Editor's Note: This article comes fromBlue Fox Notes (ID: lanhubiji)Editor's Note: This article comes from
Blue Fox Notes (ID: lanhubiji)Blue Fox Notes (ID: lanhubiji), Author: Dmitriy Berenzon, Translator: SL; Odaily reproduced with authorization.
Preface: Synthetic assets are very mature in the traditional financial market, and encrypted synthetic assets can connect the encrypted world and the traditional financial world. At the same time, synthetic assets in the encrypted world present different characteristics, including features such as permissionless and automatic execution, which can bring more new native encrypted financial products. Of course, not to mention synthetic assets, even DeFi itself is still in its early stages, and more experiments are needed. Considering the huge size of the derivatives market (see Blue Fox Notes' "
A picture to understand world currency and market
"), there will be more innovations and applications in this field in the future. The author of this article is Dmitriy Berenzon, the original title is "Synthetic Assets in DeFi: Use Cases and Opportunities", translated by "SL" of the "Blue Fox Notes" community.
Even though the primary use case for crypto assets is still speculation, I don't think that's a bad thing. Speculation was a major driver of the development of traditional financial markets and continues to play an important role in today's financial industry. More importantly, speculators provide liquidity, allowing participants to enter or exit the market more easily. This reduces transaction costs and increases entry opportunities for market participants.
Today's crypto asset market is still immature and illiquid. Unlike traditional financial system assets whose liquidity benchmarks have been built over decades, most cryptoassets have only been around for a few years. For example, Bitcoin’s 24-hour USD trading volume is around $700 million, while Apple’s is at $5.3 billion. (Blue Fox Notes: According to CMC data, the daily transaction scale of Bitcoin exceeds 10 billion US dollars). Inadequate liquidity limits the utility of the underlying protocol, as seen in decentralized exchanges and prediction markets.
The crypto asset market evolves in a similar way to traditional financial markets, for example, for institutional and retail participants, there will be a need for more complex financial instruments, especially synthetic assets.
This article will explain:
Provide examples of derivatives that can build new "crypto-native".
What are synthetic assets?
The first part will focus on basic explanations and examples of synthetic assets. If you are already familiar with this or find financial engineering too boring, you can go directly to the second part.
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Synthetics are financial instruments that mimic other assets. In other words, the risk/reward profile of any financial instrument can be simulated using a combination of other financial instruments. Synthetic assets consist of one or more derivatives, which are assets based on the value of the underlying asset, including:
Forward commitments: futures, forwards and swaps (Blue Fox Notes: Swaps are also swaps, which mainly refer to buying spot foreign exchange in the foreign exchange market and selling forward foreign exchange of the same currency at the same time, or selling spot foreign exchange Forward foreign exchange of the same currency is also purchased at the same time, and the two parties to the transaction will carry out the swap transaction within a certain period of time in the future according to the agreement agreed in advance.)
Contingent claims: options, credit derivatives such as credit default swaps (CDS), asset-backed securities
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What are the benefits of synthetic assets?
Investors choose to buy synthetic assets for a variety of reasons. These include:
l Financing
l Create liquidity
l Market access
Below I give an overview of this and provide a case illustration from traditional finance. Note that they are not mutually exclusive.
1. Financing
Synthetic assets can reduce financing costs.
One example of this is Total Return Swaps (TRS), which are used as a funding tool to ensure financing of assets held. It allows parties to obtain funds for a pool of assets they already own, while the swap counterparty can earn interest on the pool of assets as collateral. In this way, a TRS is similar to a secured loan because:
l The party that sells the securities and agrees to repurchase them is the party that needs financing
l The party who buys the security and agrees to sell it is the party who provides the funds.
2. Create liquidity
Synthetic assets can be used to inject liquidity into the market, reducing costs for investors. An example is credit default swaps (CDS). A CDS is a derivative contract between a credit protection buyer and a credit protection seller, in which the buyer pays the seller a series of cash payments and receives a promise to indemnify credit losses resulting from a "credit event", such as payment failure, bankruptcy or reorganization. This allows CDS sellers to synthetically go long the underlying asset, while CDS buyers can hedge their credit exposure to the underlying asset.
This article will demonstrate that the CDS market is more liquid than its underlying bond market. One of the main reasons for this is standardization: bonds issued by a particular company are often divided into many different bonds with different coupons, maturities, covenants, etc. These diversifications reduce the liquidity of these bonds. On the other hand, the CDS market provides a standardized venue for a firm's credit risk.
3. Market access
Synthetic assets can reproduce the cash flow of almost any security through combination instruments and derivatives, thus opening up a relatively open market.
