What Is a Synthetic Asset in DeFi?

The world of Decentralized Finance (DeFi) is focused on bringing traditional financial services into the blockchain community. More than that, DeFi, as the name suggests, is entirely based on the concept of decentralization. As such, decentralized applications and protocols in the cryptocurrency industry are built to provide financial services and systems that are not controlled by one body.

So far, lots of concepts in traditional finance have been introduced into the space, including indices, stablecoins, decentralized exchanges, and yield farming. A fairly new addition to that is synthetic assets. In this article, you will learn everything there is to know about this promising asset group.

What Is a Synthetic Asset?

Often referred to as a synth, a synthetic asset is the on-chain version of financial derivatives. In the world of traditional finance, derivates are financial contracts that provide exposure to the value of a benchmark, an asset, or a group of assets. Therefore, synthetic assets are considered tokenized derivatives.

Through the world of DeFi, crypto users can have access to financial derivatives by investing in synthetic assets. Each synthetic asset is a token that is based on the value of an asset, group of assets, or benchmark. Like derivatives, buying a synth does not give the owner possession of the underlying asset. Instead, users benefit from the fluctuation of the asset’s value. A synth token could represent the value of anything, including cryptocurrencies, fiat currencies, hard commodities like gold, and even index funds.

Additionally, synthetic assets are flexible, such that they can be tailored to meet the need of each user.

How Do Synthetic Assets Work?

Synths, unlike derivatives, the financial product it mimics, do not use contracts to create a link between the underlying asset and the derivative product.

Instead, crypto tokens represent this link by mimicking the price value of the asset to which they are pegged. Crypto investors can make a synth out of any asset group by simply utilizing a derivative already tied to an existing asset and then tokenizing that derivative. Tokenization is essentially converting meaningful data into a randomized chain of characters and processing through a cryptographic function such that the final product cannot be traced back to the original data.

Most synthetic asset protocols use oracles like Chainlink to gather accurate data on the value of the underlying asset. The process of buying and selling each synth token is backed by smart contracts, which are automated lines of code that contain the terms of each transaction.

Synthetic Assets and the Tokenization of Everything

Perhaps the most defining feature of synthetic assets is the ability to turn anything into a tokenized asset. The opportunities are almost limitless; it goes beyond traditional assets like equities. With synthetic assets, anything can have a representation on the blockchain.

Synthetic assets employ tokenization, a process of creating an on-chain asset that represents a thing in the real world. This mechanism allows users to tap into almost limitless global liquidity. The assets are transferable across, wallets, exchanges, and other applications on the blockchain.

Benefits of Synthetic Assets

Synthetic assets have been gaining traction among crypto users mainly because it brings a traditional finance strategy to the blockchain. Beyond that, synthetic assets provide users with many other advantages. They include:

Open-source and Decentralized

At the core of the DeFi movement are openness and transparency. As such, synthetic assets, a concept that has been derived from derivatives in traditional finance, represent the values of DeFi. With decentralized protocols and exchanges, the system of minting and burning synths is not controlled by a central body but by a public ledger that records and verifies each transaction. With the help of smart contracts, there is no need for intermediaries. Users can simply utilize smart contracts that oversee and execute each transaction.

Ease of Accessibility

DeFi and the projects built within the space eliminate the need for users to go through rigorous background checks to make use of its financial products. Synthetic Assets in DeFi can be used by anybody from anywhere. By utilizing smart contract-compatible blockchains like Ethereum, any crypto user can create a synthetic asset tailored to their individual investment needs. In addition, synthetic assets are exposing crypto investors to more investment strategies otherwise unavailable on the blockchain. Investors can benefit from investment strategies compatible with traditional derivatives like hedging and speculation.

Infinite Liquidity

Most Synths, particularly those minted via Synthetix, are ERC-20 tokens, making them compatible with multiple exchange platforms, liquidity pools, and standard crypto wallets. Exposure for each synthetic asset is backed by a pool of debt (the collateral deposited to mint a synth), which allows for a concept referred to as infinite liquidity.

Transferability

Crypto users who own synths also have the advantage of easy transferability. They can easily switch between various asset groups by simply making a new synth based on their preferred underlying asset. Because they do not own the synth, switching from one asset group to another is frictionless.

Are Synthetic Assets Safe?

Synthetic assets as an investment option are making great strides among users in the crypto community. However, like the rest of the ecosystem, some risks exist. Here are some of the risks involved in synthetic assets:

Smart Contract Risk

As mentioned earlier, the process of minting, burning, and transferring synths is controlled by smart contracts. As a part of the larger DeFi movement, synths are heavily reliant on smart contracts, which stand the risk of attacks from malicious actors.

Oracle Risk

Oracles are external nodes that provide much-needed accurate data to smart contracts that back synthetic assets. If the data for the price of an underlying asset has been tampered with, the entire smart contract stands to fail.

Platform Risk

No protocol is entirely immune from malicious actors or completely perfect. Apart from targeted attacks from hackers, the synthetic asset platform also stands at a risk of significant fee market fluctuations depending on the network on which it is built.

Synthetic Asset Platforms

Synthetic assets have become the basis for many innovations in the DeFi space. Many decentralized platforms are creating protocols catering to crypto users who want to create, sell or buy synthetic assets. Some platforms include:

Synthetix

Synthetix is a decentralized protocol for synthetic assets. The collateral-based protocol issues new synths, provides an exchange for trading synths, and allows users to mint new synths by utilizing various underlying assets. To create a synthetic asset on Synthetix, each user is required to deposit some cryptocurrency as collateral. The minted synth can then be traded on the platform’s decentralized exchange for other synths sold by users on the exchange. To reclaim their collateral, users must repay the loan they incurred by minting new synths. The synthetix’s architecture relies heavily on the pooled collateral mechanism to maintain the positions of the user’s synthetic assets.

Abra

Founded in 2014, Abra is one of the premier synthetic asset protocols in the industry. The decentralized platform uses an automated system that converts each user’s deposit into Bitcoin and represents it as USD. The Abra model is based on a BTC/USD peg. This structure is based on the crypto-collateralized stablecoin and hedging techniques.

Maker Protocol

This decentralized protocol is built on the Ethereum blockchain and boasts of the most widely used synthetic asset on the blockchain. Maker allows users to trade its stablecoin DAI by first providing collateral in the form of ETH. Dai serves as a synthetic asset that represents the value of USD, its underlying asset. The DAI is an EVM-compatible token and is thus compatible with most exchanges, wallets, and liquidity pools on the blockchain.

UMA Universal Market Access

The architecture of UMA is a little different from the rest. UMA’s Total return Swaps, built on the Ethereum blockchain, can be used to provide synthetic exposure to the price of underlying assets. Transactions on UMA are made possible by price oracles that provide accurate data for the transaction and a series of smart contracts that have terms of termination, economy, and margin requirements between two users. This system has once been used to create the synthetic asset, USStocks which is based on the popular S&P 500 Index.

Conclusion

The models behind synthetic assets have the power to create big strides toward reinventing financial systems. Not only do they provide exposure to traditional financial markets, but synthetic assets also ensure that the digital economy remains accessible. However, synthetic assets and by extension the DeFi movement are in their infancy. The development of new innovations and financial products is important for the success of crypto derivatives.