By definition, synthetic assets are financial instruments that imitate another asset with a few changes in its actual properties. They are a group of assets, which due to being clubbed resemble another financial instrument. In this sense, they are inherent derivatives. We’ve gone into detail on what synthetic assets are and how they work in this previous post.
Today, we uncover their objectives, applications and future potential.
What is the point of synthetic assets?
Synthetic assets come in handy for those who do not want the actual asset in their hold. This is especially a boon in the crypto world as all the investor must do is hold tokens for the asset they are speculating on, instead of holding the actual asset itself. This allows them to engage in tracking its value as per the real-world equivalent without having to leave the cryptocurrency system.
Further, this system of synthetic assets is a decentralized one, meaning that it is open for any interested investors to participate in. It allows them to get returns on their investments without any physical settlement.
Use cases in the DeFi arena
As the significance of DeFi (decentralized finance) increases day by day due to the open accessibility and security it promises, the introduction of synthetic assets is enhancing the way such platforms work.
DeFi platforms are leveling the playing field by providing more options for investors than are possible in the traditional finance world.
Coming to use cases that are presently in action:
Assume that a user wishes to hold the USD on a blockchain network. This is made possible using USD stablecoins on a crypto exchange. They allow the user to get the same exposure to the value of the asset in question as in the real world. This is because the synthetic USD’s value depends on the actual value of the USD either fully or partially.
This further points towards the fact that this is based on a matter of trust, such that when required, these tokens can be exchanged for real-world USD. This ‘trust factor’ creates some risk.
To negate this factor, some digital financial systems started using smart contracts and made stablecoins which closely replicate the value of 1 USD in the real world to the closest extent possible. This is made possible on the blockchain networks. The stablecoin is created by locking the crypto tokens as collateral. To keep the value pegged to that of USD in the real world, the smart contracts’ rules facilitate users through incentives to destroy and create the stable coin and hence increase/decrease the supply/demand.
There have been decentralized collateral-based stablecoin protocols that enable the issuance of synthetic assets and support fiat currencies, real-world assets, indexes, and commodities. With these properties, users get on-chain exposure to real-world currencies and access to a variety of both crypto and non-crypto assets.
Such tokens use a decentralized oracle system that smart contracts track based on which you may own or exchange tokens as per the asset you wish to hold. To trade, you may purchase tokens on an exchange or exchange it for synthetic USD and then further exchange them for other synthetic tokens. Or, you could buy tokens, stake them on a dApp (decentralized app) and then trade them. They can also be traded for other inverse tokens at an exchange rate mediated by the oracle.
Also, the user is not exchanging crypto with some synthetic currency but is adjusting his holdings as per the price told by the oracle. All the while, the token collateral remains the same.
Some protocols generate synthetic tokens to counter the interoperability, inaccessibility, and unstable nature of derivatives. Rather than relying on a price oracle to decide if a token issuer is undercollateralized, they employ self-executing agreements with network users who are incentivized to recognize and liquidate alleged undercollateralized token issuers. The oracle is only used to settle disputes over liquidations.
Two parties can devise and implement their own financial arrangement and custom collateralized synthetic tokens on the blockchain system with an open-source protocol, safe in the knowledge that everything is secured through collateral and made binding by the stronghold of the smart contracts they enforce.
Opportunities 2021 Brings for Synthetics
“DeFi is the story of 2021,” said Matt Hougan, Chief Investment Officer for Bitwise Asset Management.
This can directly be equated to the vehicles upon which the DeFi ecosystem flourishes upon, namely synthetic assets.
Simply put, synthetic assets are a lot easier to work with.
In this digital age wherein investors want to spend more time getting returns rather than laboriously filling out paperwork and hefty contracts, these assets save the day by potentially facilitating faster, cheaper financial transactions. In the mix, platforms using them claim full transparency, auditability, no minimum transaction amount, and no documentation.
Again, going back to the original features of synthetic assets, such as low risk, liquidity increase, etc, they are pretty popular choices amongst the interested investors anyway.
According to a Forbes article, Audrey Nesbitt, Global Head of Marketing at Metaverse mentions how there are a lot of opportunities for retail investors in the DeFi space, to create passive income. “Token holders can deposit their funds into a liquidity pool to earn a passive income. There are some more established DeFi lending and borrowing protocols like Aave. Token holders of Aave get reduced fees, improved loan-to-value ratios, and staking rewards. The more utilities there are, the greater the token is worth, in my opinion,” she says.
Further, those digital platforms including global finance systems which specifically create stablecoins to imitate financial assets also have huge opportunities if they:
- Increase their asset base. Allow a variety of assets to be speculated upon in the blockchain network.
- Enabling contacts between parties to be upgraded and redesigned.
- Decentralizing the main features of applications as well as promoting decentralized governance to as far an extent as possible.
With these use cases and opportunities in the current scenario, there’s no doubt that 2021 will be one to watch in terms of the synthetic assets market. At XCarnival, we revel in such opportunities to help consumers take advantage of all the possible opportunities in synthetic assets.