For example, we can use the CDS example again, which can be used to replicate the exposure of bonds. This can be helpful when bonds are hard to come by on the open market. Here is a concrete example. If there is a Tesla 5-year bond, it has a 600 basis point higher yield than the U.S. Treasury bond.
l Write (sell) a 5-year $100,000 CDS contract
l Receive interest on US Treasury bonds and obtain a CDS annual yield premium of 600 basis points
If there is no default, the Treasury bond plus the CDS premium will get the same yield as the 5-year Tesla bond. If the Tesla bond defaults, the portfolio value will be the Treasury bond minus the CDS payout, which is equivalent to the default loss on the Tesla bond. So no matter what happens (default or not), the return on the portfolio (Treasuries + CDS) is the same as owning Tesla bonds.
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What does it take to launch a good synthetic asset?
A total return swap (TRS) is a good example of this process. Although the credit derivatives market began in the early 1990s, total return swaps (TRS) have not been widely quoted and traded for a few years. In fact, an investor or speculator seeking exposure to a particular corporate bond or bond index is more likely to buy or short the reference bond or index outright.
As market makers began to more actively manage their credit assets and adopted two-way price quotes on a range of credit derivatives, activity began to generate and opportunities for investors to participate in synthetic credit positions through total return swaps (TRS) improved. As a strong two-way market begins to form, bid-ask spreads for synthetic assets narrow, attracting more end-users eager to acquire or transfer synthetic credit assets.
The market is now able to support a large number of certificates of credit because the underlying credit derivatives market is liquid, active, and well-supported.
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Why synthetic assets and DeFi?
There are several reasons why synthetic assets are beneficial to participants in the DeFi ecosystem.
1. Expand assets
One of the biggest challenges in this space is getting real-world assets on-chain in a trustless manner. An example is fiat currency. While it is possible to create fiat-collateralized stablecoins, such as Tether, another way is to gain synthetic price exposure to the U.S. dollar without the need for a central counterparty to host the actual assets. For many users, the price exposure is good enough.
Synthetic assets provide a mechanism for real-world assets to be traded on-chain.
2. Expand liquidity
One of the major problems in the DeFi space is lack of liquidity. Market makers play an important role here for both long-tail and established crypto assets, but have limited financial tools for proper risk management. Synthetic assets and derivatives can help markets scale by hedging positions and protecting profits.
Another issue is the technical limitations of current smart contract platforms. We have not solved the problem of cross-chain communication, which limits the availability of assets on decentralized exchanges. However, with synthetic price exposure, traders do not need to own the asset directly.
4. Broaden the participants
Synthetic assets have traditionally been open to large and sophisticated investors, but permissionless smart contract platforms like Ethereum allow smaller investors to reap their benefits. It also allows more traditional investment managers to enter the space by increasing their risk management toolsets.
1.Abra
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Synthetic Assets in DeFi
In fact, there are already many synthetic assets in DeFi. Some Synthetic Asset projects are described below, including simplified flowcharts for their asset creation. Purple in the graph represents real assets; green represents synthetic assets.
2.MakerDAO
Created in 2014, Abra is a synthetic asset OG of cryptocurrencies. When an Abra user deposits funds into the wallet, the funds are immediately converted into btc and represented in US dollars in the Abra app. For example, if Alice deposits $100 into her Abra wallet, if the btc price at that time is $10,000, then she will receive a deposit of 0.01btc, which is displayed as $100.
3.UMA
Abra can do this because it maintains the BTC/USD peg, which guarantees that Alice has the right to redeem $100 regardless of price fluctuations in BTC or USD. In fact, Abra is creating a cryptocurrency-collateralized stablecoin.
In addition, Abra hedges its risk immediately, so it redeems all trades at any time. When the user's deposited funds enter the wallet, they are actually shorting the Bitcoin position and long the position of the hedged asset, and Abra is long the Bitcoin position and short the hedged asset position.
Maker’s Dai is probably the best known and most used synthetic asset in DeFi. By locking up Ethereum as collateral, users are able to mine a synthetic asset, Dai. Dai maintains a soft anchor to USD. In effect, Dai holders receive synthetic price exposure to USD. Similar to the Abra design, this "collateral-backed synthetic asset" model has gained popularity in many protocols.
UMA provides a protocol for Total Return Swaps (TRS) on Ethereum that can provide synthetic exposure to multiple assets. The smart contract includes the economic terms of the bilateral agreement between Alice and Bob, the termination clause, and the security deposit requirements. It also requires price oracles to return the current price of the underlying reference asset.
