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Chain news (ID: chainnewscom)

, translated by Zhan Juan; the original author is Zenith Ventures research partner Dmitriy Berenzon, reprinted by Odaily with authorization.

While the primary use case for crypto assets has been, and still is, speculation, I don't think that's a bad thing. Speculation was a key driver of the development of traditional financial markets and continues to play an important role today. Most importantly, speculators provide liquidity, making it easier for participants to enter or exit the market. This reduces transaction costs and increases convenience for market participants.

The current encrypted asset market is still immature and suffers from a lack of liquidity; unlike assets in the traditional financial system that have established liquidity benchmarks over decades, most encrypted assets have only been on the market for a few years. For example, Bitcoin's 24-hour trading volume is about $700 million, while Apple's stock trades at $5.3 billion in one day. The lack of liquidity limits the utility of the underlying protocol, which has been laid bare in decentralized exchanges and prediction markets.

• I believe that the cryptoasset market will develop in a similar manner to traditional financial markets, and as such, both institutional and retail participants will require more sophisticated financial instruments, especially synthetic assets.

• In this article, I will:

• An overview of synthetic assets, explaining what they are and how they are used in traditional financial markets.

The first part of my article focuses on basic explanations and examples of synthetic assets. If you are familiar with these contents, or feel that the knowledge of financial engineering is too boring, you can scroll down and read the second half of the article.

A synthetic asset is a financial instrument that mimics other instruments. In other words, the risk/return profile of any financial instrument can be simulated by a combination of other financial instruments.

What are synthetic assets?

• A synthetic asset is a financial instrument that mimics other instruments. In other words, the risk/return profile of any financial instrument can be simulated by a combination of other financial instruments.

• Synthetic assets consist of one or more derivatives, which are assets based on the value of an underlying asset, including:

Forward Commitments: Futures, Forwards, and Swaps

What are the benefits of synthetic assets?

• get funds

• get funds

• admission to market

admission to market

get funds

Below, I provide an overview and examples of each reason in the traditional financial world. Note that these factors are not mutually exclusive.

get funds

• Synthetic assets can reduce the cost of capital.

• One example of this is the _Total Return Swap (TRS)_, which is used as a funding tool to ensure financing of holdings. It allows one party to raise funds for a pool of assets it owns, and the counterparty to the swap transaction earns interest on the funds secured by the pool. In this case, a TRS is similar to a secured loan because:

The party that sells the security and agrees to buy it back is the party that needs financing;

The party that buys the security and agrees to sell it back is the party that provides the financing.

create liquidity

Synthetic assets can be used to inject liquidity into the market, reducing costs for investors.

• Martin Oehmke of Columbia University and Adam Zawadowski of Boston University have written a paper "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets" that demonstrates why CDS markets are more liquid than their underlying bond markets . One of the main reasons for this is standardization: Bonds issued by a given company are often divided into many different tranches, each with a different coupon rate, maturity date, contractual terms, and so on. The resulting fragmentation has reduced the liquidity of these bonds. This is not the case with the CDS market, which provides a standardized venue for a company's credit risk.http://finance.wharton.upenn.edu/conferences/liquidity2014/pdf/Synthetic%20or%20Real%20The%20Equilibrium%20Effects%20of%20Credit%20Default%20Swaps%20on%20Bond%20Markets_Martin%20Oehmke.pdf

admission to market

Lianwen Note: Martin Oehmke and Adam Zawadowski paper download address:

admission to market

Synthetic assets can recreate cash flows for virtually any security through a combination of instruments and derivatives, opening up a relatively free market to access.

For example, we can also use CDS to replicate the exposure of a bond. This is useful in situations where the bond is difficult to obtain on the open market, such as there may not be any available.

Let me give a concrete example. Take Tesla's 5-year bond as an example, which yields 600 basis points higher than US Treasuries: 1. Buy $100,000 of 5-year Treasuries and use them as collateral. 2. Write (sell) a 5-year CDS contract for $100,000. 3. Obtain the interest of the national debt, and obtain the annual premium (premium) of 600 basis points from the CDS.

