The crypto industry has grown fast in the last 15 years, and derivatives are a popular niche in any financial market. The Crypto derivatives niche has burgeoned and expanded to synthetic assets.
Crypto synthetic assets are tokens that derive their value from underlying cryptocurrencies. A trader does not need to own the underlying asset to work with synthetic tokens. Synthetic assets are a level above the commonly known derivatives trading on centralized exchanges, but the concept is the same.
Let’s dive into the world of synthetic assets in crypto and find out what they are all about.
What are Synthetic Assets?
Synthetic assets, also known as “crypto synths,” are simply digital representations of physical assets such as tokens, stocks, or commodities. They have the potential to make financial markets more equitable and accessible, particularly in areas where investments are unavailable.
Regardless of the advantages, Synthetic assets provide several existing and past systems with various issues with stability, transparency, decentralization, scalability, security, and adaptability.
DeFi protocols provide investment positions that reference real assets by issuing tokens linked to the price of stocks and other assets. Therefore, a user can invest similarly without opening a bank account for traditional finance assets.
How Do Synthetic Assets in Crypto Work?
Users deposit stablecoins as collateral and receive synthetic assets like stocks and stock indices in return.
The users can then trade these synthetic assets on decentralized exchanges (DEXs) or provide liquidity by staking a pair of tokens in the pool.
The synthetic tokens get their price from blockchain oracles such as Chainlink. Blockchain price oracles are referenced from Nasdaq and other real-world markets.
The Appeal of Synthetic Assets
Most synthetic assets are issued on adaptable decentralized finance (DeFi) protocols. They do not necessarily need to rely on one price oracle; hence, the user always gets the best price quotes.
Since the DeFi protocols that offer these crypto synths exist on the blockchain, they possess the inherent immutability features of blockchains, making them secure to price manipulation.
Moreover, Synthetic assets in crypto, unlike in rigid traditional financial systems, can be scaled easily by increasing liquidity. The automated market maker (AMM) feature of the DEXs makes trading extremely fast and efficient.
The incentivized liquidity pools mean any trading pair can increase liquidity infinitely if the incentives are worth the staking.
Popular Synthetic Asset Platforms in Crypto
There are many synthetic asset platforms on the blockchain, and many more are coming up. Here are a few popular and safe ones you can explore:
1. Synthetix Network
Synthetix markets itself as the liquidity layer for on-chain derivatives, powering over 80 synthetic perpetual markets. The platform allows the creation of synthetic assets(Synths) without being backed by the original asset.
For instance, if a user wants to swap 1 sETH(synthetic ETH) to sBTC, the amount of sBTC the user will receive for the sETH depends on an Oracle price feed. The oracle pushes the price feed on-chain based on the price of the original assets on multiple exchanges. Hence, the user will receive sBTC in exchange for his sETH without moving the price of the native assets and incurring slippage.
SNX holders stake their SNX tokens to mint Synths against their collateral with a minimum collateral ratio of 400% and receive all the fees traders pay.
Synthetix offers services to blockchain protocols such as Kwenta, PolynomialFX, dHegde, and Lyra.
2. UMA Protocol
UMA is an Oracle protocol that uses an optimistic Oracle service to help smart contracts know things. This is the exact mechanism used to create synthetic assets on the platform.
Data is posted with a truth bounty on the UMA protocol, which rewards any human or bot that verifies its truthfulness. Data that passes without dispute is valid and will be served on-chain.
However, if disputed, it will trigger a token-holder vote to settle the truth of the matter. The voters have a combination of individual and collective incentives, making providing reasoned, truthful responses more profitable. UMA provides services to reputable blockchain DeFI protocols such as Across Protocol, Polymarket, and ShapeShift.
3. Indigo Protocol
Indigo protocol is a synthetic asset platform on the Cardano network. Its developers chose Cardano because of its security and scalability, believing that its protocol will handle billions of dollars worth of assets in the future.
Indigo users can mint iUSD, the indigo-native synthetic stablecoin, and other synthetic assets like iBTC, iETH, etc. These crypto synths mirror their underlying asset’s price with the help of the Chainlink Oracles.
To use the Indigo protocol, users must deposit at least 10 Cardano (ADA) as collateral, enabling them to mind any iAsset available on the protocol. The protocol will then automatically open a Collateralized Debt Position (CDP) for the user, mint the required amount of iAssets, and send them to the user’s wallet.
After this, users can borrow against this collateral at a variable interest rate to mint iAssets.
Examples of Synthetic Assets in Crypto
| Asset | Synthetic Version |
| Bitcoin | iBTC (Indigo Protocol)sBTC (Synthetix Network) |
| Ethereum | iETH (Indigo Protocol)sETH (Synthetix Network) |
| U.S. Dollar | iUSD (Indigo Protocol)sUSD (Synthetix Network) |
The synthetics market is still growing. Even though crypto synths are mostly available, the protocols can capture commodities, forex, derivatives, and indices.
Risks and Challenges
Synthetic asset platforms exist on top of blockchains and are programmable smart contracts. This means they have inherent vulnerabilities that are prone to all smart contracts. These include reentrancy attacks, timestamp dependence, denial of service (DoS) attacks, and access control issues.
Because these protocols are decentralized, they are not regulated like traditional finance. The lack of regulatory boundaries to guide these fintech startups means crypto synths are the Wild West of decentralized finance. This is because, despite the risk of non-regulation, few people understand how they work, which raises the third risk: collateralization and liquidation.
There is a need for a wide disbursement of knowledge to educate the masses on how to go about these rare DeFi products. Otherwise, there is a high chance of unintentional self-exposed risk to users.
The Future of Synthetic Assets in Crypto
The potential for growth and innovation in the decentralized synthetic assets market is great. Recently, the crypto industry has adopted the new narrative of tokenized real-world assets (RWA) as one of the drivers of the next bull run. Synthetic assets in crypto play right into this narrative.
Ondo and Parcl are some of the best-performing assets in the RWA category, and there is a high chance they will require the service of Synthetix’s liquidity provisioning protocol, UMA’s optimistic oracle (OO), and other present and future technologies surrounding synthetic assets.
Finally, as the space matures, regulatory rules must be developed to guide it into a safe and reliable investment option. The crypto industry is one of the most hazardous places to invest funds since the risk of hacks, scams, and exploits is extremely high. But luckily, with the intervention of regulations (that do not hurt users), the space can be forged into a beneficial investment hub.
Conclusion
The equally burgeoning and more popular RWA niche will only exacerbate the rising popularity of synthetic assets in crypto. Tokens like SNX and UMA will be hotcakes when the broader markets realize they are potential nets for capturing more liquidity into the crypto space. The future of synthetic assets in finance is bright and not far from becoming an industry-wide reality.