What are Synthetics?
Synthetic is a financial instrument or product that is meant to simulate other financial instruments while altering their key characteristics. The functionality of a financial instrument can be achieved through a blend of different financial instruments, as well. These tools are made to offer flexibility, customization, and ease of use to suit the needs of investors and customers.
What do Synthetics Offer?
Let’s discuss a small example.
Two traders have put their bet that the value of an asset would change in different directions in the future, i.e., either increase or decrease. Now, suppose if the value increases in the future, then one trader will lose the bet and the correct predictor earns that lost amount.
Synthetics allow an investor to buy the synthetic version of the asset with any other asset that the selling platform accepts and then sell it at the spot price in the future. In reality, on a synthetics platform when one trader buys the synthetic asset, this creates an arbitrage opportunity for market makers to buy the underlying asset if its price moves. This is the profit motive that keeps the price pegged to the underlying asset.
Now, what are the reasons that an investor would be interested in buying synthetics assets?
There are three primary things Synthetic tools offer –
- Funding – Synthetics can lower funding costs. For example, the Total Return Swap (TRS) is used as a funding tool.
- Liquidity Creation – Synthetics can be used to insert liquidity into the market, reducing costs for investors. Credit Default Swap (CDS) can be used this way to hedge credit exposure.
- Market Access – Synthetics can open up the marketplace to relatively free participation by recreating the cash flow of virtually any security through a combination of financial instruments and derivatives. CDS can be used to replicate a bond and offer it to the open market.
Why are Synthetics essential to DeFi?
Synthetics address and solve four valuable areas that can help DeFi scale up.
- Liquidity – Lack of liquidity has always been an issue in the DeFi space. Various players, especially market makers, deal with a large number of different types of crypto assets. There is a minimal number of financial tools available in DeFi space for proper risk management work. This is where synthetics can help the DeFi space scale up by protecting profits and hedging positions.
- Solving Tech Barrier – Smart contract is one of the pillars of the DeFi space, yet it is still difficult to move assets across multiple blockchains as it requires direct access to assets across all platforms. This cross-chain communication issue poses a severe limitation of asset availability on a decentralized exchange. Synthetics allow this direct access to assets to traders, thus solving the tech barrier.
- Asset Scaling – Bringing or connecting real-world assets like fiat currencies, gold, etc. to the blockchain platforms in a trustless way has always been one of the biggest challenges for the DeFi space. So far, stablecoins like Tether have taken on this role where fiat currencies are collateralized. However, a buyer having synthetic assets can deal with fiat currencies without really holding the same with a centralized agency. Thus he is not directly exposed to the market risk. Therefore synthetics provide a flexible mechanism to help in scale-up assets in DeFi space.
- More Participation – Beside assets scaling, another area synthetics directly influences is investor participation. In traditional finance, synthetics are available to large and sophisticated investors, enabling them to create intricate risk management profiles. In contrast, smart contract-based blockchain platforms with their limited fintech tools have managed to attract smaller investors in general. Synthetics in DeFi space mean bringing these large investors to the DeFi space.
DeFi synthetic assets allow a user to participate in any market with a price feed. This means that access cannot be limited to participants of any centralized agency’s choice. Anyone can engage with synthetic assets as long as the market price is public.
Synthetics Use Cases
There are various types of synthetic tools available in DeFi space. While some are similar to their traditional centralized financial space peers, some are purely native to the DeFi space.
These synthetic tools include tools for Asset Management, Analytics, Crypto Lending & Borrowing, Margin Trading, Decentralized Exchanges, DeFi Infrastructure & Dev Tooling, Insurance, Marketplaces, Derivatives, Staking, Tokenization of Assets, Payments, stablecoins, etc.
Here we will discuss a few such tools with relevant tool examples. Please note that some of these tools, though shown here in different tool categories, can offer two or more such functions. Wherever such tools are encountered, we will mention those.
# Tool 1: Crypto Lending & Borrowing
The Crypto lending space is becoming increasingly important rather quickly. So we will put much focus on this instrument.
The DeFi lending platforms provide loans to users or businesses in a trustless manner, i.e., without any intermediaries, whereas the lending protocols allows every participant to get interests on crypto coins and stablecoins.
As for the blockchain used, Ethereum and EOS dominate the DeFi lending marketplace. While most DeFi lending apps are built on Ethereum (15 as of June 2019), EOS commands the highest amount (over $600 million) locked by a blockchain. As digital assets tend to exhibit strong price volatility, these lending platforms generally require borrowers to supply an average of 150% collateralization to initiate a loan.