If the bond does not default, then the sum of the coupon on the US Treasury bond and the CDS premium will equal the yield on the 5-year Tesla bond. If the Tesla bonds default, then the value of the portfolio will be the US Treasuries minus the CDS payout, which is equivalent to the default loss on the Tesla bonds. Therefore, regardless of whether Tesla bonds default or not, the return of the portfolio (US Treasury + CDS) will be consistent with holding Tesla bonds.

How does an excellent synthetic asset form?

In some cases, the development of synthetic asset products is only possible when the underlying asset liquidity reaches a critical value. There is also little point in creating a synthetic asset if the underlying asset is too illiquid as it may reduce the economics.

Total return swaps are a good example. Although the credit derivatives market began to take shape in the early 1990s, total return swaps were not quoted or traded by more institutions in the following 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 relevant bond or index outright.

Why should synthetic assets and DeFi go together?

Extended Assets

In the Decentralized Finance (DeFi) ecosystem, synthetic assets are beneficial to all participants for several reasons:

Extended Assets

Extended liquidity

extension technology

One of the major problems in the DeFi space is lack of liquidity. Market makers play an important role in this regard for both long-tail and established crypto assets, but they have limited financial tools at their disposal for proper risk management. Synthetic assets and derivatives more broadly can help market makers scale their operations by hedging positions and protecting profits.

extension technology

extended engagement

Synthetic assets have traditionally only been accessible to large, sophisticated investors, while permissionless smart contract platforms like Ethereum allow smaller investors to reap the benefits of this tool as well. It will also bring more traditional investment managers into the space by increasing the risk management toolset.

• Synthetic Assets in DeFi

• In fact, synthetic assets are already widely used in the DeFi field. Below I provide a few examples of projects that use synthetic assets, along with a simplified illustration of the asset creation process. legend:

Abra

Green = synthetic assets

Understanding Synthetic Assets in the DeFi Field in One Article: Basic Concepts, Existing Use Cases, and Future Opportunities

• Founded in 2014, Abra is the pioneer in the field of encrypted synthetic assets. When an Abra user deposits funds into their wallet, the funds are instantly converted to Bitcoin and represented in USD in the Abra app. For example, if Alice deposits $100 in her Abra wallet, and the price of Bitcoin is $10,000, then her deposit is 0.01 Bitcoin, displayed as $100. Abra can do this by maintaining the BTC/USD peg, which will ensure that Alice has the right to redeem $100 no matter how the price of BTC or USD fluctuates. Abra is effectively creating a crypto-backed stablecoin.

MakerDAO

Lianwen Note: Abra is difficult to be classified into the DeFi field. It tried very early in providing encrypted synthetic assets, but it is actually more like a centralized cooperative asset provider.

UMA

Understanding Synthetic Assets in the DeFi Field in One Article: Basic Concepts, Existing Use Cases, and Future Opportunities

UMA provides a protocol for total return swaps on Ethereum that can provide synthetic exposure to multiple assets.

Understanding Synthetic Assets in the DeFi Field in One Article: Basic Concepts, Existing Use Cases, and Future Opportunities

MARKET Protocol

_USStocks_ is an ERC20 token that uses the UMA protocol. USStock represents the US S&P 500 index and is traded on the Beijing-based decentralized exchange DDEX. The specific method is to fully collateralize one side of a UMA contract, and then tokenize the margin account, so that the long side of the contract obtains synthetic ownership.

Rainbow Network

The MARKET Protocol allows users to create synthetic assets that track the price of any reference asset through an oracle. These “position tokens” provide limited long and short exposure to the underlying asset and provide a return structure similar to bull call spreads in traditional finance. Similar to Dai, long tokens and short tokens represent claims on a pool of collateral.

Understanding Synthetic Assets in the DeFi Field in One Article: Basic Concepts, Existing Use Cases, and Future Opportunities

Synthetix

In rainbow channels, each state represents a CFD, which is similar to a total return swap.

