Synthetic assets in DeFi: USES and opportunities

According to the author, synthetic assets can expand assets, improve liquidity, expand technology and users for DeFi. Meanwhile, synthetic financial assets such as MakerDAO, Abra and, more recently,  Synthetix

Title: synthetic assets in DeFi: USES and opportunities

Source: ETHFANS
Dmitriy Berenzon  Translation & amp; Proofread: stormpang & O sword

While speculation remains the main use of blockchain assets, I don't think it's a bad thing. Speculation is the key driver of the development of the traditional financial market and still plays an important role in the development of the financial industry. More importantly, speculators can bring liquidity to the market, making it easier for participants to get in and out. In addition, speculation can reduce transaction costs and increase market participants' access opportunities.

At present, the blockchain asset market is still immature and short of liquidity. Unlike assets in traditional financial systems, most blockchain assets are only a few years old and do not have a liquidity benchmark built over decades. Take the 24-hour dollar trading volume as an example, Bitcoin trading volume is about 700 million, Apple stock trading volume is about 5.3 billion. The lack of liquidity in blockchain assets limits the availability of its underlying protocols, a problem that has also been exposed in decentralized exchanges and prediction markets.

Blockchain asset markets will develop in a similar way to traditional financial markets. More complex financial instruments, especially synthetic assets (" synthetic financial instruments "), are needed for both investors and retail investors.

The main contents of this paper are as follows:

An overview of Synthetic assets and their definition and use in traditional financial markets.
Explain why synthetic assets are critical to the maturity of the blockchain asset market and introduce several projects currently using synthetic assets.
Examples of building new "blockchain native" financial derivatives are listed.

The first part mainly introduces the definition and examples of synthetic assets. If you're familiar with this section (or find financial engineering too boring), skip it and go straight to part 2.

What are synthetic assets?

Synthetic assets can be used to simulate other financial instruments. In other words, the risk or return of any financial instrument can be simulated by a combination of other financial instruments.

Synthetic assets consist of one or more financial derivatives, the value of which is based on the value of the underlying assets (financial derivatives), including:

Forward commitments: futures, forward contracts and swaps.
Contingent claims: options, credit derivatives (e.g., credit default swaps, credit default swaps) and asset-backed bonds.

What can synthetic assets do?

Investors choose to buy synthetic financial assets for a number of reasons. Such as:

financing
Liquidity creation
Market access

Let me explain with the examples of traditional finance. Note that these reasons can co-exist.

financing
Synthetic assets reduce financing costs.

Total Return Swap (TRS) are financing instruments that use existing assets as collateral for finance. The owner of the asset can use an existing pool of assets, which is used as collateral, to obtain funds, while the swap counterparty earns interest on the money provided. In this case, TRS is similar to a secured loan because:

The party that sells the securities and agrees to buy them back is the party that needs the financing,
And the party that buys the securities and agrees to sell them is the party that provides the financing.

Liquidity creation
Synthetic assets can be used to inject liquidity into the market, reducing costs for investors.

A good example is Credit Default swaps. A CDS is a derivative contract between a buyer of credit protection and a seller of credit protection, in which the buyer pays the seller a series of cash payments and receives a promise that the seller will compensate for any credit losses resulting from a "credit event." Example: payment failure, bankruptcy, or reorganization. This gives CDS sellers the ability to take a synthetic long position on an underlying asset, while CDS buyers have the ability to hedge their credit risk on an underlying asset.

In this article, the authors argue that the CDS market is more liquid than the underlying bond market. One of the main reasons for this is standardisation: bonds issued by a particular company are often divided into many different types, with different coupons, maturities, terms, and so on. This division reduces the liquidity of these bonds. The CDS market provides a standardised place for companies' credit risk.

Market access
Synthetic assets open up relatively free markets by replicating the cash flows of almost any security through a combination of instruments and derivatives.

We can use CDS to replicate the exposure of a bond. CDS come in handy when bonds are hard to obtain on the open market (for example, there may be no tradable bonds).

