Editor's Note: This article comes fromCrypto Valley Live (ID: cryptovalley)Editor's Note: This article comes from
Crypto Valley Live (ID: cryptovalley)
Crypto Valley Live (ID: cryptovalley)
, Author: Dmitriy Berenzon, translation: DUANNI YI, reprinted with authorization by Odaily.
While the current use cases for crypto assets are still largely speculative, that’s not a bad thing. Speculation is the main driving force behind the development of traditional financial markets, and it also plays an important role in today's financial industry. Most importantly, speculators provide liquidity to the market, which objectively reduces transaction costs and makes it easier for participants to enter or exit.
Today's crypto asset market is still immature and illiquid. Most cryptoassets are only a few years old compared to assets that have established liquidity benchmarks for decades in the traditional financial system. For example, BTC’s 24-hour trading volume is about $700 million, while related financial products targeting technology company Apple hit $5.3 billion. As we have seen, illiquidity limits the utility of the underlying protocol.
In view of this, the encrypted asset market requires more sophisticated financial instruments, especially synthetic assets (Synthetic Assets) for institutional and retail participants.
Provides an overview of synthetic assets, explains how they work, and how this tool can be used in traditional financial markets.
Explain why synthetic assets are critical to the maturation of the cryptoasset market, citing typical project use cases.
Provide use cases for native encrypted asset derivatives that can be built.
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What are synthetic assets?
Synthetic assets are composed of one or more derivatives, which are assets based on the value of the underlying asset, including:
Forward Commitment: futures, forwards and swaps;
Contingent Claims: options, credit derivatives such as credit default swaps (CDS) and asset-backed securities;
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Uses of Synthetic Assets
There are many reasons why investors choose to buy synthetic assets, including:
financing;
create liquidity;
lower barriers to market entry;
Note that the above factors are not mutually exclusive.
I. Financing
Synthetic assets can reduce financing costs. One example of this is the Total Return Swap (TRS), which is used as a funding tool to secure financing of assets held. It allows one party to obtain funds for the pool it owns, while the swap counterparty earns interest on the funds secured by the pool. In this context, a TRS is similar to a secured loan because:
The party that sells the securities and agrees to repurchase them is also the party that needs financing;
The party that buys the security and agrees to sell it to the bank is also the party that provides the financing.
II. Creating Liquidity
Synthetic assets can be used to inject liquidity into the market, reducing costs for investors. Credit default swaps (CDS) are an example. CDS is a derivative contract between a credit protection buyer and a credit protection seller, in which the buyer pays a series of cash to the seller and receives a promise that if the loss is caused by a "credit event", it will be compensated, Such as payment failure, bankruptcy or reorganization. This gives CDS sellers the ability to synthetically go long the underlying asset, while CDS buyers have the ability to hedge the credit risk of their underlying asset.
The CDS market is more liquid than its underlying bond market. The main reason is standardization. Bonds issued by a particular company are often split into many different bonds with different coupons, maturities, and covenants, and the resulting splits reduce the liquidity of these bonds. The CDS market provides a standardized venue for a company's credit risk.
III. Lowering Barriers to Market Entry
Synthetic assets can open markets by combining instruments and derivatives to reconstruct cash flows in almost any security.
For example, we can also use CDS to replicate bond exposure. This can be helpful in times when bonds are hard to come by on the public market.
Take Tesla's 5-year bond, for example, which yields 600 basis points more than U.S. Treasuries:
1. Buy $100,000 of 5-year Treasury bonds and use them as collateral.
2. Write (sell) a 5-year $100,000 CDS contract.
3. Earn interest on T-bills and receive a 600 basis point annual premium from CDS.
Components of Synthetic Assets
In some cases, the development of synthetic assets is only possible when a critical level of liquidity is achieved in the underlying asset. There is no point in creating a synthetic asset if the underlying asset is too illiquid, as it will likely reduce the economics.