Synthetix is ​​an issuance platform, collateral-type exchange that allows users to mint a range of synthetic assets. Similar to Maker, users lock up collateral to create a synthetic asset and need to repay the loan to redeem the collateral. Users can then "trade" one synthetic asset for another via the oracle. Note that the "transaction" has no direct counterparty - the user is effectively repricing the collateral based on the oracle. That is to say, due to the centralized collateral mechanism, SNX stakeholders (Stakers) collectively bear the counterparty risk of other users' synthetic asset positions.

Encrypted Native Derivatives

It is an important first step to represent real assets in a synthetic way, but I believe that there should be a huge space for the design of derivatives in encryption technology, and it has basically not been touched. Traditional derivatives designed by various participants, as well as "encryption-native" derivatives that did not exist in traditional financial markets before.

Below I will provide a few examples of both types, many of which may not be viable, or have a market large enough to obtain liquidity.
Bitcoin Difficulty Swap
The reason for this product is to provide a hedging tool for miners who want to reduce the risk of increasing the difficulty of Bitcoin production (that is, reducing their expected output) (that is, hedging the "difficulty curve risk" of miners).

In fact, BitOoda has designed and built this idea as a financial settlement product, that is, the settlement is completed through the transfer of fiat currency, rather than by renting or lending physical computing power.

Hash Power Swap

Electricity Futures

The idea is for a miner to sell some of its mining power to a buyer, such as a fund, for cash. This gives miners a steady stream of income that doesn’t fluctuate with the price of the crypto assets they mine, while allowing the fund to gain exposure to a crypto asset without investing in mining equipment. In other words, miners are able to hedge against market risk because their profitability no longer depends on the market price of the cryptoasset being mined. In fact, BitOoda has already built and provided this product, a physically-cleared "Hash Power Weekly Scalable Contract".

Electricity Futures

This product has existed in the traditional commodity market for quite a long time, in fact, it can also be provided to cryptocurrency miners. Miners only need to sign a futures agreement to purchase electricity at a given price within an agreed period of time in the future (for example, 3 months). This would give miners the ability to hedge against energy price risk, as a sharp rise in electricity costs would make mining unprofitable. In other words, miners change their electricity costs from a variable amount to a fixed amount.

This will allow validators of a proof-of-stake (PoS) network to hedge their exposure to the market risk of the cryptoasset of their choice. Similar to a hash power swap, validators sell a portion of their staking proceeds in exchange for cash. In this way, validators can earn a fixed amount of rewards from their locked assets, while buyers can gain exposure to staking income without setting up staking infrastructure.

Slashing Penalty Swap

In fact, Vest has achieved this. This market allows users to buy staking reward futures, and Stakers reduce their spread on staking rewards. The project does this through a "staking contract", which allows users to pay a sum of money (X) in return for the (T) period of time that Z tokens are staked.

Slashing Penalty Swap

This product allows delegators participating in a proof-of-stake network to hedge their operational exposure to selected validators. You can think of Slashing as a credit event, and the Slashing Penalty Swap as insurance against that event. If a validator is slashed, the delegator will receive a compensation to cover the loss. The seller of the Slashing Penalty Swap is actually longing for the excellent operation of the validator, and the buyer may even be the validator itself. At scale, this can create an interesting dilemma for protocol designers — those who short validators are incentivized to disrupt their operations.

Stability Fee Swap

While the Maker Stability Rate is currently 16.5% (it should be 14.5% now), from July 13th to August 22nd, 2019, the rate went up to 20.5%. CDP (Collateralized Debt Position) holders may want to reduce the risk of rising stable rates (variable rates) and are therefore willing to enter into a swap agreement with a counterparty to pay a fixed fee for a given time frame (interest rate swap).

Airdrops

Forward contracts for lock-up airdrops

This is a bilateral agreement that allows buyers to purchase crypto assets released from lockup airdrops at a given price. Buyers pay sellers a premium that reflects the illiquidity and opportunity costs associated with their locked assets, while also allowing buyers to gain exposure to this new crypto asset without having the necessary That underlying asset.

in conclusion