In the case of tesla's five-year bond, which yields 600 basis points more than us treasuries, we can:

Buy $100,000 of five-year Treasury notes and use them as collateral.
Enter into a five-year CDS contract for $100,000.
When the contract matures, it earns interest on Treasury bonds and an annual premium of 600 basis points on CDS.
Without a default, the Treasury coupon plus CDS premium would give you the same yield as a five-year tesla bond. If tesla defaults on its bonds, the price of the portfolio is Treasury bonds minus CDS payments, which equals the loss on tesla's bonds. So, in either case (default or not), the return on the portfolio (Treasury +CDS) would be equal to the return on the tesla bond.

What makes a good synthetic asset?

In some cases, synthetic financial product development is possible only after the underlying assets have reached critical liquidity. If the underlying assets are too illiquid, it makes little sense to develop synthetic assets, which could reduce economic returns.

Gross income swaps are a good example. Although credit derivatives markets have been around since the early 1990s, total income swaps have only become widely available in recent years. In fact, investors or speculators seeking exposure to specific corporate bonds or bond indexes are more likely to buy or short reference bonds or indexes directly. The opportunity for investors to participate in synthetic credit portfolios through gross income swaps will also increase as market makers begin to manage their credit portfolios more aggressively and adopt a two-way pricing strategy for some credit derivatives. As a strong two-way market begins to develop, bid-ask spreads on synthetic financial products are compressed, attracting more end users willing to combine to buy or transfer credit products. With sufficient liquidity, activity and support in the underlying credit derivatives market, the market can now support a broad credit reference.

What's so magical about combining synthetic assets with DeFi?

Synthetic assets are meaningful to participants of various types in the Decentralized Finance (DeFi) ecosystem for the following reasons:

Expand the asset
One of the biggest challenges facing DeFi today is how to chain real-world assets in a trusted way. Fiat money is a good example. While it is possible to create a fiat backed stable currency on the chain, as Tether did, there is another approach: by directly capturing the synthetic asset price against the dollar, the same effect can be achieved without the actual asset being held by a central counterparty. For most users, having a price is enough. Synthetic assets provide a viable mechanism for trading real-world assets on a chain.

Enhanced liquidity
The main problem in DeFi is lack of liquidity. Market makers can largely influence the liquidity of long-tail and published blockchain assets, but financial instruments for risk management are limited. More generally, synthetic assets and their derivatives can be scaled up by hedging portfolios and protecting profits.

Extension technology
Another issue facing DeFi is the technical limitations of the current smart contract platform. Cross - chain communication has not yet been addressed, which prevents many assets from entering a decentralized exchange. But with synthetic assets, participants do not need to own the assets directly.

Expand user
While traditional synthetic assets are only available to large and experienced investors, smaller investors can benefit from synthetic assets on smart contract platforms like ethereum, which have no barriers to entry. Synthetic assets enable more traditional investment managers to enter DeFi territory by adding a risk management toolset.

Synthetic assets in DeFi

In fact, synthetic financial assets are already widely used in DeFi. Let me show you a few examples of projects using synthetic financial assets and a schematic diagram of the asset creation process.

Legend:

Purple: real assets
Green: synthetic assets

Abra

UMA proposes a gross income swap on ethereum and provides synthetic exposure to a variety of assets.

Coinage native derivative

Synthetic representation of real assets is an important step, I believe that currency derivatives have very big design space, and basically has not been developed, including: block chain asset markets each participant in the design of traditional financial derivatives, and does not exist in the traditional financial markets at first cryptography currency derivatives.

Here are a few examples of two types of derivatives, many of which may not be viable or have markets large enough to provide liquidity.

