Synthetic assets have long been a mainstay of institutional traders. But now, as finance moves over to distributed systems and token-based finance applications, more people are gaining access to investment vehicles once only available to professional traders.
With synthetic assets now dipping into the crypto pool, it’s time to delve into how crypto synthetic assets work and what products are available today. We’ll start with a discussion on what synthetics in traditional markets look like, then move to today’s latest crypto innovations.
As a quick reminder, this article is meant for educational purposes only. Please do your own research and seek professional advice before investing, especially in the complex synthetic assets market. The whitepapers for projects we highlight are available for your review within the article.
What is a synthetic asset in traditional terms?
Synthetics refer to a mix of assets that mimic the returns of another asset. The returns earned by using synthetics are made possible by using a combination of other financial products, such as options, futures or swaps, which mimic an underlying asset. Examples of such underlying assets include stocks, bonds, commodities, currencies, interest rates or an index.
So instead of getting returns by directly buying and selling assets such as stocks or bonds, synthetic assets derive returns from other investment products that are based on the underlying asset. Thus, they are also coined derivatives.
To go a step further, say you purchase a call option and then sell a put option on the same stock. What is happening is that you are essentially mimicking the returns of that stock, but without owning it. This is one example of how an investment firm might hedge their risk as opposed to buying and selling the stock. Instead of investing in one traditional investment asset, such as a stock, traders use synthetics that can include multiple financial vehicles.
Traders and investors can incorporate synthetic assets into their portfolio to suit their needs. For instance, they can create a strategy with specific cash flow patterns, maturities and risk profiles.
Synthetic investment product: A type of investment using derivatives, meaning any cash flow produced by the synthetic product that actually derives from other assets. Synthetics may also be described as their own asset class.
Synthetic Assets: A mix of assets that, in combination, mimic the effect and value of another asset.
Derivative: A contract between two or more parties that derives value based on the performance of another asset or index.
Types of synthetics (traditional – we’ll get to crypto synthetics soon!)
- Options spreads
- Structured products such as a collateralized debt obligation (CDO).
- Certain investments in real estate
- Guaranteed investment contracts
Pros and Cons of Synthetics
Synthetics may be viewed as artificial. Yet they can play an important role in a large portfolio, such as with an institutional investor. For instance, a synthetic position enables traders to take a position without having to lay out the capital to buy the underlying asset. Additionally, traders use synthetics for the following reasons:
- To reduce risk
- To try for stronger returns
On the other hand, synthetic investments might cost more in fees and they involve more trading prowess due to their complexity.
Who trades in (traditional) Synthetics?
Professional traders have historically dealt with synthetics on behalf of big trading firms for institutional clients. They buy and sell options, futures and other types of financial contracts to try and help the firm’s clients avoid unforeseen price fluctuations.
Traders in derivatives constantly follow the markets as they are also constantly vulnerable to losses. One investor may be making a profit by trading a derivative. But at the very same time, another investor is losing money, making derivatives a zero-sum game.
What’s the significance of synthetic financial products in our world market?
Since high amounts of leverage are necessary to attain positions in synthetic asset markets, it’s been primarily investment firms and banks that have dominated this type of trading. So most of us have never really had any reason to pay attention to them. But if you take a closer look, you’d be shocked at how derivatives dominate the world’s money and markets.
Check out the visual representation of this concept:
As you can see from the image, the derivatives market equaled a (high end) estimate of $1.2 quadrillion in 2017. This represented vastly higher numbers than any other type of market, including stock markets, global debt and real estate.
The Abra Whitepaper
Abra is an investment platform where cryptocurrencies are used as collateral to create synthetic assets. The Abra platform is decentralized, meaning that it’s open to anyone using the app to open the Abra wallet. That right there marks a monumental difference between traditional synthetic assets and the crypto version!
Their synthetic asset model leverages smart contracts on bitcoin and Litecoin-enabled smart contracts. As a result, they’re able to offer a more seamless experience for investors who want to buy, sell or hold assets such as cryptocurrencies.
To use the Abra wallet, there are five steps:
- Deposit – User deposits funds (say $500) into Abra’s non-custodial wallet. These funds are converted to either bitcoin or Litecoin and go live on whichever blockchain is chosen. For this example, we’ll say the $500 converts to bitcoin. This first step is very unique; as crypto exchanges normally control the deposited funds.
- Peg – The $500 that was converted into bitcoin is stored in a multisig contract that is represented in USD on the app’s screen. Now a stablecoin with crypto as collateral is born.
