April 28, 2021 · 9 min read
From tokenized versions of real assets, stablecoins, to synthetic assets, there has been an active movement to bring real world assets onto blockchain.
Earlier this week, the leading crypto exchange Binance announced that it would make Microstrategy (MSTR), Apple (AAPL) and Microsoft (MSFT) Stock Tokens available on its platform. These Stock Tokens will be fully backed by the real shares of the relevant companies and they will be held by CM-Equity AG.
This week, we look at crypto synthetics.
What is a synthetic?
A synthetic is a financial instrument that uses a mix of assets or derivatives to simulate the payoff of an underlying asset.
To help your understanding, we briefly explain with examples how to create synthetic positions in traditional finance before we move on.
Let’s say you believe that TSLA could take you to the moon. Rather than buying X amount of Tesla shares, you can create a synthetic long position. How? By buying at the money call options and simultaneously selling the same number of shares at the money put options with the same expiry date.
You can also create synthetic bonds. Say you want to buy $5,000 worth of Tesla bonds yielding 500 basis over Treasuries that mature in 5 years. You can synthetically create the same return profile by buying $5,000 of Treasuries, then writing a 5-year $5,000 credit default swap contract.
Why do we create synthetic products?
Less initial capital needed - synthetics can mirror the payoff profiles without have to lay out a big chunk of capital
Customization - investors can design synthetics based on their desired maturities, risk appetite, and more.
What are crypto synthetics?
Like many other concepts and products in DeFi - from exchanges, lending, to derivatives - crypto synthetics came from traditional finance. Crypto synthetic assets allow users to gain exposure to diverse assets - from cryptocurrencies, stocks, forex to commodities and more - without actually owning them. But now we’re in the DeFi space, we do that without having to leave the cryptocurrency ecosystem. Simply said, crypto synthetic assets can bring real world assets onto blockchain.
Below we explain some of the most popular/demanded synthetic assets - synthetic USD and synthetic BTC.
Stablecoins have proven their value in the DeFi space. Bridging the gap between fiat finance and crypto finance, stablecoins provide a stable basis for activities such as borrowing and lending and allow traders to quickly lock in their gains without actually cashing out. However, the irony is that most dominant stablecoins USDT and USDC are all centralized stablecoins backed by real fiat. Synthetic stablecoins provide a valuable mechanism for real-world assets to live on a blockchain in a decentralized manner. The leading synthetic stablecoin is sUSD minted via Synthetix. We will have a closer look at Synthetix later on. sUSD is often compared to MakerDAO’s DAI, the “go-to” stablecoin for DeFi users. However, Synthetic’s sUSD has been able to grow mainly due to its native use case in the Synthetix ecosystem - a user can sell sUSD for other synthetic assets in the Synstetix system such as sBTC, sFTSE, or sAAPL. sUSD is currently ranked at 12th in the stablecoin market with a $210 million market capitalization. Another synthetic USD is Venus’s VAI. Venusis a decentralized lending protocol built on Binance Smart Chain. Users can post collaterals in Venus and mint VAI, an overcollateralized stablecoin pegged against USD. VAI is ranked at 13th following up sUSD with a $191 million market capitalization. The market leading stablecoin USDT has a market capitalization of $50 billion and DAI has $3.5 billion.
Wrapped BTC(WBTC), an ERC20 token backed 1:1 by Bitcoin, has seen a huge success over the past months. The market capitalization of WBTC in October 2020 was around $1 billion and is now $8.6 billion. The stellar growth of WBTC is a proof of increasing appetite for unlocking the liquidity of BTC and deploying the capital in the Ethereum-centric (at least for now) DeFi space. One notable synthetic BTC project is BadgerDAO. BadgerDAO’s mission is to bring BTC to Ethereum. Badger DAO and RenVM have recently announced their launch of Badger Bridge that enables users to deposit tokenized BTC into yield-bearing vaults with one click. BadgerDAO also created DIGG token, which is a synthetic rebasing asset that simulates the price of Bitcoin. However, DIGG hasn’t been able to successfully track the price of BTC.
Now let’s have a deep dive into DeFi protocols for synthetic asset issuance - Synthetix, Mirror, and UMA. The table below summarizes key characteristics of these three protocols.
