Explaining DeFi’s synthetic asset characteristics and development path

DeFi synthetic assets have the problem of difficult cold start and poor liquidity, and protocol parties mostly use token inflation issuance, rebate fees and other measures to incentivize early participants to join.

The price of traditional financial derivatives depends on the value movement of the underlying, generally constructed in the form of forward contracts, futures, options, swaps, and contracts for hedging risk exposure or leveraged speculation; the underlying covered includes stock indices, individual stocks, interest rates, foreign exchange, commodities and alternative derivatives developed based on commodity indices, credit, housing, inflation, weather, etc.

DeFi Derivatives is a segment that has not yet been fully explored. In addition to leveraged trading (similar to financing and financing), perpetual contracts, and option-based products that provide a channel for leveraged long-short trading, DeFi takes full advantage of the programmable asset feature granted by smart contracts to broaden the form and application of DeFi Derivatives by representing derivative contracts as synthetic assets. Synthetic assets are tokenized derivative positions that can be kept as assets on the blockchain and even circulated.

But why have synthetic asset projects not yet reached a market scale comparable to that of DEX and lending products? In this article, we try to find out the reasons by analyzing the characteristics of synthetic assets and summarizing several paths of current development.

Characteristics of synthetic assets
At present, the price of synthetic assets is a “mathematical function” based on the change of the underlying underlying parameters, and there is no actual value to support it, and there is no need to host the underlying assets, which are directly synthesized on the blockchain. The synthetic asset trading market itself is a zero-sum game market where the capital invested by market participants is reallocated as the price of the synthetic asset changes, using cash delivery without the liquidity problems of physical collateral auctions. Blockchain technology realizes the atomic settlement of coupon payments, avoiding the problems caused by the separate custody and clearing of “coupons” and “payments”.

The flexibility that smart contracts bring to DeFi is evident in the fact that there are no formal boundaries to the “mathematical functions” set in the synthetic asset smart contracts, which can be all-encompassing and add leverage. However, in order to achieve a decentralized trading mechanism for synthetic assets, there are several differences compared to traditional financial derivatives trading.

Margin is over-collateralized
Except for some leveraged trading programs that offer similar financing and financing services, where less than 100% margin can be pledged to create derivative positions, most synthetic asset programs that are automatically cleared on the chain require over-collateralization of digital assets to cope with the high volatility of synthetic asset gains and losses and to avoid default events as much as possible. This over-collateralized margin method reduces the capital utilization of participants and increases their liquidity costs, and has no advantage over centralized exchanges and projects that do not require over-collateralization in terms of “providing a leveraged long-short trading channel” for pure digital asset traders, so such synthetic asset projects are basically being explored in other directions, as described in the second part of this paper.

Decentralized clearing mechanism
Unlike traditional financial derivatives that rely on central counterparties for clearing, the checking and clearing of margin adequacy of synthetic assets are generally done by incentivizing permissionless, censorship-resistant clearing robots. Blockchain technology also ensures the atomicity of clearing and settlement.

Prophecy Machines
Most synthetic asset projects rely on prophecy machines to obtain “mathematical function” dependent underlying parameters to update the synthetic asset price and guide the clearing process based on the latest price. The prophecy machines used in synthetic assets are mainly decentralized prophecy machines such as Chainlink (adopted by Synthetix) and Band Protocol (adopted by Mirror) that upload off-chain data to the chain.

UMA proposes the concept of “no-feed contract” to realize an “optimistic prophecy machine” by constructing an incentive mechanism for price providers (or clearing bots) and dispute proponents, allowing price providers to respond to users’ quote requests and provide off-chain information, or allowing clearing bots to judge and execute clearing based on off-chain information sources, and dispute proponents have the right to dispute illegal quotes or clearing within two hours. Within two hours, the disputant has the right to dispute an illegitimate quote or clearing and enter a 48-hour trial. This approach improves the timeliness of off-chain information updates by increasing the fault tolerance of the system, and restrains the error rate through the post-event dispute mechanism.

Several development paths for synthetic assets
As mentioned earlier, the synthetic asset project of over-collateralized margin method has no advantage in the function of providing a channel for leveraged long-short transactions, and is basically being explored in other directions.

Improve the richness of assets on the chain
MakerDAO

Although the MakerDAO protocol is more often included in the category of lending products, its decentralized stable coin DAI, synthesized through over-collateralized ETH, can be considered as one of the earliest and most typical synthetic assets. Its starting point is to provide a decentralized, more consensual unit of account and medium of exchange for crypto assets, with a 1-to-1 anchored dollar price moving the pricing and stored value functions achieved by off-chain dollars to the chain.

