What is Synthetic Asset
A synthetic asset is a tokenized derivative that mimics the value of another asset. Generally, wrapped tokens & stablecoins are also categorized into synthetic assets because they are all pegged to other assets' prices. But usually, a synthetic asset's price is fed by an oracle.
It is usually issued by any staking users and through the help of DeFi protocols in the form of standardized crypto tokens. Synthetix (formerly known as Havven) was the first DeFi protocol to invent such derivatives in 2018. Theoretically, any asset whose price can be fed by an oracle could be minted into a synthetic tokenized asset.
For better understanding, one can think of a synthetic asset protocol such as Synthetix as a casino offering a stock/crypto market simulator game where players speculate on virtual stocks and cryptos using chips as money.
How does synthetic asset work？
The mechanism of synthetic assets is divided into two parts, asset-backed minting, and trading. For better understanding, we explain each from the perspective of two market participants.
Stakers: stake to mint and bear debts
Stakers incur a ‘debt’ when they mint Synths. Stakers need to over-collateralizing stake an asset (protocols native token or ETH, etc.) into the protocol to mint a synthetic stablecoin asset, e.g., overcollateralizing 750% of $SNX to mint $sUSD. This is equivalent to a mortgage, but only synthetic stablecoins such as sUSD can be borrowed. The system keeps a ledger book for all stakers: recording their initial debts and shares.
What do I get after staking?
- Some stable synthetic assets like sUSD.
- Start to earn a certain amount of synth trading fees (proportionally).
- A certain amount of variable debt.
What else can the staker do when they get the above?
- Become a Synth trader, speculate on other synthetic assets, or hedge their debt exposure (see below for details).
- Become a Synths market maker in the over-the-counter market.
- Sell them directly in over-the-counter.
Stakers are players who get their chips (sUSD) through official casino counters. This casino buys chips by over-collateralizing the casino's own stock (tokens) to mint chips. The system keeps a ledger for the staker, recording how many chips the staker creates and what share the staker accounts for. Also, the total value of the staked assets must be at least 7.5 times the value of the chips. As an incentive for those players, the casino rewards them a proportional share of the transaction fees.
Example: Alice has $75,000 worth of SNX, stakes into Synthetix, and mints 10,000 sUSD. At this point, Synthetix will credit Alice with $75,000 SNX in assets (collaterals), $10,000 sUSD in debt, and 750% in collateral ratio. Now Alice is already earning a proportional fee. She can then become a synths trader and trade sUSD for other synthetic assets, hold it, or choose to sell sUSD in the OTC market like Uniswap or become an LP in the sUSD/USDC pool, etc.
What is the risk of a staker?
Stakers share an unit and volatile debt pool as their debt. One staker could encounter the situation that their debt is constantly rising, and they cannot add more collaterals in time, and then they will suffer a liquidation risk.
All synthetic assets are added to a large pool of chips, and the value of this pool should be precisely equal to the value of the total debt on the books. Hence it is also called a debt pool. It is easy to find that the total debt amount constantly changes with the amounts, types, and anchor prices of original assets. The total value of collateral should always remain at or above 7.5 times the entire debt pool. The amount of change in the debt pool that increases or decreases is apportioned to each stakers proportionally, and each time the system directly modifies the staker's debt balance.
The system tracks the debt pool by issuing debt shares (a token) to stakers when they mint or burn sUSD. A staker’s debt percentage would be their tokens balance divided by the total supply of debt shares.
When one's debt balance decreases and the collateralization rate increases, the staker can mint new synths to lower the collateralization rate. When one's debt balance increases and the collateral rate decreases, the staker can burn some synths or replenish the collateral to increase the collateral rate. When the collateral rate is too low and stakers fail to operate in time, the collaterals will be forced to be liquidated by the system.
