Synthetic Assets Demystified: The Biturai Guide

Synthetic Assets: What Are They?

Imagine you want to invest in gold, but you don't want to deal with physical storage or the traditional financial system. A synthetic asset offers a solution. It's a digital token that mimics the price of another asset, like gold, a stock (e.g., Tesla), a commodity (e.g., oil), or even a fiat currency (e.g., the Euro), without you actually owning the underlying asset itself. Think of it as a digital mirror reflecting the value of something else.

Key Takeaway: Synthetic assets allow investors to gain exposure to various markets within the crypto space without directly holding the underlying assets.

Mechanics: How Synthetic Assets Work

Synthetic assets are built on blockchain technology using smart contracts. The process usually involves:

1. Collateralization: To create a synthetic asset, you typically need to deposit collateral. This is usually another cryptocurrency, such as Ethereum (ETH), a stablecoin (e.g., USDC), or sometimes even a basket of assets. This collateral acts as a guarantee for the value of the synthetic asset you're creating.

2. Minting: Once you've provided the collateral, the smart contract mints (creates) the synthetic asset. The amount of synthetic assets you can mint is determined by the amount of collateral you provide and the collateralization ratio (the minimum amount of collateral required relative to the value of the synthetic asset).

3. Pricing: The price of the synthetic asset is usually determined by an oracle. An oracle is a service that feeds real-world price data onto the blockchain. For example, a Chainlink oracle might provide the current price of Tesla stock. The synthetic asset then reflects this price.

4. Trading: You can then trade the synthetic asset on a decentralized exchange (DEX) or other platforms. The price should ideally track the price of the underlying asset.

5. Liquidation: If the value of your collateral drops too low relative to the synthetic assets you've minted, the smart contract may trigger a liquidation. This means your collateral is sold to cover the value of the synthetic assets, and you lose your collateral. This is similar to a margin call in traditional finance.

Definition: A Collateralization Ratio is the minimum amount of collateral required relative to the value of the synthetic asset.

Definition: An Oracle is a service that feeds real-world price data onto the blockchain.

Trading Relevance: Price Movement and Trading Strategies

The price of a synthetic asset is designed to mirror the price of the underlying asset. Therefore, factors that influence the price of the underlying asset will also influence the price of the synthetic asset.

Price Drivers:

• Underlying Asset's Performance: If Tesla stock goes up, the synthetic Tesla token should also go up.
• Market Sentiment: Overall market sentiment can impact the demand for both the underlying asset and the synthetic asset.
• Oracle Reliability: The accuracy and reliability of the oracle are crucial. If the oracle provides inaccurate data, the synthetic asset's price can deviate from the real asset's price.
• Liquidity: The availability of buyers and sellers for the synthetic asset on the DEX impacts price. Low liquidity can lead to slippage (price changes when you buy or sell).

Trading Strategies:

• Tracking: The primary strategy is to track the underlying asset's price movements. If you believe the underlying asset will increase in value, you can buy the synthetic asset.
• Arbitrage: If the synthetic asset's price deviates from the oracle price, arbitrage opportunities can arise. Traders can buy the cheaper asset and sell the more expensive asset, profiting from the price difference. This helps to keep the synthetic asset price aligned with the oracle data.
• Hedging: Synthetic assets can be used to hedge against price movements. For example, if you own Bitcoin and are worried about a price drop, you could short a synthetic Bitcoin asset.

Risks of Synthetic Assets

Synthetic assets, while offering exciting possibilities, come with significant risks:

• Smart Contract Risk: Smart contracts can have bugs or vulnerabilities that could lead to the loss of collateral or the manipulation of the synthetic asset.
• Oracle Risk: Oracles can be compromised or provide inaccurate data, leading to incorrect pricing and potential losses.
• Liquidation Risk: If the price of your collateral drops, you risk liquidation, losing your collateral. The collateralization ratio is a critical factor in mitigating this risk.
• Counterparty Risk: In some synthetic asset systems, there may be counterparty risk, meaning that the protocol itself could fail or be attacked.
• Volatility: The crypto market is volatile. Price swings in the underlying collateral can lead to liquidations or unexpected price movements.
• Regulatory Uncertainty: The regulatory landscape for synthetic assets is still evolving, which can create uncertainty and risk.

History and Examples

Synthetic assets have emerged as a significant component of the Decentralized Finance (DeFi) ecosystem. Several protocols have pioneered their use:

• Synthetix: One of the earliest and most well-known synthetic asset platforms, Synthetix allows users to create and trade synthetic assets representing a wide range of assets, including cryptocurrencies, fiat currencies, commodities, and stocks. Synthetix uses its native token, SNX, as collateral.
• Mirror Protocol: Built on the Terra blockchain (now defunct), Mirror Protocol allowed users to mint and trade synthetic assets that tracked the price of real-world stocks, commodities, and ETFs. The collapse of Terra highlights the risks of synthetic assets built on less established blockchains.
• Other Platforms: Numerous other platforms, such as UMA and Nexus Mutual, offer synthetic asset creation and trading functionalities.

The evolution of synthetic assets mirrors the broader development of DeFi, starting with more complex and risky structures and gradually moving towards more robust and secure models. The future will likely see increased adoption, improved risk management, and broader access to a wider range of assets through synthetic asset platforms.