5.Rainbow Network
One implementation of the protocol is an ERC20 token for U.S. stocks, which represents the U.S. S&P 500 index and is traded on Beijing-based decentralized exchange DDEX. This is fully collateralized by one party to the UMA contract, which then tokenizes the margin account, thereby gaining ownership of the synthetic asset for longs on the contract.
6.Synthetix
Rainbow Network is an off-chain non-custodial transaction and payment network that supports any liquid asset. It consists of "Rainbow channels", a variant of payment channels where settlement balances are calculated based on the current price of other assets. In other words, the protocol nests synthetic assets in payment channels along with other assets. In a Rainbow channel, each state represents a difference in contracts, similar to a Total Return Swap (TRS).
Encrypted Native Derivatives
Synthetix is an issuance platform, collateral type, and exchange that allows users to mine a range of synthetic assets. Similar to Maker, users lock up collateral to create synthetic assets, and need to repay the loan to recover the collateral. Users can then trade between synthetic assets through an oracle exchange. Note that the "transaction" has no direct counterparty - the user is effectively repricing the collateral based on the oracle. That is to say, because of the collateral pool mechanism, SNX stakers collectively bear the counterparty risk of other users' synthetic asset positions.
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Encrypted Native Derivatives
The synthesis of real-world assets represents an important first step, and the derivatives design space for cryptocurrencies is vast and largely unexplored. This includes traditional derivatives, which build products for different participants in the crypto asset market, as well as crypto-native derivatives, which do not exist in traditional financial markets.
Below are examples of two variants, many of which may not necessarily work, or have a large enough market to get liquidity.
1. Bitcoin difficulty swap
The premise is to provide a hedge for miners who want to mitigate the risk of reducing their expected Bitcoin output due to an increase in difficulty. That is, hedging the "difficulty curve risk" of miners. In fact, Bit0oda is building and providing such a financial settlement product today, which means that it achieves settlement through fiat currency transfer rather than renting or lending physical computing power. At scale, it's not clear how attractive this product is to both sell-side (ie, who would go long?) and market-makers (ie, swap dealers)? It is also possible for large miners to manipulate the market (i.e. collude to lower the difficulty).
2. Hash Power Swap
The idea is that miners sell some of their mining power to buyers, thereby obtaining funds, such as cash. This provides miners with a steady stream of income that is not dependent on the underlying cryptoasset price and provides exposure to the cryptocurrency in which it is funded without investing in mining equipment. In other words, miners can hedge against market risk because they do not have to depend on the market price of the cryptocurrencies they mine to remain profitable. This is also built and provided by Bit0oda through its physically delivered "Hash Power Weekly Extended Contract".
3. Electricity futures
This product has existed for a long time in the traditional commodity market, but can be offered to cryptocurrency miners. Miners only need to sign a futures agreement to purchase electricity at a certain price at an agreed time in the future (such as 3 months). With sharply rising electricity costs making mining unprofitable, electricity futures allow miners to hedge their energy price exposure. In other words, miners can change their electricity costs from floating to fixed.
4. Staking income swap
This allows validators of a PoS network to hedge their market exposure to the cryptocurrency of their choice. Similar to a hashpower swap, validators sell a portion of their staking proceeds in exchange for cash. This allows validators to receive a fixed amount based on their locked assets, while buyers gain exposure to staking revenue without having to set up a staking facility.
This is already possible on Vest, a marketplace that allows users to buy future staking rewards, and validators to reduce the volatility of future staking rewards. This project is implemented through a "staking contract", which allows users to pay X funds and receive the proceeds of staking Z tokens for T period.
5.slashing penalty swaps
This allows delegators in a PoS network to hedge the operational risk exposure posed by their chosen validators. You can think of slashing (Blue Fox Notes: Reduction) as a credit event, and Slashing penalty swaps as insurance for this event. If validators are slashed, delegators can receive payouts to cover losses. Sellers of Slashing Penalty Swaps can be good at long validator operations, and possibly even the validators themselves. At scale, this can present an interesting dilemma for protocol designers - those shorting validators have an incentive to disrupt their operations.
6. Stability Fee Swap
Although the Maker stability fee is at 16.5% (Blue Fox Note: it has dropped to 12.5% at present), it was as high as 20.5% between July 13, 2019 and August 22, 2019. CDP holders may want to mitigate the risk of rising stability fees (variable interest rates), so they can enter into a swap agreement with a counterparty to pay a fixed fee over a certain time frame (interest swap).
8.Lockdrop Forward
in conclusion
This would be a bilateral agreement for buyers to purchase the cryptocurrency released from the lock at a certain price. Buyers pay sellers a premium that reflects the illiquidity and opportunity costs associated with their locked assets, but allows buyers to gain exposure to new assets without locking up their underlying assets.
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