Read the Synthetic Assets in DeFi: Basic Concepts, Existing Use Cases, and Future Opportunities

Both institutional and retail participants will need more sophisticated financial instruments, especially synthetic assets.

Written by: Dmitriy Berenzon, Research Partner, Zenith Ventures, Blockchain Investor

Although the main application scenarios for cryptographic assets have been and are still speculative, I don't think this is a bad thing. Speculation is a key driver of the development of traditional financial markets and still plays an important role today. Most importantly, speculators provide liquidity, making it easier for participants to enter or exit the market. This reduces transaction costs and increases the convenience of market participants.

At present, the crypto-asset market is still immature, and it is also suffering from a lack of liquidity. Unlike the assets in the traditional financial system that has established a liquidity benchmark for decades, most of the crypto assets are only available for a few years. For example, Bitcoin's 24-hour trading volume is about $700 million, while Apple's stock trades $5.3 billion a day. Insufficient liquidity limits the utility of the underlying agreement, which has been exposed in decentralized exchanges and forecasting markets.

I believe that the crypto-asset market will evolve in a similar way to traditional financial markets, so both institutional and retail participants will need more sophisticated financial instruments, especially synthetic assets.

In this article, I will:

  • An overview of synthetic assets, explaining what they are and how they can be used in traditional financial markets.
  • Explain why synthetic assets are critical to the maturity of the crypto-asset market and provide examples of projects that use synthetic assets today.
  • Provide examples of new "encrypted native" derivatives that can be built.

The first part of my article focuses on the basic explanations and examples of synthetic assets. If you are familiar with the content, or feel that the financial engineering knowledge is too boring, you can pull down and read the lower part of the article.

What is a synthetic asset?

Synthetic assets are a financial tool that simulates other tools. In other words, the risk/reward profile of any financial instrument can be modeled using a combination of other financial instruments.

A synthetic asset consists of one or more derivatives that are assets based on the value of the underlying asset, including:

  • Forward commitment: futures, forwards and swaps
  • Contingent claims: options, credit derivatives such as credit default swaps (CDS), and asset-backed securities

What are the benefits of synthetic assets?

There are many reasons why investors choose to buy synthetic assets. Among them are:

  • Get funding
  • Creating liquidity
  • admission to market

Below, I will provide an overview and examples of the traditional financial sector for each reason. Please note that these factors are not mutually exclusive.

Get funding

Synthetic assets can reduce capital costs.

One example is the Total Return Swap (TRS) , which is used as a funding tool to ensure the financing of assets held. It allows a party to raise funds for an asset pool it owns, and the counterparty to the swap transaction can earn interest from the funds secured by the pool. In this case, TRS is similar to a secured loan because:

  • The party that sells the securities and agrees to buy back is the party that needs financing, and
  • The party that purchases the securities and agrees to sell them is the party that provides the financing.

Creating liquidity

Synthetic assets can be used to inject liquidity into the market, thereby reducing the cost of investors.

One use case is credit default swap (CDS) . CDS is a derivative contract between a credit protection buyer and a credit protection seller. In this kind of contract, the buyer regularly pays a certain amount of cash to the seller. In the event of a “credit event” such as failure to pay, bankruptcy, reorganization, etc., the seller Committed to paying the buyer a loss of credit default. This gives CDS sellers the ability to synthesize more than one underlying asset, while CDS buyers have the ability to hedge their exposure to a base asset's credit risk.

Martin Oehmke of Columbia University and Adam Zawadowski of Boston University have written a paper "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets" to demonstrate why the CDS market is more liquid than its underlying bond market. One of the main reasons is standardization: bonds issued by a particular company are usually divided into many different batches, and the coupon rates, maturity dates, and contract items of each batch are different. The resulting fragmentation reduces the liquidity of these bonds. The CDS market is not, it provides a standardized place for the company's credit risk.

