To mature as an industry on its own decentralized finance (DeFi) should not be limited to digital assets only. Traditional finance is still much bigger than DeFi. Most people active in financial markets still trade financial instruments such as bonds, currencies, stocks, and ETFs. To unlock value worth trillions of dollars DeFi should bring those assets to blockchain. But how do you do it? Synthetic assets are the name of the game.

Synthetic assets are like derivatives represented on blockchain. Derivative contracts track the price of an underlying asset. Therefore, they allow users to get exposure to an asset without owning that asset. A synthetic asset is a tokenized derivative. Let’s say, you believe that Microsoft will perform well; that’s why you want to buy MSFT shares. But for some reason you don’t or cannot buy it through an ordinary brokerage account. What you can do is to purchase a token representing MSFT share on a synthetic asset platform.

Synthetic assets bring improved liquidity and lower transaction costs to investors. They also make assets accessible to retail investors who otherwise couldn’t afford to invest in them (e.g., precious metals). Synthetic assets can be used as a risk management tool for hedging as well. If you own GOOG (Google stock) but want to hedge against the downside price movement, you can sell a token representing GOOG share on a synthetic asset platform.

Protocols

Synthetix

Out of all synthetic assets apps the largest in terms of TVL (total value locked) is Synthetix. Synthetix Spot Synths are synthetic assets tracking the value patterns of real-world assets, which can be fiat currencies, cryptocurrencies, or commodities. For example, holding sETH gives an owner exposure to ETH price.

Since it’s the largest protocol of its kind it has been described many times. I won’t go deep into Synthetix.

Poison Finance

Poison Finance is a multi-chain synthetics protocol. Synthetic tokens on Poison are called Potions or pTokens and are collateralized by multiple stablecoins such as USDC, USDT, FRAX, and DAI. The issuance of Potions is allowed once collateral is locked in the Vault Contract. At the time of writing, the protocol allows to mint pTokens for three commodities (gold, silver, oil) and several high-tech stocks.

Potion Finance is an overcollateralized protocol. It means that a Vault’s collateral value has to be higher than that Vault’s current minted tokens. For pGOLD and pSLVR the minimum collateral ratio is 130%; for other Potions a Vault should have at least 150% collateral ratio. Collateral ratio is calculated according to the following formula:

cRatio = collateral / (pToken amount * pToken price)

What this formula implies is that when the pToken’s price goes up, the user has to add more to her collateral to dodge liquidation risk. So, essentially this means that a Vault is a short position against the underlying asset.

Parcl

Parcl differs from other mentioned (and not mentioned) protocols in that it creates synthetic assets of the different asset class. Most synthetic asset protocols design products tracking the value pattern of fiat currencies, cryptocurrencies, stocks, or commodities. For Parcl the underlying asset is real estate. Built on Solana, Parcl allows you to trade price movements in real estate.

Through Parcl Labs, a Big Data and AI/ML company, the protocol brings tangible asset prices on-chain. The protocol gives users exposure to real estate in US cities such as Miami, New York City and Los Angeles. Toward the end of 2023 the protocol will offer real estate in several non-US cities, such as Paris, London, and Singapore.

Domination Finance

Another innovative protocol is Domination Finance, the first DEX allowing to do domination trading. Bitcoin domination is one of the most watched metrics in the crypto market. The metric is as volatile as Bitcoin, and the crypto market in general. When the altseason takes off, we can see a sharp decline in BTC dominance. And this is what the chart below shows. During the bear market, on the other hand, it is reasonable to expect an upward movement in the metric. That’s because when the sentiment is bearish, though BTC is sold, altcoins are sold got rid of even harder. Crypto investors sell their riskier assets into safer digital assets such as BTC, ETH and stablecoins.

We can think of a situation where we’d like to bet neither on BTC itself nor altcoins rather on BTC dominance. Say, you expect a bearish sentiment in the future but you don’t want to directly short the crypto assets because it is too risky. What you can do is to bet on BTC dominance. But is there a protocol allowing to do it you wonder? Thanks to Domination Finance, yes, there is! They launched a synthetic asset based on the market share of Bitcoin.

If you believe that BTC dominance will increase, you can buy BTCDOM tokens. If you think the market dominance of first cryptocurrency will decrease, you can buy invBTCDOM tokens. The protocol allows to trade ETH and USDT dominance as well.

Outcome Finance

The space of synthetic assets is full of interesting ideas. When I am saying that synthetic assets are tokenized derivatives tracking prices of underlying assets, I am missing Outcome Finance. The protocol developed the product called Key Performance Indicator Options which are synthetic tokens with the expiry date. Instead of being based on real-world assets, the value of KPI Options tracks the value of a particular metric at a predefined maturity date. They have been designed with the DeFi protocols and DAOs in mind.

How does it work? Let’s say a DAO has a target of enlisting 500 new members in a year. That is the Key Performance Indicator. The DAO will collateralize some of its governance tokens to create KPI Options which are ERC-20 tokens. Now, to hit the target DAO can distribute those synthetic tokens to community members who can enlist new members. Members are interested in achieving that KPI because the value of their tokens depends on the status of KPI at the expiry date. This mechanism is good in that it aligns the incentives of the DAO and its members to serve the shared purpose.

Another example would be a DeFi protocol with the target of increasing Total Value Locked (TVL) during the next three months. Once KPI Options are collateralized by the protocol’s token, they are minted to that protocol’s users. As users’ payout from Options are based on the TVL after 3 months, they will try to improve that metric. After the expiry date the users will be able to redeem their KPI Options for the protocol’s tokens. Once again, a very clever scheme for alignment of incentives between the DeFi protocol and its users.

Risks

- Dependence on one blockchain. That’s the same thing as not to be decentralized enough. That’s what happened with Mirror protocol which was built on the now infamous Terra blockchain network. With the depeg of UST which was a near-death experience for the Terra ecosystem most apps including Mirror halted to function properly. Not all that is claimed to be decentralized proves to be so in the end.

- Significant variation between the price of the underlying asset and the synthetic asset tracking it.

- Liquidation risk. If the collateral value is not sufficient and the user fails to add to her collateral, position will be liquidated which can result in 100% loss of initial investment.

- Smart contract risk. As with all DeFi protocols, synthetic asset apps may have serious bugs which can be exploited to steal user funds. Another related risk is price oracle risk. Since these protocols depend on oracle networks to fetch price of underlying real-world assets, any problem in oracles can lead to unintended consequences.

Conclusion

Synthetic assets are essential to bring value otherwise locked in real-world assets, such as fiat currencies, cryptocurrencies, commodities, and real estate. By unlocking the value, they increase liquidity and make those assets accessible to retail investors. These assets are capital-efficient as well since their transaction fees are usually much lower than their off-chain counterparts.

Not only that. The space of synthetic assets is new and thus, open to innovative, progressive ideas. One protocol, Domination Finance, builds synthetic products that allows traders to bet on otherwise unavailable things, such as BTC dominance. Outcome Finance devised a product called Key Performance Indicator Options the underlying of which is not currencies or stocks or commodities. These synthetic tokens derive their value from the DeFi protocol-related metric, such as number of users or Total value Locked at a predefined expiry date. The sky is the limit when it comes to synthetic assets!