Source: Novum Insights up to 27th April
Synthetix is an Ethereum-based DeFi synthetic asset protocol that enables users to gain price exposure to any asset. Users can mint, exchange and provide liquidity for a vast array of assets.
To create synths on Synthetix, you first need to purchase SNX tokens, the network’s native token. SNX tokens are available at most major crypto exchanges including Binance, Coinbase, Uniswap, Kraken and more. SNX has the largest market capitalization of $2.4 billion among the native tokens of the above protocols. SNX increased by more than 2000% in the past year.
To mint or create Synths, users lock in SNX tokens as collateral. The collateral ratio of the Synthetix network is 750%. For instance, to mint $1,000 USD on Synthetix, the user needs to lock in $7,500 worth of SNX. Once minted, you can take your sUSD to Synthetix Exchange and trade them for synthetic Facebook shares (sFB) and earn networks’ exchange rewards. SNX holders are incentivized to stake their SNX in order to earn staking rewards. Annual percentage yield for staking SNX is 25.59%. You can also borrow Synths - sUSD, sETH, sBTC - against ETH or renBTC as collateral.
Synthetix currently supports synthetic cryptocurrencies (both long and short positions), fiat currencies, stocks, indices and commodities. The most minted assets on Synthetix are ETH, USD and BTC.
Source: Synthetic.io up to 27th April
Mirror Protocol is a Terra-based synthetic asset issuance platform. To create mAssets (synthetic assets on Mirror Protocol), users lock up either mAssets or UST (Terra stablecoin) as collateral. The minimum collateralization ratio for Mirror is 150%. To trade mAssets, users go on Terraswap. It is also possible to participate in the protocol as a liquidity provider to Terraswap pools and earn LP tokens. Users can stake either LP tokens or MIR tokens, the governance token of Mirror Protocol and earn rewards. Annualized staking rewards for MIR is 16.01%. Users who stake MIR can use the staked MIR tokens to vote on polls. The figure below shows some of its past polls.
Souce: Mirror up to April 27th
Despite being the youngest project of the three, Mirror has the highest TVL. The most traded assets in Mirror Protocol are MIR, mUSO (United States Oil Fund) and mTWTR(Twitter).
UMA, short for Universal Market Access, provides an open-source framework for creating self-executing derivative contracts to create synthetic positions on Ethereum. In UMA, it takes two parties to enter into a formalized financial agreement and this model is known as Total Return Swap, where one party makes a payment based on the total return of an underlying asset and the counterparty makes fixed periodic payments. The illustration below explains how UMA contracts work.
Source: UMA Medium
What differentiates UMA from other synthetic asset protocols is its oracle design. UMA doesn’t rely on third party price feeds such as Chainklink, Band Procol or Tellor. UMA’s “Liquidators” are incentivized to monitor the value of the collateral by referencing off-chain price feeds. On the other side of the network of Liquidators, there exist “Disputers” who determine if a liquidation by Liquidators was valid or not. An oracle is needed only when there’s a dispute. Disputes will then be resolved via a crowdsourced oracle called Data Verification Mechanism (DVM). The collateral currency can be determined by two parties. There are 43 tokens approved to be used as collateral currencies, and if you wish to add another currency that is not yet on the list, you can do so via a UMIP(UMA Improvement Proposal) process.
There are currently 11 DeFi projects using UMA including uSTONKS, a synthetic that tracks the ten most bullish Wall Street Bets stocks and uGAS, a synthetic Ethereum gas price futures token. Synths created via UMA are free to travel around the DeFi space without any friction. Take your uGAS to Uniswap and trade for ETH.
UMA has recently developed a new incentivization mechanism called “KPI options”. The options’ values depend on key performance indicators. The uTVL-0621 is a KPI option whose key performance indicator is UMA’s TVL. uTVL-0621 will expire on June 30 2021. The minimum value of the option is 0.1 $UMA and when the TVL hits $2 billion, each option will pay out 2 $UMA.
Despite being the largest financial market in the world, estimated to be worth over $1 quadrillion, the global derivatives markets have been only accessible to institutional investors or accredited investors. The emergence of DeFi protocols such as Synthetix and UMA made it possible for anyone to tap into the derivatives markets. Synthetics will continue to contribute to the growth and maturation of DeFi, and DeFi continues to democratize the financial system.
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