The traditional lending and borrowing rate of USD-based institutions in the US stands at between 2-3% in general. But the lending and borrowing rates in DeFi space are higher with the borrowing rate at 6-10% in USDC and Dai commanding borrowing rates as high as 17.5%.
The lending-borrowing platforms and protocols offer various benefits for market participants –
- Ability to short an asset: A borrower can buy an asset and immediately sell it on any other exchange for any other crypto coin, thus shorting the asset. This replicates margin trading in centralized exchanges and also offers margin trading functionality into platforms that don’t support it.
- Borrow a utility: The borrower may decide to temporarily borrow a token to earn certain rights or power on the blockchain, e.g. governance rights.
- Long-term Investment Reward: A long-term investor can earn an additional amount from interest on lent assets besides capital appreciation or a HODL strategy.
- Earning opportunity from Stablecoin: Stablecoin issuers can have the chance to win incentives by distributing part of their revenue from floating interest rates collected on their bank deposits to users who support the circulating supply through these decentralized platforms.
- For Both: This offers arbitrage opportunities across multiple platforms. An arbitrage opportunity exists if the borrowing rate is lesser than the lending rate.
- Arbitrage between DEX and CEX: A user, who has access to credit in US dollars (or any other fiat currency), can borrow dollars at a rate lower than the DEX’s, trade it on a CEX for a crypto coin and lend it on the DEX to earn arbitrage fee. Usually, a platform with stricter KYC requirement offers this opportunity. However, insufficient demands, counterparty, and platform-specific risks are present.
- Arbitrage between DEXs: This is a rare opportunity as the lending and borrowing rates spread widely. To best perform an arbitrage of this type, here, two loans (different DEXs) must possess similar parameters such as the term duration and maturity dates. The risks may include different network environments, native inflation rates, changes in price, and optionality, prepayment, and liquidity.
Crypto lending offers some key advantages over traditional financial products –
- Transparency in fund movements and the underlying smart contract
- Price efficiency as prices are subject to market demand
- Much easier access for users
- Greater platform utility, speed, and flexibility in lending/borrowing
- Censorship resistance and immutability
This also poses some disadvantages –
- Smart contract risk replaces the counterparty risk of traditional lending
- Low liquidity limits to borrowing and lending at current interest rate without materially affecting the equilibrium interest rates
Examples of such non-custodial type platforms and protocols are Dharma, Compound, Maker, Nuo Network, dYdX, Fulcrum, ETHLend, etc. BlockFi and Nexo would be examples of the custodial type platforms. MakerDAO, Dharma, and Compound represent nearly 80% of the total ETH locked in DeFi platforms.
Dharma is a semi-centralized P2P lending/borrowing platform based on Ethereum. The platform supports DAI, ETH, USDC for collateralization. The average collateral ratio is 210%. The interest rates are different for each coin.
It allows users to lend and borrow coins for 90 days at a fixed interest rate. The lending and borrowing rates are equal here. This interest rate is determined manually in a black box process by the team. One interesting fact here is that even if a borrower pays the loan before 90 days, he must pay the total interest for the entire 90 days.
The trades on Dharma are handled manually since Dharma is non-custodial. A user requests to lend his asset and then need to wait for a borrower to match his offer. This is a direct match-making type platform.
Compound is an Ethereum-based money market protocol for various tokens. It supports BAT, DAI, ETH, USDC, REP, ZRX tokens. Every asset market is connected to the cToken (cBAT) which acts as an intermediary token for all transactions and lenders earn interest through the cTokens. This is a liquidity pool type P2p platform.
Unlike Dharma, the interest rate here is not fixed. It varies based on real-time market dynamics. The interest rate will increase when there is a surplus demand from borrowers and decrease when there’s too much lendable amount. The lending interest rate is always lower than the borrowing rate to offer more liquidity.
The withdraw function offered here enables users to convert the cTokens to the original assets, e.g. from cBAT to DAI or ETH. The interest rate gets compounded over time as it is done at the block level. The average collateral ratio here is 400%.
Maker’s Dai stablecoin is probably the most well-known and widely used synthetics in DeFi.
Supporting DAI and ETH tokens, the Ethereum-based platform allows a user to borrow DAI, which maintains a soft peg in USD, by placing ETH token in reserve in Collateralized Debt Position (CDP). The loans here are overcollateralized at a rate above 150% at the beginning of the loan – around 480%. There are different mechanisms in place for the crypto-collateralized stablecoins to maintain its peg value against fiat currency.
Unlike P2P models where existing coins are transferred, here, the protocol actively issues coins from reserve pools. The Maker token (MKR) enables users to participate in the operational earnings through “governance fees,” which act as interest rates for the network.