Bitcoin difficulty swap

The derivative is intended as a hedging tool for miners to reduce the risk of a decline in bitcoin production as mining becomes more difficult (i.e., to hedge miners' "difficulty curve risk"). In fact, BitOoda is designing and providing such financial settlement tools, which means that the settlement is done by transfer of fiat money rather than by renting or lending physical power. In terms of scale, it is unclear how much influence the product will have with sellers (that is, on the hard side) and market makers (that is, swap dealers). At the same time, large mines can also manipulate the market (e.g., collude in attacks).

Hash force swaps

The derivative involves miners selling some of their power to buyers, in the form of funds, to make cash. This allows miners to get a steady stream of income without worrying about underlying blockchain asset prices, and allows funds to invest in blockchain assets without having to invest in mining equipment. In other words, because miners do not have to rely on market prices of blockchain assets they are mining to stay profitable, they do not have to worry about market risk. BitOoda builds and provides this functionality through their physical settlement contract "Hash force weekly extension contract".

Electricity futures

Power futures have existed in traditional commodity markets for a long time, but they are still applicable to cryptographic currency miners. Miners only need to sign a futures contract to buy power at a fixed price at a future agreed time (say, three months). The product allows miners to hedge their exposure to the energy market, since sharply rising electricity costs can make mines unprofitable. In other words, the miner buys the product to change the cost of electricity from a dynamic to a fixed value.

Equity income swap
Equity income swaps allow Proof of Stake networks verifiers to hedge their market exposure to the blockchain assets of their choice. Similar to Hash force swaps, verifiers need to sell some of their equity in exchange for cash. This allows the verifier to obtain a fixed amount of income from the locked asset and the buyer to obtain equity income exposure without equity pledge.

The Vest platform now offers such services. In the Vest market, buyers can buy future returns on equity, and equity owners can reduce their returns on equity. The project is realized through an "equity contract", in which the buyer pays the amount of X and receives the benefit of the Z scrip equity during period T.

Slashing the fine swap
Slashing the fine swap, interest in network (Proof of gaining networks) clients to hedge the selected verifier's operational risk exposure. Think of margin forfeiture as a credit event for the verifier, and think of a penalty swap as insurance against such an event. If the authorized verifier is forfeited, the principal receives a compensation to cover the loss. The seller of the swap is actually looking at the efficiency level of the long verifier, or the verifier itself could be the seller. However, once the product is scaled up, the protocol designer enters an interesting dilemma -- users who lack validators have an incentive to sabotage existing validators.

Stable rate swap
While Maker's current stable rate is 16.5%, on July 13, 2019, solstice August 22, it was as high as 20.5%. CDP holders may wish to reduce the risk of a rise in the stable rate (variable rate), so they can enter into a swap agreement with a counterparty to pay a fixed rate (interest rate swap) over a given time frame.

Drop the option
An airdrop option is an option to buy a block chain asset and its transaction price is equal to the airdrop price. The yield structure of the contract buyer is similar to that of the option contract in the large-volume market, where the market price of the airdrop is the royalty of the option contract. If the airdrop completes successfully, the buyer exercises the option while the seller pays for the blockchain asset. If the airdrop is not successfully completed, the buyer waives the option and the seller receives the option premium.

Lock-up airdrop forward
Lock-up airdrop forwards are bilateral agreements that allow buyers to buy blockchain assets at a set price. In such contracts, the option premium paid by the buyer to the seller reflects the liquidity price of the lock-up asset (or the opportunity cost of the lock-up), but it also allows the buyer to participate in the lock-up without holding the underlying asset required for the lock-up.

conclusion

If you've seen the end, consider becoming a CFA! Synthetic instruments are complex financial instruments that have repeatedly brought the global economy to its knees. They can also pose risks to protocol security in ways we do not yet understand. Still, synthetic assets play an important role in traditional financial markets and are becoming a key component of the DeFi trend. The industry is still in its infancy and we need more experimentation by developers and financiers to really bring new financial products to market.

Related reading:https://www.theblockbeats.com/news/5793
Source:https://medium.com/zenith-ventures/synthetic-assets-in-defi-use-cases-opportunities-19b11f57a776

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