Synthetic Assets

Basics & Possible Future Applications

The word synthetic sometimes brings us associations related to chemicals and can even lead us to refer to something unsafe. However, before going deeper into synthetic assets, it is important to note that all information that constitutes a synthetic asset is taken from the real world. This leads us to realize that even synthetic assets have a kind of nature stamp. Whether this natural stamp is relative to traditional real economy or crypto real economy. Regardless of the case, there will always be a portion that anchors them in reality, in the movements of the economic ecosystem in which their real-world relatives are inserted.

Something very interesting about the characteristic of synthetic assets is the ability to choose how connected to reality the financial engineer wants that synthetic asset to be. The exploration of this variable level of connection with the real world is the key to understanding the synthetic assets. There are two main factors that will dictate the proportion of this connection to the real world:

• The complexity of the synthetic asset pricing formula
• The quality of the data taken from the real world to execute the pricing formula

Let’s keep this information for now and explore in a more basic way the constitution of these assets.

The agreement, the basis of everything.

Just like derivatives, where a contract between two or more parties is based on an underlying asset, such as a security or an index, on synthetic assets the basis will also be an agreement between parties. Investor interest in this agreement is essential for the birth of a synthetic or derivative asset. The more interest in this agreement, the more a synthetic or derivative asset has a chance of generating the desired impact and achieving the success of its designed purpose.

Ballast Agreement

In the traditional economy, contracts can be backed by the simulated asset itself or by its value represented by some fiat currency. This will depend on the contract and, ultimately, it will reflect the interest of investors.

In decentralized finance this will be no different. We will always have an agreement, but in this case, the agreement will include the formation of a liquidity pool to represent this ballast that the synthetic asset needs to have some perceived value.

Note that in both cases the value or backing comes from the interest of investors in signing the agreement. The only difference is that this agreement is manifested through the legal guarantee of a contract in the traditional economy and through smart contracts and liquidity pools in decentralized finance.

The quality of the data

Since the basis of synthetic assets are agreements, what good would it do if these agreements are of interest to investors or are well designed, if they use corrupted data. We will move from the phase where the problem is the lack of data to the phase where the problem will be the quality of the data. The necessary trust for the good development of these agreements is fundamentally linked to the auditability and transparency of these data. In addition, another fundamental point is the importance of good security management of these data and the development of mechanisms to defend against attack through data entry ports.

The pricing formula, where the magic happens.

One of the fundamental points of this agreement is the pricing formula. For example, in simpler formulas we can explore ways to accentuate or make asset price changes more aggressive. It is the type of agreement that users of Perpetual Futures Markets usually sign to leverage their positions. More complex ways of dealing with this formula, such as baskets of assets of equal weights or baskets of assets of different weights, are representations widely used in traditional finance, for example in ETFs.

The challenges of decentralized finance will require a new level of complex use of pricing formulas. For example, agreements involving diverging data entry points for restricted-priced assets could revolutionize access to new asset classes through well-designed formulas. In parallel, successful synthetic asset projects could have their transactions analyzed to generate even more information to feed back on these formulas making their result more robust and reliable.

My thoughts on future use cases

In my view there were 3 major sub-niches where the future use cases will be located.

Liquidity Creation

The generation of liquidity is a current challenge for the ecosystem and has been successfully attacked by several projects. Synthetic stablecoin projects like MakerDAO and others are setting the stage for DeFi’s next challenges.

Synthetic Crypto-natives

These assets will be extremely important in the near future. As a first use case, as the crypto ecosystem evolves, these assets will be needed as a form of protection for miners and validators. Some examples of these assets are Hash-Power, Slashing Penalty and Staking Yield swaps.

Access to Real Markets

For years we have created a parallel world in blockchain. We gained skill and developed as investors. But I believe that today a large part of the crypto investors that have been investing and creating our parallel world since the beginning have a strong desire to expose themselves in other traditional economy markets. But these investors strongly disapprove of CeFi. Synthetic assets from real markets are the opportunity to solve this problem. A market that is ready to be developed and will, in my view, have very large adoption both from old blockchain investors and will attract new entrants.

Conclusion

In my opinion, our next main challenge of decentralized finance is to guarantee the access of DeFi users to new markets in the traditional economy. The use of instruments as synthetic assets will be essential to overcome this challenge. And the key to opening this access door is inside the design of pricing formulas and access to great data.

The greater the spread and the restriction of access to the prices of these assets to be synthesized, the greater the challenge for financial engineers. But as the sage would say; if there is a problem, there is an opportunity. There are dozens of asset classes that have thousands of investors requiring integration into the world of decentralized finance. And as decentralized finance gains more and more adoption, that number tends to grow more.