A Detailed Guide On Synthetic Assets

Synthetic refers to financial instruments designed to imitate other instruments while altering essential characteristics, such as duration and cash flow.

Synthetic assets are digital assets that are backed by a bundle of underlying assets, such as stocks, commodities, or currencies. These underlying assets are used to create a "synthetic" version of the asset, which can be traded and owned just like any other digital asset. Synthetic assets can be created using various techniques, such as smart contract development, tokenization, and collateralized debt positions. Because synthetic assets are backed by real-world assets, they often have less volatility and risk than other digital assets. Additionally, synthetic assets can be used to gain exposure to a wide range of assets that may be difficult or expensive to own directly. This can make synthetic assets a valuable tool for investors looking to diversify their portfolio or gain exposure to specific markets. Furthermore, synthetic assets can be utilized as collateral for lending, hence it has its use case in DeFi. Synthetic assets have gained popularity recently as a new financial instrument in the crypto space and have the potential to revolutionize traditional finance by providing new opportunities for investment and risk management. They can provide liquidity for assets that lack it, or increase the accessibility of assets for investors. Synthetic assets can be also used for hedging purpose and risk management. Synthetic assets can be also used to create decentralized marketplaces, and synthetic assets can also be used for prediction markets. Synthetic assets, as a form of decentralized finance, it can provide more accessibility and transparency to financial market. Overall, synthetic assets can provide investors with more choice, flexibility and opportunities. A blockchain development company, with a team of blockchain technology experts, is well-equipped to handle the creation and management of synthetic assets.

KEY TAKEAWAYS

  • Synthetic refers to financial instruments designed to mimic other instruments while modifying key characteristics, such as duration and cash flow.
  • Synthetic positions allow traders to take a position without actually purchasing or selling the underlying asset.
  • Synthetic products are custom-designed investments created for large investors typically.

Comprehending Synthetic

Frequently, synthetics provide investors with customized cash flow patterns, maturities, risk profiles, etc. The structure of synthetic products is tailored to the needs of the investor. There are numerous reasons for the creation of artificial positions.

  • One example of this is taking a "synthetic position," which involves utilizing other financial instruments to mimic the results of a certain financial instrument.
  • A trader may create a synthetic short position using options because it is simpler than borrowing and selling short stock. This also applies to long positions, as options allow traders to simulate a long position in a stock without purchasing the stock.

For instance, a synthetic option position can be created by simultaneously purchasing a call option, buying a call option, and selling (writing) a put option on the same stock. Whenever the strike prices of the two options are the same, say $45, this strategy would have the same effect as buying the underlying asset at $45 when the options expire or are exercised. The call option grants the buyer the right to purchase the underlying asset at the strike price. In contrast, the put option obligates the seller to purchase the underlying asset from the put buyer.

Buyers of call options stand to gain if the market price of the underlying security rises over the strike price and the options are exercised to acquire the security at $45. Suppose the price drops below the put buyer's strike price of $45 a share. In that case, the put buyer can exercise their right to sell to the put seller, who must buy the underlying securities. Therefore, the synthetic option position would have the same outcome as a genuine stock investment without capital outlay. This is a bullish trade; a bearish trade is made by putting the two options in the opposite order (selling a call and buying a put).

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Having Knowledge of Synthetic Cash Flows and Products

Synthetic products are more complicated than synthetic positions because they are typically the custom-built per contract. There are two primary types of generic investments in securities.

  • Those who pay in terms of income
  • Those who pay in terms of price appreciation

Some securities straddle a line, such as a stock that pays dividends and appreciates. A convertible bond is as synthetic as things need to get for the majority of investors. Convertible bonds are ideal for companies seeking to issue lower-interest debt. The objective of the issuer is to increase bond demand without increasing the interest rate or the amount of debt service. The attractiveness of being able to exchange debt for stock if the company thrives attracts investors who desire a steady income but are willing to sacrifice a few percentage points for the possibility of appreciation. Various features can be added to the convertible bond to sweeten the offer. Some convertible bonds provide principal insurance. Other convertible bonds provide a higher yield in exchange for a lower conversion factor. These characteristics serve as incentives for bond investors.

Imagine, however, that an institutional investor desires a company that has never issued a convertible bond. To meet this market demand, investment bankers collaborate directly with the institutional investor to create a synthetic convertible by purchasing the necessary components — in this case, bonds and a long-term call option — to meet the institutional investor's desired characteristics. Most synthetic products consist of a bond or fixed-income product designed to protect the principal investment and an equity component designed to generate alpha.

Types of Synthetic Assets

The products used to create synthetic products may be assets or derivatives, but synthetic products are derivatives by definition. In other words, their cash flows are derived from other assets. There is even a class of assets called synthetic derivatives. These securities are designed to track the cash flows of a single security.

For instance, synthetic CDOs invest in credit default swaps. The synthetic CDO is further subdivided into tranches that offer large investors varying risk profiles. The structure of these products can leave holders of high-risk, high-return tranches with contractual obligations that are not fully valued at the time of purchase, even though these products can offer significant returns. The innovation behind synthetic products has been a boon for global finance. Still, events such as the financial crisis of 2007-2009 suggest that synthetic product creators and purchasers are not as well-informed as one might hope.

