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- 1 Synthetic Assets are token forms of derivative contracts that derive their value from an underlying asset.
- 2 As a form of derivative, crypto synths allow investors to profit from assets without actually owning them. This gives investors the flexibility when switching between assets or making investments.
Synthetic asset is a type of derivative asset. To help you understand what it is, we will examine what a derivative is and how synthetic assets differ from other types of derivative assets.
What Is Derivative?
A derivative is a contract between two parties that states the conditions in which money will be exchanged between the parties. These conditions could include:
(a). The type of asset that the contract is based on.
(b). The factors that define how the asset influences payment.
For instance, if the underlying asset of the contract is shares of a company, the other factors on the contract could include the effect of index price fluctuations (where a party gets paid if the price of the share reduces), the notional value (which is the actual quantity of assets the contract signifies; for instance, 50% share of the company), and the obligations of each party.
Derivatives allow investors to participate in a market without owning the underlying assets. This gives them flexibility when making investments. Since you don’t have to buy an actual house to invest in real estate or go through a vigorous process to own shares or bonds, you can switch between investments with ease or make investments in asset classes that would have been difficult to own.
Derivatives also allow you to modify your participation in the underlying asset. The contract can weaken the influence of price fluctuations of the asset (for instance, if it states that only 0.5% of the price movement will affect payments), strengthen the influence ( if it states that whatever result of the market move will be multiplied by 2), or allow the investors to gain from the inverse price movement of the asset.
Now, how do synthetic assets relate to derivatives?
Synthetic assets are tokenized forms of derivatives. Instead of just creating a contract, synthetic assets allow you to create a token that signifies the contract. This increases the options of where derivatives can be traded and who can access them.
The majority of the traditional derivatives are traded over the counter in a private market between the parties. When they are traded in open exchanges, there are usually concerns about how restricted the derivative exchanges are and how much is needed to trade. Synthetic assets solve these concerns by making derivative assets accessible to retail traders.
How Are Synthetic Assets In DeFi Different From Traditional Synthetic Derivatives?
In decentralized finance, synthetic assets are blockchain tokens that represent derivatives. Blockchain synthetics (also called synths) combine blockchain technology and the traditional derivative market to produce assets that offer flexibility when making investments as well as decentralization for its investors.
For traditional investors, crypto synths allow them to benefit from the security and immutable nature of transactions carried out on the blockchain. Since blockchains use a trustless structure, investors can be certain that all derivatives will be executed according to the terms stated in the contract. It also decentralizes synthetic assets; anyone can mint or trade them on exchanges from their mobile devices.
For crypto investors, synths allow them to diversify their portfolios. Apart from minting synthetic assets for cryptocurrencies, you can mint synths for other asset classes like stocks, commodities, and even real estate. This allows you to profit from less volatile markets.
How Can You Mint Synthetic Assets In DeFi?
The process involved in minting synths differs with exchanges. In most exchanges, synths can be created by staking another token as collateral. Some exchanges allow you to mint specific types of synths while others offer a variety of asset classes that can be used as underlying assets.
All synths are minted and traded on synthetic asset exchanges.
Here are two top synthetic asset exchanges and how they work:
1) Synthetix Protocol
Synthetix is a protocol built on the Ethereum blockchain that allows users to mint and trade synthetic assets as ERC-20 tokens. Synths on the protocol can be made from crypto assets fiat currencies (like USD or GBP), commodities (like gold), and future contracts.
To mint synths, the investor is required to stake the protocol’s utility token, $SNX. The staked token serves as collateral while the synth that is created is considered as a debt. For your minting to be successful, the tokens you staked as collateral must be more than the debt synth you want to create. This is because of the volatility that affects crypto assets like $SNX. If you stake the collateral in a 1:1 ratio with the synthetic asset and the price of $SNX reduces, the collateral will no longer cover the debt. To balance the ratio, you will have to burn some synth. Synthetix protocol also uses Chainlink Oracle to get an updated price of all underlying assets.
2) Mirror Protocol
Mirror protocol is a synthetic asset protocol that is built on the Terra blockchain. It allows users to mint synthetic assets of cryptocurrencies ( like BTC and ETH), stocks (like shares from Telsa or Microsoft), and Exchange-Traded Funds (like Invesco Trust). These assets are referred to as Mirrored Assets (mAssets) on the protocol, so the synthetic version of Bitcoin is denoted as mBTC and that of Microsoft stock is shown as mMSFT.
Mirror protocol also allows fractional ownership of synthetic assets. The mAssets are blockchain tokens that can be subdivided and bought in smaller quantities. Instead of trading a $1000 mMSFT share, you can buy $100 worth of tokens from the share.
Like the Synthetix protocol, the Mirror protocol allows users to mint synthetic assets through an over-collateral method. The value between the collateral and the debt must be kept within a 1.5:1 ratio. This means that if you are to mint 1 share of an EFT that is worth $1000, the collateral you provide must be worth $1500. The collateral is staked in the form of Terra blockchain’s stablecoin, UST.
Conclusion
As a blockchain token, crypto synths allow traditional investors to benefit from Web3 security and decentralization while crypto investors can diversify their portfolio to invest in less volatile asset classes like real estate, ETFs, or bonds.
Steve Anderson is an Australian crypto enthusiast. He is a specialist in management and trading for over 5 years. Steve has worked as a crypto trader, he loves learning about decentralisation, understanding the true potential of the blockchain.