The reason for considering this as a lending product may be that the vault casting out of DAI is designed as a lending practice, with an annualized 8% “stabilization fee” to redeem the collateral. To measure the value of the overcollateral, MakerDAO uses a federated prophecy machine of its own design, and there is an effort to move to a more decentralized approach. Collateral below the liquidation rate is regulated through a collateral auction and reverse collateral auction mechanism to attract guardians to participate in liquidation, while the price of synthetic asset DAI is regulated through a debt auction and surplus auction mechanism to incentivize bidders to participate.

Mirror

In addition to synthetic dollars, the Mirror protocol has been relatively successful in launching synthetic assets anchored to U.S. stocks, providing digital asset holders with an avenue to speculate on the rise and fall of U.S. stock prices. The platform has amassed $380 million worth of synthetic assets, with daily trading volume reaching around $78 million.

The Mirror protocol is also one of the few projects built on the Cosmos ecosystem blockchain Terra and its stable coin UST, which has seen its price drop to $0.92 under the stress test of the recent selloff, reflecting the instability of the Cosmos ecosystem’s local structure. The risk posed by this unstable structure can be transmitted to the associated synthetic asset system, exposing it to potential shocks.

Explaining DeFi's synthetic asset characteristics and development path

Mirror Protocol Top 10 Synthetic Assets Trading Volume

Users mint synthetic assets by pledging USTs and can trade synthetic assets, liquidity mining and other activities through AMMs built on the Mirror platform. This is a universal solution to address the illiquidity of long-tail markets, as pioneered by Uniswap. The mechanism of participating in liquidity mining for MIR tokens has brought some growth revenue to an otherwise zero-sum game market, giving it the initial momentum to scale the network, but the value capture of MIR and the sustainability of this model, like many other projects, will require painstaking work.

Synthetix

Synthetix is unique as a benchmark project in the synthetic asset track of the ethereum ecosystem. All investors of the synthetic asset sUSD through the over-collateralized SNX share a “debt pool”. sUSD can be instantly converted into other synthetic assets through the Synthetix exchange (corresponding to different synthetic asset smart contracts) based on the prophecy machine quotes, enabling P2C (peer-to-peer smart contract) transactions without counterparties, while the total debt resulting from all synthetic asset price increases or decreases remains with the synthetic asset. The total debt caused by the rise or fall of the price of all synthetic assets is still shared by the creators of the synthetic assets that collateralize the SNX.

For example, there are two participants in the market, Medio and Yan, each minting 50,000 sUSD at 800% overcollateralized SNX. At this point, the bitcoin price is assumed to be $50,000, and Medio exchanges 50,000 sUSD for 1 sBTC. half of the debt. After some time, assuming the bitcoin price rises to $75,000, the face value of Medio’s sBTC holdings rises, and the total debt rises to $125,000. The increased total debt is divided equally between the two parties in the same proportion as before, resulting in a net gain for Medio of $12,500, which corresponds to Yan’s loss on his sUSD holdings.

Explaining DeFi's synthetic asset characteristics and development path

Example of Synthetix debt pool in action

It can be seen that the trader of Synthetix (e.g., Medio, who exchanges sUSD for sBTC) is a set of counterparties in a zero-sum game with all the collateralizers of the debt pool (including Medio itself). For a third-party trader who buys Synthetix’s synthetic assets directly from the secondary market, his profit or loss corresponds directly to the increase or decrease in the price of the synthetic assets, betting against all of the debt pool’s collateral.

This “debt pool” design breaks down the liquidity boundaries of different synthetic assets through a P2C trading model and introduces prophecy machine quotes to reduce slippage losses. In addition, Synthetix incentivizes collateralists to participate in the minting of synthetic assets through a trading fee split mechanism, and the SNX inflation issuance mechanism encourages collateralists to be long-term betting parties for outside traders. If the synthetic assets on this trading platform attract a constant influx of outside traders, it is equivalent to the synthetic assets minted by the mortgagee finding a channel to circulate outward, an expanding zero-sum game market.

Currently, Synthetix supports the minting of synthetic asset underlying types including cryptocurrency prices, reverse cryptocurrency prices, cryptocurrency indices, foreign exchange, and commodities, with daily trading volumes reaching millions of dollars in sUSD, sETH, and sEUR. This shared debt pool design may also provide investors with a broad asset class allocation if it can attract more underlying classes The pools are based on the three examples above.