What are synthetic crypto assets?

Synthetic assets based on cryptocurrencies aim to expose users to various assets without requiring them to hold the underlying asset. This includes fiat currencies, such as the United States dollar or the Japanese yen, commodities, such as gold and silver, index funds, and other digital assets.

By utilizing these distinctive synthetic assets, investors can continue to hold tokens that track the value of certain assets without leaving the cryptocurrency ecosystem. Crypto synthetic assets provide users with all the advantages of decentralization, as they are accessible to all users across borders by utilizing smart contracts and other instruments, and the data is stored on distributed ledgers.

Synthetic Cryptocurrency Assets

  • Abra
    Abra was founded in 2014 and is one of the crypto industry's pioneers of synthetics. It is a decentralized investment platform that uses cryptocurrencies as collateral to create synthetic assets. Using smart contracts enabled by the litecoin and bitcoin blockchains reduces friction for those who wish to buy, sell, and hold alternative cryptocurrencies.
  • MARKET Protocol
    By providing users with a trustless and secure environment, MARKET Protocol facilitates the creation of decentralized derivative Position Tokens. Through an oracle, it is possible to create synthetic assets that track the price of any reference asset. Bull call spreads provide long and short exposure to the underlying asset in conventional finance. Position tokens offer a comparable payout structure.
  • Synthetix
    Synthetix is a collateral type, issuance platform, and exchange that enables users to create an assortment of synthetic assets. Users can create a synthetic asset by securing collateral, which can then be traded using an oracle. The user purchases collateral through the oracle instead of a direct counterparty, resulting in a repricing of their collateral. To recover collateral, the user must repay the loan.
  • Worldwide Market Access (UMA)
    UMA is a platform for decentralized financial contracts that uses smart contracts and a mechanism known as a "provably honest oracle." UMA allows any two parties to establish financial contracts on their terms. Using ERC20 tokens, investors can create their own tokenized derivatives on the platform. Similar to ETFs, derivatives offer short, long, and leveraged exposure to real-world assets.

Why are synthetic crypto assets so significant?

Models of synthetic currency backed by cryptocurrencies and powered by smart contracts can have enormous implications for the traditional finance industry. These models allow cryptocurrency holders to trade traditional assets and their derivatives while remaining within the digital ecosystem.

Decentralization provides open access to the global investor community. Before introducing products such as Abra, Synthetix, and UMA, only a select group of institutional investors had access to the global derivatives market. Now, anyone with a smartphone and a basic understanding of the functioning of synthetic assets can gain access to these potent investment vehicles.

With cryptocurrency synthetic asset platforms opening the door to derivatives for thousands of new investors, only time will tell how a potential influx of new cryptocurrency-collateralized derivative contracts will affect the traditional financial landscape.

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Advantages of Synthetic Assets

  • Permissionless Minting: Using blockchains such as Ethereum, anyone can create a synthetic asset system.
  • Accessibility and portability: Synthetic assets can be freely traded and transferred. It can transfer between stocks, synthetic silver and gold, and other assets without holding the underlying asset.
  • Global liquidity: Additionally, synthetic asset protocols offer "infinite liquidity.

Benefits of synthetic assets

Synthetic assets have many advantages over real-world counterparts that could appeal to a DeFi trader.

  • Speculation
    Speculation is one motivation a trader may have for utilizing synthetic assets. Many people trade cryptocurrencies in the hopes of making a profit in the future. However, trading on an asset exchange comes with costs such as price spreads and trading fees. Without the exact underlying costs, synthetic asset exchanges provide traders with more liquidity than traditional asset exchanges. This is due to the distinctive value transfer between synthetic assets.
  • No equivalent
    A more significant amount of cryptocurrency must be locked as collateral when a synthetic asset is created. When synthetic assets are traded against one another, the sold asset is destroyed, and a new asset of equal value is created. This implies that synthetic assets are not exchanged, as one can be withdrawn from circulation to release its value and create a new asset of equal value. Order books — where sellers and buyers of an asset meet at a predetermined price — are no longer required for synthetic assets because a counterparty is no longer required for trades.
  • Decentralized
    Suppose all synthetic assets are collateralized in the same manner. In that case, a synthetic exchange can create an almost limitless supply of any asset that fits within the parameters of its collateral. In other words, a synthetic asset protocol may mint as many tokens as desired so long as their total value is adequately backed. Synthetic asset exchanges utilize non-custodial DeFi protocols, so there are no brokers, KYC systems, or transaction fees. Consequently, exchanging synthetic assets is the most decentralized and cost-effective trading method.
  • Over collateralized
    One disadvantage of synthetic assets is that using capital to mint them may be inefficient. Synthetic assets must always be adequately backed to maintain a secure peg to their target value. To maintain a buffer against price volatility, the value of the collateral must be multiple times that of the synthetic assets. Being over-collateralized makes synthetic cryptocurrencies stable even during volatile market conditions with significant price declines.

Conclusion

The impact of crypto-synthetic assets and the models that support them on finance is profound. These models permit holders to trade traditional assets and derivatives while retaining access to the digital economy. The synthetics industry plays a crucial role in conventional financial markets and is also gaining importance in the DeFi movement. The financial industry is still in its infancy, and developers and financiers must experiment more with new financial products.

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