Today, most Decentralized Finance (DeFi) applications look like copies of traditional financial products. You can swap one token for another, borrow or lend a token in a money market, and even trade on an exchange with margin and leverage.
But DeFi can go much further. Blockchains are open, global platforms that carry programmable value at their core. It’s only a matter of time before DeFi produces something truly unique — with no corollary in the traditional world.
Enter the first possible example: synthetic assets
What are Synthetic Assets?
Synthetic assets are a new type of derivative. Recall that derivatives are assets whose value is derived from a different asset or benchmark. Things like futures and options, where buyers and sellers trade contracts that track the future price of an asset.
DeFi simply adds a twist: synthetic assets are tokens that are digital representations of derivatives. Where derivatives are financial contracts that provide custom exposure to an underlying asset or financial position, synthetic assets are simply tokenized representations of similar positions.
As such, synthetic assets carry unique advantages:
- Permissionless creation: Blockchains like Ethereum empower anyone to construct synthetic asset systems
- Easy access and transferability: Synthetic assets are freely transferable and tradeable
- Global pools of liquidity: Blockchains are global by default, anyone in the world can participate
- No central party risk: There are no central parties with privileged control
What are some examples?
To start, synthetic assets can tokenize physical assets, bringing them onto a blockchain and imbuing them with all the advantages listed above. Imagine anyone in the world buying a token that tracks the S&P 500, and being able to use that token as collateral in other DeFi projects like Compound, Aave, or MakerDAO. The model can be extended to commodities like gold or grains, equities like TSLA or indexes like SPY, debt instruments like bonds, and anything else.
Consider that last piece — this is where it gets exciting. We’re not far away from exotic, novel instruments like pop culture markets, meme markets, personal token markets, etc, that can be traded through synthetic assets.
And the implied market size is substantial given that any asset can have a synthetic version brought onto a blockchain. Just as one reference point, the total global equities trading volume Q1’20 is ~$32.5T, which theoretically could be replaced in part by synthetic versions that trade on a global pool of liquidity with open and free access to anyone.
In late 2019, a few developers had an idea and released a prototype — what if we had a synthetic asset that tracks the frequency of poop sightings in San Francisco? Token holders profit when more poop is sighted, and the token issuer profits if poop sightings decrease, using an oracle that simply reports the number of poop sightings.
This poop token market could align incentives for local SF government. If the city of SF issues poop tokens, they are incentivized to clean up the streets in order to profit. Conversely, citizens could purchase poop tokens as an emotional hedge, ensuring that at least they make money if the streets don’t get better. A simple example, but showcases the potential of synthetic assets and markets for anything.
What types of Synthetic Asset platforms exist today?
Universal Market Access (UMA)*
UMA is a synthetic-asset protocol that allows anyone to recreate traditional financial products, exotic crypto-based products, and more. Through UMA, two counterparties come together to permissionlessly create an arbitrary financial contract that is secured through economic incentives (collateral), and enforced through smart contracts on Ethereum. Given Ethereum’s global, open nature, the barriers to entry are significantly reduced, creating “Universal Market Access.”
- Crypto-based contracts: Crypto futures tokens, yield curves, perpetual swaps, etc.
- Tokens that track cryptocurrency or DeFi metrics: E.g., BTC dominance, DeFi TVL charts, decentralized exchange (DEX) market share charts, or any other metric.
- Traditional financial products: US & Global equities (e.g., a TSLA or APPL token), private pension plans, insurance and annuity products
- Exotics: The poop.exchange example, pop culture, meme markets, etc.
UMA is positioning itself as the protocol for the long-tail of exciting and creative financial markets. As with poop.exchange, some of these contracts might be used to fundamentally realign incentives — a zero-to-one innovation!
* Note: UMA is a Coinbase Ventures portfolio company
Synthetix is a protocol for creating global liquidity for synthetic assets on Ethereum. Synthetix facilitates the creation and trading of numerous asset classes including crypto, equities, and commodities, all on-chain.
Tokens that track the price of these assets can be bought and sold natively within the Synthetix ecosystem, which uses a combination of collateral, staking, and trading fees to operate. Notably, the Synthetix ecosystem is transitioning to be operated entirely by a structure of DAOs, where the SNX token is central to the entire ecosystem. SNX can be staked to provide collateral backing synthetic asset positions while accruing trading fees in return, and act as a governance token in the DAOs.
As the leading synthetic asset platform in DeFi, Synthetix has currently issued over $150 million of “Synths”. Chief among them is sUSD, their platform’s stablecoin, which is approaching $100M in market cap.
Today, Synthetix mostly offers crypto-based synthetic assets like sETH and sBTC, as well as index-tokens like sDeFi and sCEX that track a basket of assets. Much of their traction can be owed to their unique market design, where assets trade against an oracle price and therefore suffer no slippage when buying or selling.
* Note: DerivaDEX is a Coinbase Ventures portfolio company
Synthetic assets are new primitives made possible by the maturation of Ethereum and the DeFi ecosystem. But we are just at the beginning, and should not be blind to the inherent risks:
- Smart contract risk: Exploits in smart contracts are possible, and synthetic assets could be strong targets
- Governance risk: These platforms are mostly often governed by their decentralized participants, which remains relatively untested at scale
- Oracle Risk: Many synthetic assets rely on oracles to function properly, which carry their own trust assumptions and failure modes
- Platform risk: Ethereum and other underlying blockchains may struggle at scale, and perform worse the moment you need them most. Fee markets can be inefficient, and frontrunning or griefing attacks could be challenging.
However, balance the downside with the potential. Synthetic assets represent open and global access to existing financial markets, itself an important primitive. But cut deeper and you can see the innovation behind markets for anything.
We can potentially use these primitives to construct novel, new financial markets that can fundamentally align incentives and change the way we live our lives.