Government bonds and shares of stock used to be pieces of paper held by their owners. In a broader financial sense, money was previously backed by (and redeemable for) gold. However, these financial instruments are now 1’s and 0’s on servers, yet they serve the same roles as they did before their digitization.
The increasing global reliance on digital resources, such as storage and computational processing, has meant that more real-world assets have moved “online” over the years.
Synthetic assets, or synths, are a natural evolutionary step in this process. In crypto, the term is used more broadly to describe cryptocurrency tokens that also represent real-world assets (like currencies, stocks, or commodities) or non-native cryptocurrencies (like Bitcoin on another chain). This is the more inclusive definition that will be explored here.
In sum, synthetic assets are financial instruments that are meant to simulate other assets in a different setting or for an alternate use. They grant market participants unique exposure to those assets for trading purposes.
In traditional finance
Derivatives are frequently used to simulate trading “underlying” assets (i.e. the assets from which they derive their value), and through these financial instruments traders can hedge their strategies and/or use varying degrees of leverage.
Certain trades using derivatives are explicitly called synthetic positions. For instance, a synthetic call involves buying shares of stock plus a put option contract to protect against downside risk. Alternatively, synthetic bonds are made up of multiple assets and are meant to act in a similar way to corporate bonds. In this way, combinations of buying derivatives and other assets can synthetically recreate strategies of trading other financial instruments.
In cryptocurrency
The traditional finance definition of synthetic assets certainly applies to the cryptocurrency space, as well. However, as previously mentioned, this is not the only way of using the term.
Synthetic assets in crypto are also tokenized representations of other cryptocurrencies on their non-native chains or digital versions of real-world assets. This allows traders to get exposure to off-chain or real-world assets on a platform where they do not otherwise exist—and therefore the assets exist only synthetically on-chain.
What synthetic assets can be traded?
- Fiat currencies – As one of the most important pieces of decentralized finance (DeFi), fiat stablecoins are synthetic representations of real-world currencies. They provide synthetic, blockchain-based exposure to the US Dollar, the Euro, and other currencies through either centralized backing (by cash or cash equivalents) or overcollateralization (as with MakerDAO’s DAI).
- Off-chain crypto – Do you want to be able to trade Bitcoin on the Ethereum blockchain or its layer 2 solutions? Because Bitcoin calls another blockchain home, this would not be possible without assets like wrapped Bitcoin (WBTC). Wrapped Ether (WETH) similarly grants exposure to ETH to users of Polygon’s sidechain and many other networks.
- Commodities – Paxos issues PAXG, a token that is linked to the price of gold and is backed by physical gold. Other commodities like silver and platinum have been tokenized, as well.
- Financial derivatives – Just as the traditional finance system has watched the growth of derivative trading, futures and options have also been introduced to the crypto space, both offered by centralized services and DeFi protocols like Opyn and Hegic.
- Stocks – Some smart contract-based protocols provide users the opportunity to mint and trade blockchain-based, synthetic versions of stocks. The tokenization and blockchain-based trading of stocks has been a hot topic in equity markets, but its adoption has been tempered by questions of regulatory compliance.
- Inverse cryptocurrencies – Operating like inverse exchange-traded funds (ETFs) in TradFi, the price action of these tokens opposes the natural movement of other cryptocurrencies. For instance, an inverse BTC product may decrease by 5% when the price of BTC increases by 5%.
- Real estate – Houses have been tokenized as non-fungible tokens (NFTs) so that their ownership can be transferred on the immutable record of the blockchain. One such house was sold in South Carolina for $175,000 in 2022.
How do synthetic assets work?
So far, there are a few main ways that synthetic assets are created—or minted—as tokens on a blockchain. All are intended to take advantage of the immutability and transparency of blockchain-powered technologies. This way, users can verify when each individual token is minted, burned, or traded. Still, some synthetic assets are supported by centralized services or companies, while others exhibit different gradations of decentralization.
- Centralized issuance – Many stablecoins are issued by companies who hold cash or cash equivalents to insure the value of their tokens. Examples of this include Circle’s USDC and Tether’s USDT.
- Smart contract custodians – In order to tokenize an asset on a non-native blockchain, users must have a custodian hold (or burn) that asset as 1:1 collateral. The Wrapped ETH smart contract is a trustless way to accomplish this process, allowing users to convert ETH to WETH and vice versa.
- Overcollateralization – In order to mint the DAI stablecoin, users must deposit a certain value of crypto assets into the issuing platform’s (Maker’s) smart contracts. This value must always be more than the value of DAI created—even accounting for market price fluctuations—which ensures no DAI will ever be un-backed. The Synthetix platform relies on a similar model, allowing users to mint synthetic assets as long as they overcollateralize their withdraws with its native SNX token. Mirror protocol also operated on this model—before the demise of the Terra blockchain.
What challenges do synthetic assets face?
Certain synthetic assets have relatively “safe,” established roles in crypto. Wrapping protocols, for instance, improve the ability for users to trade crypto like ETH and BTC across chains—a necessary function in DeFi. However, there is still some regulatory uncertainty surrounding fiat-backed stablecoins. Moreover, the future of tokenization of other instruments like stocks and financial derivatives remains even murkier.
All things considered, blockchain-based synths are relatively new, and their development has been rapid. This means that their use will change significantly both as the technology develops further and as the world learns more about their role in crypto.
Synthetic assets essentials
- Synthetic assets (synths) are representations of real-world assets, cryptocurrency products, or financial instruments that are tokenized on the blockchain
- Some examples of synthetic assets include: stablecoins (like USDC), commodities (PAXG), crypto (WETH), financial derivatives (options), and tokens that mimic stocks
- Synthetic assets are created (or “minted”) on a blockchain in a number of ways such as by centralized issuance, overcollateralization, or smart contract custodians