The Maker platform intends to enable borrowers to deposit multiple assets as collaterals (in single borrowing) to alleviate the volatility of a single asset. Maker is the most go-to such platform, locking $403.92 million worth of ETH.
# Tool 2: DeFi Derivatives
A derivative is a financial contract between two or more parties that derives its value from the performance of an underlying entity. This entity can be an asset, interest rate, or index, as well as bonds, commodities, etc. This is often called just ‘underlying.
Derivatives in DeFi offers immense flexibility across multiple assets and platforms. Smart contracts can issue tokenized derivative contracts which are executed permissionless and automatically. Though used for various purposes, there are two primary purposes of using a derivative –
- To protect oneself from price fluctuation in the future by signing a contract to buy an asset for a fixed price
- To gain by speculating how the price of that entity is going to change in the future
There are four types of derivatives –
- Future – Here a buyer must purchase an asset at an agreed-upon rate on a fixed date in the future. These are traded on exchanges.
- Forward – Similar to Future but more customizable and flexible to suit both parties.
- Option – Here a buyer has the right to purchase or sell the underlying asset at a specific price, but certainly not obliged to.
- Swap – These contracts allow two parties to exchange one type of cash flow for another – this is usually between fixed flow to floating flow. This swap is usually between interest rates and crypto coins.
In DeFi space, Future derivatives are essential for traders to hedge positions and reduce the risk of crypto’s price volatility. Various derivatives allow traders to gain from the price fluctuation of Bitcoin and major altcoins – buy now at a lower price and sell at a higher price later. But this is a very risky strategy as it is relevant only during a bull market.
Another strategy is to do Shorting. A trader borrows the asset from an exchange or broker, then sell it on a downtrading market. As the asset price dips more, the borrower purchases back the same amount of asset at a lower price now, thus profiting from the lower trading rate. They give a small profit portion to the lender.
Institutional exchanges like LedgerX started trading regulated swaps and options contracts in October 2017 as per the approval of the U.S. Commodity Futures Trading Commission (CFTC). Bakkt is another such platform going to offer Bitcoin futures trading. Major crypto exchanges like OKEx offers futures and perpetual swaps trading. Daxia, Set Protocol, Synthetix, UMA fall in this category.
Let’s look at two such projects –
Synthetix is a multi-tier issuance platform, collateral type, and exchange, which allows users to mint various synthetic assets, including fiat currencies, cryptocurrencies, derivatives. This is a Peer-to-contract trading platform. The Synths tokens provide exposure to more than 20 different assets such as Bitcoin, U.S. Dollars, gold, TESLA, and AAPL within the Ethereum blockchain.
A user puts collateral in the form of SNX tokens to create a synthetic asset. Now he can exchange or swap one synthetic asset for another i.e. reprice the collateral through an oracle. There is no direct counterparty involved in the process.
Synthetix employs a pooled collateral mechanism and hence, the SNX stakers collectively take on the counterparty risk of other users’ synthetic positions.
UMA is a decentralized financial contract platform that allows Total Return Swaps on Ethereum to offer synthetic exposure to a wide variety of assets.
UMA’s open-source protocol enables any two counterparties to customize and create their own financial smart contract, specifying the economic terms, margin requirements, and termination terms of the agreement. But these contracts are secured with economic incentives. It also requires a price feed oracle to return the current price of the underlying asset.
An implementation example of UMA’s protocol would be the USStocks ERC20 token, which represented the U.S. S&P 500 index and traded on DDEX, the Beijing-based decentralized exchange. This was done by fully collateralizing one side of a UMA contract and then tokenizing the margin account. This resulted in synthetic ownership of the long side of that contract.
The design scope of derivatives in DeFi space is enormous. Whereas many innovative traditional derivative tools can be implemented in the DeFi space, there is a lot of untapped scope for crypto-native derivatives as well. These derivative contracts haven’t existed in the traditional finance market. Let’s check out a few such crypto-native derivatives.
Ex 1: Hash-Power Swaps
Here a miner sells a portion of their mining capacity for cash to a buyer, such as a fund. This creates a steady income stream for the miner that doesn’t rely on the underlying asset price. This also enables funds exposure to a crypto asset without having to invest in mining equipment. This is called the Hash-power swap and is offered by BitOoda via their physically settled Hash-Power Weekly Extendable Contracts.
Ex 2: Electricity Futures
Electricity Futures can also be offered DeFi space. This has so far been available in traditional commodity markets only. Here the miner simply enters into a ‘futures’ contract to purchase electricity at a set price at an agreed time in the future. This enables the miner to safeguard their energy risk against any possible sharp rise in electricity costs, which can make mining unprofitable. In other words, the miner turns their electricity costs from variable to fixed.
