Why is DeFi Crazy for Synthetics?

Clayton Roche

September 25, 2019

If someone told you they owned digital synthetic soybeans, what might that mean to you?  It might sound like in-game RPG vittles or some new genetically modified food. What it could mean, though, is that someone purchased a synthetic commodities asset on a blockchain platform.

Synthetic assets are becoming a popular topic in DeFi, with top projects coming out and releasing new and exotic financial instruments.  But what are they, exactly? More importantly, why do we care about synthetic assets?

A synthetic asset is a mix of assets that mirrors the return of a different asset.  This mix is typically made up of futures and options. For example, if you were holding a synthetic gold stock, the value of that stock might increase with the value of gold, but you do not actually own any gold.  Synthetic assets have existed for quite some time and are not specific to crypto. 

How are Synthetic Assets Possible?

How could these synthetic assets actually track the price of the reference assets without any actual ownership?  There are multiple solutions to this, but the most common is by combining short and positions on an asset. Two traders may take opposing positions on an asset, each betting that the value of the asset will move in the opposite direction as the other.  

Alice: Believes soybeans will go from $100 to $110

Bob: Believes soybeans will go from $100 to $90

Charley: Buys Synthetic soybeans today and wants to be able to sell it in the future for the spot price of soybeans.  Charley can buy the synthetic soybeans with any asset type the platform accepts.  

Let’s say the price of soybeans moved to $110.  Where is everyone sitting?

Bob lost $20, because the price of the asset moved against his position by an additional $10 ($110-$90).  

Alice earns $10 of this lost amount from Bob, as she made the correct prediction.

Finally, the value remaining on the platform are Charley’s initial $100 investment into the synthetic asset, plus the $10 loss from Bob, or, the exact price of soybeans: $110!

In reality, the participants on a synthetics platform are not three individuals.  Instead, one agent buys the synthetic asset, and this creates an arbitrage opportunity for market makers to buy the underlying asset if its price moves.  It is this profit motive that keeps the price pegged to the underlying asset.

This is the way that UMA Protocol works, which is a decentralized synthetics platform.  Next, we will cover how Synthetix accomplishes this.

A second way to create synthetic assets

A simple way to think of a synthetic asset is to imagine it like a bookie taking bets: He tries to be “market neutral” by taking both sides of a bet and make his profit on fees, but without any exposure (risk of loss.)

What if a bookie took everyone’s bets, and did not worry about being market neutral?  This is what Synthetix does with synthetic assets, using a game theoretical system that rewards token holders for staking tokens on the platform as collateral.  They are exposed to the risk that a bookie tries to avoid, but they also earn inflation returns from the platform.  

This is all very clever.  But why do it?

We have explored a lot of clever financial maneuvering to create these synthetic assets, but the first question most people have is “Why not just buy the underlying asset?”

The primary reason is near and dear to the hearts of DeFi builders: access.  In fact, UMA Protocol’s initialism actually means “Universal Market Access.”  Just as lenders and borrowers can connect and create mutually favorable outcomes without any centralized oversight, decentralized synthetic assets allow people to participate in any market with a price feed.  This means that access cannot be limited to participants of any centralized agency’s choosing: as long as market price is public, anyone can participate with synthetic assets.

How Synthetic Assets Help DeFi Eat Legacy Finance

The evolution of synthetic assets also means that the DeFi space can leverage the existing rails to capital markets.  Instead of building those rails anew (as security tokens aim to do), synthetic assets allow for tokenized versions of existing asset rails.  This has certain limitations, for example, as the same old barriers to project fundraising is still limited by the IPO process. Synthetic assets could be seen as attacking the problem from the other side: as some projects aim to tokenize new and existing assets, synthetic assets tokenize existing ways to trade those assets.  Both methods allow the DeFi space to gobble up some “low hanging fruit” from a product-market fit perspective, and each contribute to the utility of the system as a whole.

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About the author
Clayton Roche

Contributing Author

Clayton Roche is the Head of DeFi with Mosendo, where they’re making peer-to-peer electronic cash a reality.

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