Synthetic Assets in DeFi: A Comprehensive Guide
Tags: blockchain
Published: 2020-11-05 19:34:08

The market of crypto-synthetic assets has been steadily gaining traction. According to the latest available estimates, there is more than $69 million locked in synthetic derivative contracts. To understand this growing importance of synthetic assets, we have to take a step back and find out what synthetic assets are and how they are relevant to the world of crypto.

# Synthetic Assets

In the traditional world of finance, the term synthetic assets refer to a combination of assets that bear the same value as another asset. Generally, the assets that are combined belong to the derivative asset class. These derivative products can be options, futures, or swaps. The combination of these derivative products follows the value of an altogether different asset class. These underlying assets can be stocks, bonds, commodities, indexes, currencies, or interest rates.

Let’s try to understand this phenomenon with a real-life example. Suppose a trading firm has not directly purchased a stock. Instead, what it has done is, it has purchased a call option on the stock and then sold a put option on the same stock. Through this strategy, although the investment firm is following the value of the stock, it is diversifying the risk associated with stock among two different assets.

# Synthetic Assets in the World of Cryptocurrency

Crypto synthetic assets follow the philosophy and deploy the same strategy. Crypto-synthetic assets offer investors exposure to other types of assets without actually holding them. These other types of assets can be instruments of traditional finance such as currency or commodities or index funds. They can be other types of digital assets as well.

The holders of crypto-synthetic assets hold these assets in a tokenized form. What it means is that the investors hold tokens whose value follows the value of assets belonging to a different class. This helps investors to expand their investment avenues without having to leave the domain of cryptocurrency. Moreover, crypto-synthetic assets also enjoy all the benefits associated with a decentralized financial system. These benefits include the deployment of smart contracts, a secure environment of a decentralized system, and the facilities that come with the distributed ledger technology.

# Synthetics in DeFi: Use Cases and Key Players

Crypto-synthetic assets have found a wide range of applications. Here, we will try to look at some of the most prominent use cases.

## Abra

Here, fiat currencies are converted into crypto assets. In other words, the price of the crypto asset is pegged with a different asset class, the fiat currency in this case. Let us try to understand this with an example. 

Suppose, an Abra user has deposited $1000 in his wallet. Upon receiving this fund, Abra will immediately convert the fiat currency into a cryptocurrency of equivalent worth. The cryptocurrency is bitcoin in this case. If the price of bitcoin at the time of depositing the fund was $10,000 per coin, the thousand dollar worth of funds would become 0.1 BTC in the wallet. The price of the BTC will now follow the value of USD. Therefore, the user is taking a short position on bitcoin and a long position on the USD. Abra is taking the reverse position. A long position on bitcoin and a short position on the currency.

## MakerDAO

MakerDAO is somewhat similar to Abra in its approach. In the case of MakerDAO, investors use Ethereum as collateral. In exchange for keeping Ethereum as collateral, Maker DAO offers an opportunity to mint a synthetic asset named Dai. The value of this synthetic asset follows the value of US dollars. In effect, the holders of crypto assets, which is Ethereum in this case, get exposure to the price fluctuations of USD.

## UMA

UMA creates provision for a two-party agreement where one goes short and the other goes long on the same asset. Suppose X and Y have agreed on the expected price of an asset. X believes the value of the asset will go down and therefore goes short on it. Y believes that the value of the asset will go up and therefore goes long on it. Both parties create a smart contract to agree on this. It is called a UMA smart contract. Both parties also deposit the agreed percentage of the margin requirement. After the duration of the agreement, if both parties have correctly followed the margin-terms mentioned on the smart contract, the contract is settled immediately.
In UMA, Ethereum is thus used to trade on a variety of other types of assets.

## Market Protocol

Market Protocol helps create position tokens for crypto investors who can not trade in high-value assets. By depositing collateral, any investor can mint position tokens from Market Protocol. The collateral remains intact on the blockchain for the duration of the trade. Once the investor gets hold of the position tokens, she can use them on any exchange or application. The investor can exit the trade by trading it with another user or she can wait for the position to expire. Trading in the market protocol involves no margin calls. It is always solvent and offers safe leverage.

## Rainbow Network

It offers an off-chain non-custodial exchange as well as a payment network that supports any liquid asset. A user can trade, lend, borrow, send, and receive any liquid asset through a singular on-chain payment channel. The on-chain payment channel uses a single asset as collateral. All the transactions happen off-chain.

The project is called the Rainbow network because it is comprised of Rainbow channels, a variant of payment channels. In the Rainbow channels, the computation of the settlement balances is based on the prices of the other assets.
The advantage of a Rainbow channel is that it supports both long and short positions on any asset as long as the participants agree on a price oracle.

## Synthetix

One of the most popular projects in the world of crypto-synthetic assets is Synthetix. Synthetix is a combination of an issuance platform, a collateral type, and an exchange. It offers users the facility to mint synthetic assets. The users put up collaterals to mint one. These minted synthetic assets can then be exchanged for another type of synthetic asset. This exchange is moderated by a price oracle. The uniqueness of Synthetix is that there is no counterparty to this exchange. Instead, what the user does is repricing the collateral as per the price oracle.

# The Advantages of Synthetic Assets

Now that we have got an overview of how crypto-synthetic assets are put to use, let us try to understand why these assets are gaining ground so quickly. Crypto-synthetic assets help the world of DeFi to chain real-world assets in a way that is credible and trustworthy.

The world of DeFi lacks financial instruments. Investors in the traditional world of finance enjoy a lot of financial instruments. Resultingly, they can deploy a variety of strategies with different combinations of these instruments. Synthetic assets in the DeFi environment help extend the availability of financial instruments and investment strategies. This results in better risk management and an increased volume of trading. Increased trading volume improves liquidity.

Synthetic assets also help to mitigate challenges associated with weak cross-chain communication protocols. The DeFi environment still suffers from these issues. But, with the help of synthetic assets, users can trade in assets without having to own them.

The popularity of crypto trading has still been restricted to crypto enthusiasts and within the group of people who are well-aware of the DeFi environment. Synthetic assets help to overcome this limitation. People who have traditional fiat currencies to invest in or people who want to participate in the traditional market can now do so without having to leave the blockchain environment. This facility helps to expand the user base for cryptocurrency overall.

# Conclusion

Crypto synthetic assets are only going to get bigger in market value in the days to come. The opportunities to mitigate risks by deploying a wide range of investment strategies on a diverse set of assets is going to prove useful. It will encourage existing crypto-investors to trade in increased volume and pull in traditional investors to the world of decentralized finance.
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