TRS (Total return swaps) is a good example. Although the credit derivatives market began to form in the early 1990s, TRS was not widely quoted or traded for several 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 portfolios and adopted two-way quotes on a range of credit derivatives, trading activity began to build and opportunities for investors to participate in synthetic asset positions through TRS have improved. With the formation of a strong two-way market, the comprehensive auction spread was compressed, attracting more end users. The market is now able to support a wide range of credit references due to the liquid, active nature of the underlying credit derivatives market.
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The Significance of Synthetic Assets to the DeFi Ecosystem
Synthetic assets are significant for participants in the Decentralized Finance (DeFi) ecosystem for several reasons:
Expand asset fields
One of the biggest challenges in this space is bringing real-world assets on-chain in a trustless way. Fiat currencies are an example. While it is possible to create fiat-backed stable assets like Tether, another approach is to gain synthetic price exposure to the U.S. dollar, eliminating the need for a centralized counterparty to host the actual asset. For many users, the price exposure is enough. Synthetic assets provide a viable mechanism for real assets to be traded on the blockchain.
expand liquidity
One of the main problems in the current DeFi space is the lack of liquidity. Market makers play an important role for long-tail and mature crypto-assets, but their financial tools are of limited utility for risk management. Broadly speaking, synthetic assets and derivatives can help markets scale by hedging positions and protecting profits.
Another issue is the current technical limitations of smart contract platforms. We have not solved the problem of cross-chain communication, which limits the usability of assets on decentralized exchanges. With synthetic price exposure, traders do not need to own the asset directly.
broaden participation
While synthetic assets are generally only available to large and sophisticated investors, permissionless smart contract platforms like Ethereum allow smaller investors to reap the benefits as well. By adding to the risk management toolset, more traditional investors can also enter the space.
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Case Study: Synthetic Assets in DeFi
In fact, synthetic assets are already widely used in the DeFi space. Below are some examples of projects that use synthetic assets.
Abra
legend:
Purple = Real Assets
MakerDAO
Green = synthetic assets
UMA
Founded in 2014, Abra is an OG (old-school, old school) in the field of encrypted synthesis. When Abra users deposit funds into their wallets, the funds are instantly converted to BTC and displayed as USD in the Abra app. If a user deposits $100 into his Abra wallet when the BTC price is $10,000, he will receive a deposit of 0.01 BTC and it will appear as $100. Abra can do this by maintaining a BTC/USD peg, which guarantees customers the right to redeem $100 regardless of price fluctuations in BTC or USD. In effect, Abra is creating a crypto-collateralized stablecoin.
Additionally, Abra hedges its risk instantly, so it can cash out all trades at any time. When a user tops up his or her wallet, they are effectively shorting BTC and long on the hedged asset, while Abra is long on BTC and shorted on the hedged asset.
The Maker'Dai stablecoin is probably the most widely known and used synthetic money in DeFi. By locking up Ethereum as collateral, users can mint the synthetic asset Dai, maintaining a soft peg to the U.S. dollar. Dai holders receive composite price exposure in USD. Similar to Abra’s design, this “collateral-backed synthetic asset” model has become popular among other protocols.
UMA provides a protocol for TRS on Ethereum that can provide comprehensive exposure to multiple assets.
Smart contracts contain economic clauses, termination clauses and security deposit requirements involving bilateral agreements between different users. It also requires a price feed database to return the current price of the underlying reference asset.
Rainbow Network
One implementation of the protocol is the USStocks ERC-20 token, which represents the U.S. S&P 500 index and is traded on Beijing-based decentralized exchange DDEX. This is accomplished by fully collateralizing one side of the UMA contract, and then tokenizing the margin account, thereby obtaining ownership of the synthetic asset for the long-term portion of the contract.
MARKET protocol
Synthetix
Rainbow Network is an off-chain non-custodial transaction and payment network that supports arbitrary liquid assets. It consists of "Rainbow Channels", a variation of payment channels where settlement balances are calculated based on the current price of other assets. In other words, the protocol nests composites inside payment channels along with other assets.