Note: Martin Oehmke and Adam Zawadowski paper download address: http://finance.wharton.upenn.edu/conferences/liquidity2014/pdf/Synthetic%20or%20Real%20The%20Equilibrium%20Effects%20of%20Credit%20Default%20Swaps%20on %20Bond%20Markets_Martin%20Oehmke.pdf

admission to market

Synthetic assets can re-create cash flow for almost any kind of security through a combination of tools and derivatives, opening up a market that is relatively free.

For example, we can also use CDS to replicate the exposure of a bond. In cases where the bond is difficult to obtain on the open market, such as may not have any available bonds, this is useful.

Let me give a concrete example. Take the Tesla 5-year bond as an example. Its yield is 600 basis points higher than that of US Treasury bonds: 1. Purchase a $100,000 5-year government bond as a collateral. 2. Write (sell) a five-year, $100,000 CDS contract. 3. Earn interest on government bonds and receive a 600 basis point premium from the CDS.

If the bond does not default, then the sum of the US Treasury bond coupon and the CDS premium will be equal to the 5-year Tesla bond. If the Tesla bond defaults, then the value of the portfolio will be US Treasury bonds minus CDS expenses, which is equivalent to the default loss of Tesla bonds. Therefore, regardless of whether the Tesla bond defaults or not, the return on the portfolio (US Treasury + CDS) will be consistent with the holding of Tesla bonds.

How is a good synthetic asset formed?

In some cases, the development of synthetic asset products is only possible when the liquidity of the underlying assets reaches a critical value. If the liquidity of the underlying assets is too low, then there is no point in creating a synthetic asset , as this may reduce economic efficiency.

The total revenue swap is a good example. Although the credit derivatives market began to take shape in the early 1990s, total revenue swaps were not quoted or traded by more institutions for the next few years. In fact, investors or speculators seeking a specific corporate bond or bond index exposure are more likely to buy or short-term related bonds or indices. As market makers begin to manage their credit portfolios more aggressively and offer a two-way quote for a range of credit derivatives, trading activity begins to increase and investors have more opportunities to participate in synthetic credit positions through total revenue swaps. As a robust two-way market begins to take shape, the buyer-seller spread of synthetic assets is compressed, attracting more end users eager to assume or transfer synthetic credit. This market is now able to support a wide range of credit certificates because its underlying credit derivatives market is liquid, active and well supported.

Why are synthetic assets and DeFi going together?

In the DeFi ecosystem, synthetic assets are beneficial to all parties involved for the following reasons:

Extended assets

One of the biggest challenges in the DeFi space is to chain real-world assets in a way that doesn't require trust. An example is the legal currency. While it is possible to create a stable currency that is guaranteed in French currency like Tether, there is another way to get a synthetic price exposure to the US dollar without having to host the actual assets by a centralized counterparty. For many users, the price exposure is good enough. Synthetic assets provide a mechanism for real-world assets to trade on a blockchain.

Extended liquidity

One of the main problems in the field of DeFi is the lack of liquidity. Market makers play an important role in this aspect of long tail and mature cryptographic assets, but their financial instruments for proper risk management are limited. Synthetic assets and broader derivatives can help market makers expand their business by hedging positions and protecting profits.

Extended technology

Another issue is the technical limitations of the current smart contract platform. We have not addressed cross-chain communication issues that limit the availability of assets in decentralized exchanges. However, if there is a synthetic asset price exposure, the trader does not need to own an asset directly.

Extended participation

Traditionally, synthetic assets are only open to large, experienced investors, and unlicensed smart contract platforms like Ethereum allow smaller investors to get the benefits of this tool . It will also allow more traditional investment managers to enter the field by adding a risk management toolset.