Therefore, Alice's $10,000 debt balance is always floating. Assuming the total debt pool is worth $20,000, when the value of the sBTC (assume the pool consists of sBTC) synthetic asset rises by $5,000, the entire debt pool also rises to $25,000. Since Alice has 50% of the debt, she is sharing half of the new debt, which is $2,500. Therefore, Alice's new debt balance after the increase becomes $12,500. Alice's net loss is -$2,500. If Alice does not add more SNX or burn some of the sUSD, the collateral ratio will be less than the required 750% collateral ratio but still less than the liquidation ratio.
The difference between this and traditional casino is the difference in gamble counterparties: traditional casinos are all about players making players' money and the casino taking a commission. In the synths market, on the other hand, the staker's assets act as counterparty to the total volatility of all synthetic assets, so the dealer paying the gambler in the event of an overall market rise is all stakers too.
Two reasons why most synthetic asset protocols follow the principle of over-collateralizing:
- Collaterals often have high volatility. Over-collateralization reduces the risk of under-collateralization. If the collateral value falls too much, the system will liquidate and sell it early before the minimum requirement is touched.
- The debt pool often has high volatility. Even if the value of collateralized assets is stable, there is a risk that the total debt pool will rise too quickly and be under-collateralized.
Once you have some synths, you are a synths trader. Stakers can trade synths directly after minting.
For one that wants to avoid acquiring synths by staking, which means they don't want to bear the debt risk, they can buy some synths using ETH/USD cryptos in OTC directly. Some synthetic assets have liquidity in external AMM pools (e.g., sUSD/USDC in Curve, sETH/ETH in Uniswap, etc.) that can be purchased directly.
What can a synth trader do?
Trading of synthetic assets to earn spreads.
- Feature 1: Reduce the friction cost of holding a spot. Users can trade $sXAG (Synthetic Gold) instead of real spot gold, which behaves like the underlying asset by tracking its price using data oracles such as Chainlink. Because tangible gold assets always cost more than their price: carrying cost, transportation cost, and security risk. Even with a platform, you need to KYC and deposit money into the account to get exposed to the volatility of Gold.
- Feature 2: No slippage to trade synthetic assets. Since the synthetic asset price is fed from the oracle, the synths holder does not need to worry about illiquidity and slippage when trading.
- Feature 3: Synth transactions are not between two players but are a process of system tracking, burning, minting, and tracking again. The prices are all fed from external oracles.
Once having some chips (sUSD), the player pays for whichever stock he wants to buy at a reasonable price, and the system calculates the quantity based on the actual external stock price (from oracle) and issues the player the correct number of shares/crypto notes token (sBTC, etc.). When the player feels his stock is rising enough to close his position, he will burn the notes and mint the chips. The system will update the total debt balance.
Example: Alice, with 10,000 sUSD, wants to buy all sETH. The system will first burn 10,000 sUSD in Alice's wallet ➡️ update the total sUSD supply balance (-10,000) ➡️ Oracle determines the ETH price rate (assume $1,000) ➡️ collect the fee ➡️ mint the corresponding number of new sETH (about 10) to Alice's wallet ➡️ update the total sETH supply balance (+10).
Hedging the risk of the debt. (For stakers only)
The Synthetix protocol has a unique synthetic asset that mainly tracks the total debt pool index, and holding this asset can hedge the loss incurred by the stakers' debt increase.
What are the popular synthetic assets DeFi protocols?
Popular synthetic asset issuers and synthetic assets are listed below.
- Synthetix, over-collateralized ETH (150%) or SNX (750%) to mint synth.
- Linear Finance, over-collateralized native token LINA (500%) to mint synths.
- lUSD, lADA, etc.
- Mirror protocol, used on Terra chain and built by Terra Labs, over-collateralized UST (150% - 200%, Lol) to mint mAssert, real-world asset pegged. However, on August 2022, price feed oracle Band protocol announced that it permanently ceased price feed support for Terra Classic, including Mirror protocol. Without price feed support, the protocol will no longer function.
- mAsset usually pegged to stocks: mAAPL, mTSLA, etc.
- Synthetify, synthetic asset protocol on Solana blockchain, over-collateralized native token SNY to mint.
- xSOL, etc.
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