25th October 2023| ZebPay Trade-Desk
An Overview
Crypto synthetic assets, also known as “synthetic assets,” are a category of digital financial instruments designed to replicate the behaviour and value of real-world financial assets. These blockchain-based instruments allow users to simulate the performance of assets like stocks, commodities, currencies, and crypto assets without the need to possess the actual underlying assets. They are created through the use of sophisticated financial derivatives and smart contracts on blockchain platforms, primarily within decentralised finance (DeFi) ecosystems.
Key characteristics include the ability to develop decentralised smart contracts, employ collateral to secure value, precisely track the prices of target assets, and generate versatile leveraged or derivative products. These crypto synthetic assets provide DeFi users with broader access to financial markets and assets, reducing their dependence on traditional intermediaries. However, users must exercise caution, as these instruments introduce complexity and risk, necessitating a solid understanding of their underlying mechanisms and their impact on investment strategies.
Distinguishing Between Traditional and Crypto Synthetic Assets
Traditional assets have a physical or monetary presence and are traded on well-established financial markets. In contrast, crypto synthetic assets are entirely digital constructs, engineered using blockchain technology to replicate the value and behaviour of these conventional assets.
The primary divergence between traditional and crypto synthetic assets is their physicality. Traditional assets can be tangible or paper-based, while crypto synthetic assets exclusively exist in the digital realm of blockchain networks. While crypto synthetics offer distinct advantages in terms of accessibility, liquidity, and programmability when compared to traditional assets, they also introduce a set of unique risks and complexities.
Read more: Crypto Investing vs Crypto Trading
Varieties of Crypto Synthetic Assets
Crypto synthetic assets manifest in diverse forms, including synthetic stablecoins, tokenized commodities and equities, leveraged and inverse tokens, and yield-bearing synthetic assets. Here’s an overview of these categories:
- Synthetic Stablecoins: These digital tokens replicate the value and stability of traditional fiat currencies like the US dollar or the euro. They provide a means for conducting transactions and preserving value within the crypto space while avoiding the price volatility associated with crypto assets. An instance is sUSD on the Synthetix platform, which aims to offer users a stable digital currency mirroring the value of the US dollar.
- Tokenised Commodities and Equities: These are blockchain-based representations of real-world assets, such as gold, oil, stocks, or other commodities. They enable decentralised fractional ownership and exchange of traditional assets on blockchain networks. For example, sOIL on the Synthetix platform tracks the price of crude oil, allowing investors to gain exposure to price changes without owning physical oil.
- Leveraged and Inverse Tokens: Synthetic assets designed to magnify or counteract price movements in an underlying asset. Inverse tokens profit when the price of the underlying asset decreases, while leveraged tokens amplify both gains and losses. For instance, BTC3L (Binance Leveraged Tokens) aims to provide daily returns three times greater than Bitcoin’s price. If Bitcoin rises by 1%, BTC3L should increase by 3%.
- Yield-Bearing Synthetic Assets: These DeFi-related synthetic assets reward holders with returns through activities like staking or lending, offering an opportunity for passive income. cDAI from the Compound protocol is an example; it allows Dai (DAI) holders to participate in lending operations on the Compound platform, earning interest over time, thus qualifying as a yield-bearing synthetic asset.
Use Cases for Crypto Synthetic Assets
Crypto synthetic assets have a wide array of applications, appealing to different groups of users in the crypto ecosystem:
- Trading and Investment: Crypto synthetic assets open doors to various trading and investment opportunities. Traders can employ them for leveraged trading, amplifying their exposure to market price movements, potentially leading to increased profits (or losses) compared to traditional trading. These assets cover a broad spectrum of underlying within the crypto space, including stocks and commodities, enabling investors to diversify their portfolios easily.
- Yield Farming and Liquidity Provision: Users who stake crypto synthetic assets in DeFi protocols can actively participate in yield farming. This involves earning incentives in the form of additional synthetic assets or governance tokens by contributing to liquidity pools and engaging in DeFi activities. Furthermore, synthetic assets significantly bolster liquidity across DeFi platforms, which is crucial for efficient trading, lending, and borrowing within the DeFi ecosystem.
- Risk Management and Hedging: Synthetic assets offer potent risk management tools and hedging strategies. Traders and investors can use inverse synthetic assets as effective hedges to safeguard their portfolios against downturns in the underlying assets. Additionally, synthetic stablecoins provide a decentralised alternative to conventional stablecoins, preserving the value of assets amidst the inherent volatility of the market.
The Advantages
Crypto synthetic assets offer a wide range of advantages, enhancing the capabilities of digital finance:
- Diversification: These assets enable users to access a diverse array of assets, including traditional stocks, commodities, and currencies. This facilitates portfolio diversification within the crypto ecosystem, reducing risk and enhancing investment strategies.
- Leverage: Crypto synthetic assets provide opportunities for leverage, allowing traders to amplify their exposure to price volatility, potentially leading to higher returns.
- DeFi Engagement: Synthetic assets are integral to decentralised finance (DeFi), enabling active participation in yield farming and liquidity provision. Users can earn rewards for their involvement in DeFi activities.
- Liquidity Augmentation: These assets are essential for bolstering the liquidity of DeFi platforms and crucial for efficient trading and lending activities in the DeFi space.
- Risk Mitigation: Synthetic assets serve as powerful risk management tools, enabling users to protect their investments against volatile price fluctuations. They offer hedging possibilities, particularly through inverse synthetic assets.
Challenges and Risks
While synthetic assets offer innovative solutions, they come with several challenges and risks that must be carefully considered. These include:
- Smart Contract Vulnerabilities: The complexity of smart contracts can lead to vulnerabilities or exploits. The exploitation of these weaknesses can result in significant financial losses, as demonstrated by the infamous DAO attack in 2016, which led to the theft of approximately $50 million worth of Ether (ETH).
- Liquidity Issues: Some synthetic assets may have lower liquidity compared to their real-world counterparts. This can result in challenges such as price manipulation and slippage during trading, affecting market stability.
- Regulatory Uncertainty: The regulatory landscape for synthetic assets is still evolving. Governments worldwide are grappling with how to define and regulate these unique financial products. Ongoing legal disputes and regulatory changes involving stablecoins like Tether (USDT) are examples of the legal challenges synthetic assets may face.
- Oracle-Related Concerns: Synthetic assets often rely on oracles to access real-world data. More reliance on these systems can pose security risks. Compromised oracles could provide incorrect data, impacting the value and utility of synthetic assets dependent on them.