Synthetic assets in DeFi

In fact, synthetic assets are widely used in the DeFi world. Below I will provide several examples of projects that use synthetic assets, along with a simplified illustration of the asset creation process. legend:

  • Purple = actual assets
  • Green = synthetic assets

Abra

Founded in 2014, Abra is the originator of the field of cryptographic composite assets. When Abra users deposit funds into their wallet, the funds are immediately converted to Bitcoin and are expressed in dollars in the Abra app. For example, if Alice deposits $100 in the Abra wallet and Bitcoin costs $10,000, then her deposit is 0.01 bitcoin and is displayed as $100. Abra can do this by maintaining the BTC/USD anchor, which will ensure that Alice has the right to redeem $100 regardless of the price of the BTC or USD. Abra is actually creating a stable currency for encryption guarantees.

Moreover, Abra will hedge the risk immediately, so it can accept all transactions at any time. When users refill their wallets, they actually hold short positions on Bitcoin and long positions on hedged assets, while Abra is long on Bitcoin and short on hedged assets.

Note: Abra is difficult to partition into the DeFi space. It tries to provide encryption and synthetic assets very early, but it is more like a centralized partner asset supplier.

MakerDAO

Maker's Dai Stabilizer is probably the most widely used and widely used synthetic asset in DeFi. By locking ETH as a collateral, users can create a synthetic asset, Dai, which maintains a soft link to the dollar. In fact, Dai's holders gained a synthetic price exposure to the US dollar . Similar to Abra's design, this " collateral-backed synthetic asset " model is also popular in many other agreements.

UMA**

UMA provides an agreement for total revenue swaps at Ethereum, which provides a composite exposure to multiple assets.

The smart contract in the above chart contains the economic, termination and margin requirements for the bilateral agreement between Alice and Bob. It also requires a price data oracle to return the current price of the underlying reference asset.

USStocks is an ERC20 token that applies the UMA protocol, and USStock represents the US Standard & Poor's 500 Index and trades on the Beijing-based decentralized exchange DDEX . This is done by fully pledgeing one of the UMA contracts and then tokenizing the margin account, allowing the long term of the contract to acquire synthetic ownership.

MARKET Protocol

The MARKET Protocol allows users to create synthetic assets and track the price of any reference asset through a predictor . These “position tokens” provide limited long and short exposure to underlying assets and provide a return structure similar to the bullish call option spreads in traditional finance . Similar to Dai, long and short tokens represent the right to seek a collateral pool.

Rainbow Network

The Rainbow Network is an under-chain unmanaged transaction and payment network that supports any liquid asset . It consists of a "Rainbow Passage", a variant of the payment channel, and the settlement balance is calculated based on the current price of other assets. In other words, the protocol nests synthetic assets and other assets in a single payment channel.

In the rainbow channel, each state represents a CFD, which is similar to a total revenue swap.

Synthetix ** **

Synthetix is a publishing platform, collateral-type exchange that allows users to cast a range of synthetic assets . Similar to Maker, users lock in collateral to create a composite asset and need to repay the loan to redeem the collateral. The user can then "transaction" one synthetic asset to another through the oracle. Please note that there is no direct counterparty to the "transaction" – the user is actually re-pricing the collateral based on the oracle. That is to say, due to the centralized collateral mechanism, SNX's stakeholders (Staker) collectively bear the counterparty risk of other users' synthetic asset positions.

Encrypted native derivatives

It is an important first step to express real assets in a synthetic way, but I believe that there should be huge room for the design of derivatives in encryption technology, and it has basically not been touched , including the Traditional derivatives designed by participants , as well as "encrypted native" derivatives that were not previously found in traditional financial markets .

Below I will provide a few examples of these two types, many of which may not be feasible, or there is not enough market to get liquidity.

Bitcoin difficulty value swap

The reason for this product is to provide miners with a hedging tool that they want to reduce the risk of bitcoin production (and thus reduce their expected output) (ie, the “difficulty curve risk” of the miners).

