A Comprehensive Understanding of the Prospects and Potential of Synthetic Assets

This article was published on September 4, 2020, on the Coinbase blog and compiled by Ethereum enthusiasts, authored by Justin Mart.

Most current DeFi applications look no different from traditional financial products; users can exchange one token for another, borrow and lend in money markets, and even engage in margin or leveraged trading on exchanges.

But the potential of DeFi goes far beyond that. Blockchain is an open global platform, and its core value lies in programmability. One day, we will see the emergence of unique products in the DeFi space that have never existed in the traditional world.

The first possible emergence is: Synthetic Assets

1. What are Synthetic Assets?

Synthetic assets are a new class of financial derivatives. The definition of financial derivatives refers to assets whose value derives from other assets or benchmarks, with contracts traded between buyers and sellers that track the future prices of assets, such as futures and options.

DeFi takes this a step further; synthetic assets are tokens that represent financial derivatives in digital form. If derivatives are financial contracts tailored to the risk exposure of underlying assets or financial positions, then synthetic assets are a tokenized representation of such positions.

As a result, synthetic assets have unique advantages:

• Permissionless Creation: Blockchains like Ethereum allow anyone to create synthetic asset systems.

• Ease of Access and Transfer: Synthetic assets can be freely transferred and traded.

• Global Capital Pool: Blockchains are inherently global, allowing anyone in the world to participate.

• No Centralized Risk: There is no centralized authority with privileged control.

2. Are there any examples?

First, synthetic assets can tokenize tangible assets, bringing them into the blockchain world and endowing them with all the aforementioned advantages. Imagine that anyone in the world who buys this token tracking the S&P 500 can use it as collateral for other DeFi projects (like Compound, Aave, or MakerDAO). This model can extend to commodities like gold or grains, stocks like Tesla, indices like the S&P, and debt instruments like bonds.

Thinking about this last point is quite exciting. We could soon tokenize various novel items (such as pop culture markets, meme markets, personal token markets, etc.) and trade them in the form of synthetic assets.

Since any asset can be represented as a synthetic asset on-chain, the potential market size is enormous. Just looking at one statistic, the total global stock trading volume was approximately $32.5 trillion in the first quarter of 2020. Theoretically, a portion of this could be replaced with synthetic assets, allowing anyone to trade freely in a global capital pool.

3. Specific Example: Poop Exchange

At the end of 2019, some developers had a creative idea: could we create a synthetic asset to track the frequency of poop found in San Francisco? They then developed a prototype. Token holders profit when more poop is discovered, while issuers profit when the frequency of poop discovery decreases, using a shared information transmission mechanism to report poop occurrences.

The poop exchange could serve as an incentive for the local government of San Francisco. If the city government issues poop tokens, they would have the motivation to clean the streets for rewards. Correspondingly, citizens could buy poop tokens as a form of emotional hedging; if the streets do not become cleaner, at least they can earn some money. This is just a simple example, but it showcases the potential of synthetic assets in various markets.

4. What synthetic asset platforms currently exist?

UMA *

UMA is a synthetic asset protocol that allows anyone to recreate traditional financial products, quirky products based on cryptocurrencies, and more. Through UMA, two counterparties can create any financial contract together in a permissionless manner, secured by economic incentives (collateral) and enforced through Ethereum smart contracts. Since Ethereum is globally open, the barriers to entry will be significantly lowered, creating "Universal Market Access."

Currently, the UMA community is working on developing token yield curves (e.g., yUSD), but anyone can create various financial contracts through the platform. A few simple examples include:

• Cryptocurrency-based contracts: Cryptocurrency futures tokens, yield curves, perpetual swap contracts.

• Tokens tracking cryptocurrency or DeFi metrics: For example, BTC market cap ratio, DeFi locked value trends, decentralized exchange market share trends, or any other metrics.

• Traditional financial products: U.S. stocks and global stocks (like Tesla stock tokens or Apple stock tokens), commercial pension plans, insurance, or other annual return products.

• Some quirky things: The previously mentioned poop exchange, pop culture, meme markets, etc.

UMA aims to serve long-tail products in the rapidly innovating financial market. Just like the example of the poop exchange, these contracts have the potential to fundamentally redistribute incentives and facilitate zero-to-one innovations.

*Note: UMA is a member of the Coinbase Ventures portfolio

5. Synthetix

Synthetix is a protocol on Ethereum that creates a global capital pool for synthetic assets, facilitating the creation and trading of various asset classes (including cryptocurrencies, stocks, and commodities), all done on-chain.

Tokens tracking the prices of these assets can be traded within the Synthetix ecosystem, utilizing a combination of collateral, locked tokens, and transaction fees. Notably, the Synthetix ecosystem is transitioning to be fully operated by a DAO structure, making the SNX token the core of the ecosystem. Users can lock SNX as collateral for synthetic asset positions while earning transaction fees in return, and SNX also serves as the voting token for the DAO.

As a leading synthetic asset platform in the DeFi world, Synthetix has issued over $150 million in "Synths" synthetic assets. The most significant among them is sUSD, its stablecoin, which is rapidly approaching a market cap of $100 million.

Currently, Synthetix primarily offers synthetic assets based on cryptocurrencies, such as sETH and sBTC, as well as index tokens tracking asset portfolios, like sDeFi and sCEX. The appeal of these tokens mainly comes from their unique market design, where assets are traded at prices transmitted through information mechanisms, thus avoiding price slippage during trades.

6. Others

There are many other platforms building uniquely designed synthetic assets. These include Morpher, DerivaDEX*, FutureSwap, DyDx, Opyn, Hegic, and Augur.

*Note: DerivaDEX is a member of the Coinbase Ventures portfolio

7. Conclusion

Synthetic assets are a new component formed after the gradual maturation of Ethereum and the DeFi ecosystem, but we are just getting started, and we should not overlook their inherent risks:

• Smart Contract Risks: Smart contracts can potentially be exploited by malicious actors, and synthetic assets are likely targets for such individuals.

• Governance Risks: These platforms are typically managed by decentralized participants arranged by the protocol, and the effectiveness of governance has not been tested on a large scale.

• Information Transmission Mechanism Risks: Many synthetic assets rely on information transmission mechanisms, each with its own trust assumptions and failure modes.

• Platform Risks: Ethereum and other underlying blockchain platforms may face scalability issues, preventing them from functioning when most needed. The transaction fee market may also be inefficient, with front-running or griefing attacks being tricky problems.

However, we must find a balance between risk and potential. Synthetic assets represent global access to existing financial markets, making them an important component. A deeper understanding reveals the innovations behind various markets.

We may use these components to create new financial markets, reshape incentive mechanisms, and change our lives.