In Rainbow channels, each state represents a difference contract, similar to TRS.
Synthetix is an issuance platform that allows users to mint a range of synthetic assets. Similar to Maker, users can lock up collateral to create synthetic assets, and need to repay their loan to get back the collateral. Users can then “exchange” one synthetic asset for another through the database. Note that the "exchange" here has no direct counterparty and the user is effectively repricing the collateral against the advance. That is, due to the pooled staking mechanism, SNX stakers jointly bear the counterparty risk of other users' synthetic positions.
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Special category: native encrypted asset derivatives
The appearance of physical assets is the first step in synthetic assets, which is very important. However, the design space of encrypted asset derivatives is huge and has yet to be developed. These include: traditional derivatives purpose-built for the cryptoasset market, and Crypto-native derivatives that previously did not exist in traditional financial markets.
Below, we will provide some examples, some of which do not have the market conditions to obtain liquidity and therefore are not feasible at this time.
This is a hedging tool for miners who want to reduce the risk of expected BTC production while increasing the difficulty of mining (i.e. hedging against "difficulty curve risk"). Today, BitOoda has effectively structured and offered it as a financial settlement product, meaning that settlement is done through a fiat transfer rather than by leasing or borrowing physical computing power. It is unclear how much traction the product will gain among sellers and market makers (swap dealers), as there is also the potential for large miners to manipulate the market (e.g. colluding to lower mining difficulty).
Electricity Futures
Hash Power Swap
The idea is for miners to sell some of their mining power to a buyer (such as an investment fund) in exchange for cash. This enables miners to obtain a stable cash flow that does not depend on the price of the underlying encrypted assets; at the same time, it also allows funds to invest in encrypted assets without investing in mining equipment. In this model, miners are able to hedge market risk because they do not need to rely on the price increase of the crypto assets they mine to remain profitable. This is also enabled by BitOoda through its Hash-Power Weekly Extendable Contracts.
Electricity Futures
The product has been sold on traditional commodity markets for a long time, but is now available to cryptocurrency miners. Miners only need to sign a futures agreement to purchase electricity at a given price at an agreed time in the future (for example, 3 months). This gives miners the ability to hedge against energy risks, as many times sharp increases in electricity costs can render miners unprofitable. In this model, the cost of electricity for miners changes from variable to fixed.
Equity Pledge Swap
This will allow validators in a PoS network to hedge the market exposure of their crypto assets. Similar to a hashpower swap product, validators will sell a portion of their staking proceeds in exchange for cash. This will allow validators to earn a fixed amount from locked assets, while buyers can earn staking income without staking infrastructure.
This service is currently live on Vest, a marketplace that allows users to buy future staking rewards, and stakers can reduce the difference in staking rewards. The project does this through a "staking contract" that allows users to pay X over a period of T and be rewarded for staking Z tokens.
This will allow delegates in the PoS network to hedge operational exposure for selected validators. You can think of slashing feedback as a credit event and the slashing penalty swap as insurance against that event. If validators are slashed with fines, delegators will receive a payout to cover their losses. Sellers who slash penalty swaps are effectively long the superior use of validators, and possibly even the validators themselves. At scale, this can create a dilemma for protocol designers, where those shorting validators are incentivized to disrupt their operations.
airdrop
While the Maker stability fee is currently 16.5%, from July 13, 2019 to August 22, 2019, this fee was as high as 20.5%. CDP holders may wish to reduce the risk of rising stabilization fees (variable interest rates), and therefore have the possibility to enter into a swap agreement with a counterparty to pay a fixed fee over a given time frame (interest rate swaps).
Lock up
Lock up
Summarize
This is a bilateral agreement for buyers to purchase crypto assets released from lockups at a given price. Buyers pay sellers a premium that reflects the illiquidity and opportunity costs associated with their locked assets, but gives buyers the opportunity to gain exposure to new crypto assets without the underlying assets necessary to lock them up.
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