In fact, BitOoda has designed and built this idea as a financial settlement product, that is, settlement is done through legal currency transfer, rather than by renting or lending physical calculations. In terms of scale, it is unclear how attractive the product will be to sellers (such as those who are more difficult to see multi-bitcoin) and market makers (ie swap dealers). In addition, large miners are also likely to manipulate the market (such as collusion to reduce difficulty).

Hash computing power interchange

The idea was to have a miner sell some of his mining capabilities to buyers , such as a fund, to get cash. This allows miners to achieve a steady stream of income that does not fluctuate with the price of the crypted assets they are digging, while allowing the fund to gain exposure to an encrypted asset without investing in mining equipment. In other words, miners can hedge against market risk because their profitability no longer depends on the market price of the crypto assets being mined. In fact, BitOoda has built and provided this product, the “Hash Computing Weekly Expandable Contract” for physical clearing .

Electricity futures

This product has been in the traditional commodity market for quite a long time, but it can also be provided to miners of cryptocurrency. The miner only needs to sign a futures agreement to purchase electricity at a given price for a specified period of time (for example, 3 months). This will give miners the ability to hedge their energy price risks, as a sharp rise in electricity costs will make mining unprofitable. In other words, the miner changed his power cost from a variable to a fixed amount .

Staking income swap

This will allow the certifiers of the Proof of Entitlement (PoS) network to hedge the exposure of the market risk of the crypto assets they choose . Similar to the Hash Computing Interchange, the verifier sells a portion of the Staking proceeds in exchange for cash. In this way, the verifier can get a fixed amount of return from the assets it locks, and the buyer can gain exposure to equity without having to set up the Staking infrastructure.

In fact, Vest has achieved this. This market allows users to purchase Staking Reward Futures, while Staker reduces their difference in Staking rewards. The project achieves this through the “Staking Contract”, which allows the user to pay a sum of money (X) and get a return from the (T) period in which the Z tokens are pledged.

Slashing fines swap

This product allows the principal participating in the equity certification network to hedge its operational risk exposure due to the selected verifier. You can think of Slashing as a credit event and the Slashing penalty swap as insurance for the event. If a verifier is Slashing, the principal will receive a compensation to cover the loss. The seller of the Slashing fines swap is actually doing a great job of doing more than a verifier, and even the buyer may be the verifier himself. In terms of scale, this may create an interesting dilemma for the protocol designers – those who short the verifier are motivated to destroy their operations.

Stabilization fee swap

Although the Maker stabilization rate is currently 16.5% (currently 14.5%) , from July 13 to August 22, 2019, this rate is as high as 20.5%. CDP (mortgage debt) holders may wish to reduce the risk of rising stable rates (variable interest rates) and are therefore willing to enter into swap agreements with counterparties to pay a fixed fee (interest rate swap) within a given time frame.

Airdroptions

This is an option to purchase an encrypted asset whose strike price is equal to the price of the airdrop. The payment structure obtained by the option buyer is similar to a deep-in-the-money call option whose premium is equal to the market price of the airdrop. If the airdrop is performing well, the buyer exercises the option and the seller delivers the encrypted asset. If the airdrop performance is not good, the buyer can not exercise the right, and the seller gets the premium.

Locked-air forward contract

This is a bilateral agreement that allows buyers to purchase encrypted assets that are released from lock-in airdrops at a given price. The buyer pays the seller a premium, which reflects the illiquidity and opportunity cost associated with the locked asset, and also allows the buyer to gain exposure to the new crypto asset without having to have the necessary lock That kind of underlying asset.

in conclusion

If you have already read this, consider taking a CFA!

Synthetic assets are a complex financial instrument that has repeatedly put the global economy in a difficult position. Similarly, they may pose a risk to protocol security in ways that we do not yet understand. Despite this, synthetic assets still play an important role in traditional financial markets and are becoming a key component of the DeFi movement. It is still in its infancy, and we need more experimentation by developers and financiers to bring new financial products to market.

Written by: Dmitriy Berenzon, Research Partner, Zenith Ventures, Blockchain Investor