- Hedge – With the $500 pegged to BTC, what if the bitcoin price drops? Every time an Abra user opens a smart contract (thus creating the stablecoin), Abra places a corresponding hedge in an exchange account. So that the user still has that available $500 if they want to use it, no matter when the BTC price changes.
- When making trades with Abra, it’s always done using that $500 stable value. Once the peg and hedge are set up in the multi-sig contract, all adjustments happen by the use of bitcoin scripts in the background.
- The payout happens when a user is ready to cash out, transferring assets to another wallet or to a bank account. The stablecoin assets that have been in storage on the blockchain then convert to the currency of choice.
Hedging your position
By downloading the wallet, investors essentially are taking a short position on bitcoin or Litecoin, while taking a long position on the hedged asset. Conversely, Abra takes the long position on bitcoin or Litecoin while shorting the hedged asset. As with many traditional synthetic products, Abra hedges price movement risk by borrowing an equal amount of assets from a cryptocurrency broker.
“The implications for this technology are enormous and could eventually lead to creating crypto-backed representations of all kinds of value, including traditional securities. As cryptocurrencies continue to grow in terms of both market capitalization and use cases, a crypto-collateralized synthetic currency model could also provide the underpinnings of a global crypto bank.” – Abra
The Synthetix platform enables traders to mint and then trade synthetic cryptocurrencies on their P2P platform. Essentially, they’ve built a market for crypto-backed synthetic assets.
Built on the Ethereum Blockchain, Synthetix is a multi-tier issuance platform, a type of collateral, and an exchange. Users can mint synthetic assets from cryptocurrencies to derivatives. That way they can gain access to synthetic products that give exposure to assets like gold, bitcoin, USD, and stocks.
As one example, a user could set up a crypto synthetic product with an underlying asset, say Ethereum. They mint the sETH token which adjusts according to an oracle-backed price feed.
You may have heard about this Ethereum-based synthetics platform in the news regarding an oracle attack reported by The Block in June 2019. At the time, Synthetix put a hold on transactions on the platform. After instituting a successful bug bounty program, the platform was back to normal.
Synthetix currently has 20 “Synths” available with no liquidity restrictions. They utilize a distributed pool of token holders for collateralization and stability purposes. Their three current dApps are:
- Synthetix Exchange – exchange Synths without counterparties
- Mintr – Allows users to stake SNX so they can mint Synths and earn fees.
- Dashboard – gives an overview of the Synthetix Network, as seen in the following image:
UMA (Universal Market Access)
The name, Universal Market Access, perfectly encapsulates how crypto synthetics change the game with the global derivatives market, which as we learned earlier in the article, is massive. Whereas before only a select few in the institutional investment industry could access these types of products, now they are open to anyone with a smartphone.
UMA is a decentralized platform for financial contracts. It uses self-enforcing smart contracts and a “provably honest oracle mechanism” to enable users to create financial products using the standard ERC20 token and other protocols. In essence, UMA enables any 2 counterparties to create financial contracts of their own design.
What sets UMA synthetics apart from traditional derivatives is that their contracts are secured by economic incentives alone. This aspect also goes hand in hand with the self-enforcement inherent with smart contracts and oracles, as well as worldwide availability. UMA’s open-source protocol operates on a permissionless, public blockchain.
On the platform, investors can design their own ERC20 tokens for creating tokenized derivatives that long, short or leverage exposure to real-world underlying assets in a format similar to ETFs.
Understanding the platform
This twitter thread from UMA Co-Founder/CEO does a good job of walking you through all the steps of creating a synthetic asset using UMA:
Another way to get a short overview of the process is to review the graphic below:
Decentralized cryptocurrencies and smart contract capabilities have changed the derivatives market by opening it up to the retail investor. Whether they’re ready or not! While they may not yet be qualified to make these complex trading products, it is only a matter of time. As we know in the crypto industry, it’s vital to do your own research.
Many self-made traders are already succeeding in the blockchain-based market. Additionally, the knowledge and skill levels of all are increasing in this rapidly advancing industry.
When a trader is ready to use synthetic products and derivatives, the platforms will be in place. And, unlike their counterparts in traditional finance, these platforms are based on the tenets of decentralization:
- Open to all regardless of economic standing
- Secured using incentivization and game theory
- No borders/globally available
- Immutably stores data distributed ledgers
We encourage you to check out these platforms. Even if you’re not ready now, these three projects are evolving as the market matures. So you have time. Be safe out there and only invest what you can afford to lose.