In addition to the above three examples, the Polkadot-based Standard Tokenization Protocol proposes a cross-chain synthetic asset that supports anchoring a portfolio of assets on multiple chains to cast synthetic assets, facilitating investors to save cross-chain friction in managing exposure to assets on multiple chains.

Provide hedging tools
UMA provides developers with a common template for casting synthetic assets. One example of a synthetic asset project built on UMA is uGAS, a synthetic asset project developed by uLABS, which is a futures contract-like hedging tool for Ether gasoline fees. uGAS has a “mathematical function” that calculates the median Ether gasoline fee for the 30 days before the settlement date. Tradable directly in AMM, uGAS provides a hedge for frequent traders such as liquidity miners to maintain a stable fee cost, and helps Ether miners to earn a stable fee income; while attracting investors to speculate on its price rise and fall itself.

The DeFi insurance program is also a synthetic asset, where the underlying can be a binary outcome of a discrete event (e.g. whether it was hacked) or some form of CDP (e.g. providing a hedge against parameters such as machine gun pool yields, lending rates, etc.).

The LP Token in the form of NFT introduced by Uniswap V3 can actually be considered a synthetic asset as well. Unlike Uniswap V2, the liquidity provided by LPs is no longer homogeneously blended, but separated by intervals, represented by NFTs. The LP Token itself can be sold to the average investor as a synthetic asset anchored to the return of the market making strategy, or a fixed rate swap based on the LP Token to provide a fixed return for a portion of the LP.

Providing Alternative Underlyings
Due to the wide range of underlying or ‘mathematical functions’ of synthetic assets, it is appropriate to introduce alternative underlying instruments. For example, the prediction tokens purchased by participants in the prediction market synthesize the probability of discrete events (politics, sports, blockchain ecosystem development milestones, etc.), but they have been lukewarm due to the lack of participation and poor liquidity in the long-tail market constituted by these discrete events. They hope to improve the liquidity of the long-tail market through AMM’s automatic market-making mechanism. But the main problem here is that the prediction results are hardly a valuable reference for the DeFi ecosystem to motivate users to participate.

The most critical information for DeFi is currently asset prices, which are being realized through prediction machines such as Chainlink. A liquid prediction market is naturally a good prophecy machine and can upload off-chain information to the blockchain in a gaming mechanism rather than a timed median. When there is a strong demand for alternative information in the future, the liquidity of synthetic assets in the prediction category may break through and gain positive feedback by providing a prophecy machine function to charge fees to the trading and insurance demand side.

Synthetic alternative assets also have a place in DAO governance, such as SF coins that incentivize governments to improve street cleanliness, KPI options that incentivize project development progress, etc.

Combining NFTs
Some of the card-based NFTs also have the properties of synthetic assets, where the underlying can be IP reputation, rise or fall in popularity, or potential scarcity. Another class of projects is developing synthetic assets based on NFT issues, giving them additional financial attributes. For example, while each Crypto Punks corresponds to only one NFT token, a synthetic asset that tracks its sales volume, price, and other information could provide investment opportunities for a wider range of investors, or a basket of NFT index synthetic assets could be created to allow traders to profit from the price fluctuations of a specific NFT without holding it.

At a deeper level, if in the future NFTs can represent a resource or a right in the physical world, synthetic assets based on such NFTs provide an opportunity to explore new trading models for commodities and equity derivatives.

Summary and thoughts
DeFi synthetic assets suffer from long-tail market difficulties in cold-starting and illiquidity, and the zero-sum game further hinders them from achieving critical scale to realize network effects. Currently, the synthetic asset project owner adopts AMM automated market maker mechanism and debt pool pool sharing to achieve P2C transactions without counterparties; and uses the project token inflation issuance mechanism and rebate fees to incentivize early participants to join.

The selection of the synthetic asset underlying is critical to its success. The underlying should be matched by a high level of demand in the DeFi market, so that the synthetic asset can be used directly to hedge risk or provide valuable information. For synthetic assets that do not have much extrinsic value and provide pure speculative opportunities for both betting parties to reach critical scale, relying on self-organization characteristics to turn a zero-sum game into a non-zero-sum game may be a path to explore.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/explaining-defis-synthetic-asset-characteristics-and-development-path/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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