There are other derivatives as well such as stability fee swap, Airdroptions, Slashing Penalty Swaps, etc.
# Tool 3: Asset Management Tools – DeFi Wallets
Asset management tools act as a custodian but is a specialized financial institution that safeguards a user’s financial assets and is not engaged in any traditional commercial or banking services. In DeFi space, asset management tools include wallets, apps, and dashboards for managing user assets.
The crypto gateways interacting with Web 3.0 must be secure, intuitive, and accessible for any user around the world, but offer full control to the user. Asset management tools, such as non-custodial wallets, are, therefore are essential in progressing web 3.0 to the mainstream.
For a new investor, the process was very complicated – setting up crypt wallets, finding exchanges, spreading out their assets for diversification, keep track of them across multiple platforms, etc. Besides working your way out, the first can prove to be pretty challenging. Hence crypto-asset management tools have been created to take the technicalities out of the way.
Over the past few years, we’ve seen drastic improvements to wallets and other asset management tools in terms of access, features, and security, drawing investors, especially retail investors, to the $400 billion space.
Example of DeFi wallet includes MetaMask, Brave, Coinbase Wallet, Burner Wallet, MyEtherWallet, Abra, InstaDapp, Trust Wallet, Argent Wallet, Gnosis Safe, etc.
Abra is probably one of the oldest synthetics of crypto space. Beginning as a simple crypto wallet, Abra now allows you to invest in cryptocurrencies as well as traditional assets like stocks and ETFs. It also offers portfolio management manage on the go via its mobile app.
When a user deposits funds into their Abra wallet, the funds are immediately converted to Bitcoin and represented as USD in the Abra app. Abra can do this by maintaining a BTC/USD peg, which guarantees that a user can redeem the original value, regardless of the price fluctuations of either BTC or USD. This means Abra is able to create a crypto-collateralized stablecoin.
Also, the DeFi tool immediately safeguards its risk so it could honor all trades every time. When you fund your wallet in Abra, you are effectively taking a short position on Bitcoin and a long position on the hedged asset. Thus Abra is doing the reverse – long position on Bitcoin and short position on the hedged asset.
InstaDApp is a decentralized smart wallet built on top of the MakerDAO protocol. It requires an Ethereum web 3.0 wallet like Metamask, Coinbase Wallet, TrustWallet, etc. to interact with the InstaDApp portal for now. You need to have ETH to make gas fee during transactions.
Being an asset management tool, the wallet desk helps you keep track and manage your blockchain-based assets and analyze them in a complete non-custodial manner. The app optimizes and manages all your holdings across different protocols.
The wallet allows you to leverage your assets, borrow and lend, do shorting, or debt switching. You can earn variable algorithmic interest over time from the lent assets. InstaDApp enables switching positions between protocols to take advantage of rates, liquidations, etc.
Open Zeppelin is named as the auditing firm for the tool.
# Tool 4: DeFi Insurance
Though ideally supposed to be risk-free, users have experienced loss of their crypto fund through exchange hacks, private keys compromisation, and simply mishandling their crypto funds. And since the transaction nature is decentralized – fund recovery and user security are problematic, unlike banks or credit card firms in traditional finance. Hence DeFi insurance holds a vital role in securing the fund of the user, thus drawing more investors to the DeFi space.
DeFi insurance protocols allow its users to take out insurance policies on smart contracts, funds, or any other digital asset through pooling individual funds to cover any claims. Though the crypto-insurance space is small, the market is untapped and as the need grows, more insurance applications would emerge in the future.
DeFi examples include Nexus Mutual, Ethersc, Cdx, etc. Let’s check an example.
It’s an Ethereum-based decentralized insurance protocol that uses a risk-sharing pool allowing anyone to buy an insurance cover or contribute capital to the pool. Its members wholly own the pool.
In Nexus Mutual, anyone can participate as the mutual by contributing ETH into the pool in exchange for NXM – the native token. The token can be used for claim assessment, risk assessment, governance, etc.
The mutual’s first insurance product is a smart contract that covers for purchasing protection for value storing contracts (which are inherent to DeFi and TVL). For the mutual to begin processing claims, the fund must meet the minimum capital requirement of 12,000 ETH locked in the fund.
Synthetics are exciting instruments that are full of promises and hidden potentials. However, there are several risks involved as it has taken down the traditional finance space and the global economy a few times – we all remember the US recession in 2007 due to this.
But there is no doubt that synthetic is the critical component for growing the DeFi space. It is still in its nascent stage, and therefore nothing can be predicted for sure. The DeFi synthetic space needs continuous research from developers and financiers to bring innovative instruments in DeFi space, thus allowing real flexibility and ease of access and use.