advantages of Synthetic crypto assets
There are several reasons as to why crypto-based synthetic assets are becoming popular. These include:
1. Decentralizes conventional assets
Primarily, synthetic crypto assets work by tokenizing conventional assets, such as stocks and forex, thus bringing them in the larger decentralized finance (DeFi) ecosystem. As such, trading transactions are recorded in a distributed ledger, which guarantees security and transparency. Additionally, the decentralization of conventional assets grants investors open access to global derivatives that were only open to a few institutional investors.
2. Improves liquidity
The DeFi space lacks liquidity since it has a limited number of investment vehicles, unlike the traditional financial market that is populated by a wide range of investment tools. The idea here is that the more the investment vehicles, the higher the trading volume, which then translates to higher liquidity. So, by using tokens to collateralize conventional assets, the crypto synthetic model brings in more assets into the DeFi space, thereby increasing liquidity.
For crypto market investors, their investment options are limited to digital currencies and Initial Coin Offerings (ICOs). However, these investment vehicles do not offer enough diversification opportunities to hedge against risks. The Crypto-synthetic assets model, therefore, allows investors to diversify their portfolio by allowing them to invest in conventional assets in a decentralized marketplace.
Popular crypto synthetic assets
Abra is a decentralized investment platform that allows investors to use their cryptocurrencies as collateral to create synthetic assets. The platform’s model leverages smart contracts enabled by Bitcoin (BTC) and Litecoin (LTC).
To use Abra, all you have to do is download the app and take a short position on BTC or LTC, which means the platform gets to be in a long position. As with many traditional synthetic products, Abra then hedges the risk of price movement by borrowing an equal amount of crypto assets from a broker. For example, say, you want to buy XY stocks worth $500. You’ll be required to collateralize your cryptocurrency, say BTC, worth the same amount as the stocks you intend to buy. The platform will then peg your BTC against the XY stock price. If the price goes up/down, an equivalent amount of BTC will be added or subtracted from your account.
Synthetix is an Ethereum-based platform that allows users to mint and also trade synthetic cryptos on its peer-to-peer platform. In this model, investors gain access to synthetic assets that concurrently give them exposure to non-crypto assets such as gold, USD, and securities. For example, a user can set up a crypto synthetic product using an underlying asset, say Ethereum. So, the user will mint the sEth token, which adjusts according to the price of Ethereum crypto. Currently, the platform has more than $69 million locked-in synthetic derivative contracts.
To make it easy for users to invest, Synthetix has three decentralized apps. They include;
- The Synthetix exchange – allows users to exchange minted synthetic assets (Synths) without counterparties directly.
- Mintr – enable users to stake the platform’s native SNX token. In turn, the users earn fees and can mint synthetic assets using cryptocurrencies.
- Dashboard – offers an overview of the entire Synthetix network.
iii) Universal Market Access (UMA)
UMA is a decentralized platform for financial contracts. It uses self-executing smart contracts and a “provably honest oracle” mechanism to enable users to create financial products using ERC20 tokens and other protocols. In essence, the platform can be used by two counterparties to create unique financial products that give them exposure to real-world assets in a similar format as Exchange Traded Funds (ETFs).
What’s unique about UMA is that their contracts are secured by economic incentives alone. This aspect works in perfect collaboration with the platform’s self-executing smart contracts that automate trades.
Crypto synthetic assets are here to change the derivative market by opening it up to retail investors through decentralization. This way, cry investors can trade traditional assets by collateralizing their holdings while remaining in the crypto-market space the whole time. Most importantly, the decentralization brought by the crypto synthetic assets platforms will open up the global derivative market to all classes of investors. In the long run, this will have a ripple effect on the traditional financial market as more investors trade crypto derivative products.