With the meteoric rise of DeFi, many new terms have entered the crypto dictionary. Yield farming, wrapped assets, white labeled wallets: it seems the list grows by multiple entries daily. That’s just how fast this space moves. One important bit of terminology that has entered the ecosystem is “synthetic.” In this context, a synthetic references a traditional financial (tradfi) asset that is being represented by a token. By representing a tradfi asset in this manner, many interesting and novel investment strategies can be unlocked. Trade ideas that were never possible before can take flight… and perhaps even more interesting is that these trade ideas are not locked away in some big glass building on Wall Street. While the concept can seem heady — it’s actually pretty straight forward.
In the next few paragraphs, we are going to demystify the idea of blockchain synthetics and tell you why they have fundamentally changed the way assets are traded forever. (This change is so fundamental that all of the suits in those big glass buildings I referenced are only now starting to come around… more on this later.)
Let’s start at the beginning — We will roll through how these assets have historically been created and used, we’ll go through a few examples of synthetic creation and use, and finally we will discuss how this esoteric TradFi concept is now a mainstream concept in DeFi.
What Are Synthetics In TradFi?
Synthetic exposure is a concept that existed far before the emergence of blockchain tech. Generally, the idea is that an investor can achieve a certain type of asset exposure without owning the actual asset. Put another way, synthetic exposure emulates the targeted key characteristics of an asset without bringing other, perhaps, less desirable aspects. Synthetics are typically a more complicated amalgamation of a few different positions that then yield the preferred mix of asset characteristics.
Historically Why Would A Trader Want To Use Synthetics?
Synthetics are interesting to a trader if they do not want to outlay the capital to buy or sell the asset. Strategies that would demand synthetic exposure are typically more complicated and historically have come from institutional investors that have capital management requirements or are pursuing an investment mandate that requires a certain type of exposure while precluding direct asset exposure due to a risk management requirement. In more straightforward language: Institutional investment strategies may have very specific requirements in order to follow the mandate that their investors are expecting (thus satisfying fiduciary duty, risk management hurdles, portfolio balance, etc) or in order to stay within the legal bounds of the trading rules they must follow in accordance with regulatory agencies. Synthetics can be a useful tool within this context. If you are thinking that this sounds too complicated for a trader buying a few shares of Apple, you are correct. In TradFi, synthetic exposure is a custom, architected trade. These types of trades or products are complicated and are most likely reserved for only a small group of companies or traders.
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The next section gets into a bit of annoying finance jargon. If you want to give it a try read on, if not -
TL/DR — Synthetics in TradFi are built to mimic other assets so that the trader does not have to own the target asset and has more control over the open position. With this in mind, skip to Synthetics in DeFi or read on!
Examples of Synthetics In TradFi
Investopedia outlines a perfect example of the power of a synthetic asset in TradFi.
Let us consider a synthetic options play built to mimic a long position in a stock:
“For example, you can create a synthetic option position by purchasing a call option and simultaneously selling (writing) a put option on the same stock. If both options have the same strike price, let’s say $45, this strategy would have the same result as purchasing the underlying security at $45 when the options expire or are exercised. The call option gives the buyer the right to purchase the underlying security at the strike, and the put option obligates the seller to purchase the underlying security from the put buyer.
If the market price of the underlying security increases above the strike price, the call buyer will exercise their option to purchase the security at $45, realizing the profit. On the other hand, if the price falls below the strike, the put buyer will exercise their right to sell to the put seller who is obligated to buy the underlying security at $45. So the synthetic option position would have the same fate as a true investment in the stock, but without the capital outlay. This is, of course, a bullish trade; the bearish trade is done by reversing the two options (selling a call and buying a put).”
As you can see, that’s a pretty wild idea — you basically own the returns of a long position without laying out the cash to own the stock. Start looking around and you find many examples of this type of exposure. Synthetics have been massively on the rise in TradFi. No wonder 2008 hit a little different!
Another example of synthetic exposure can be found in the form of a debt vehicle called a “convertible bond.” This instrument starts as debt and converts to equity. This satiates the needs of both the company that is issuing the bond: they now have more flexibility in terms of how they raise and pay for debt, as well as the investor in that debt: their bond guarantees cash flow and might just convert to equity.
Whether you fully grok the two examples above is not important. What is most important is that you understand that synthetics are built to mimic another position without requiring you to take that position.
They are a proxy for a position in TradFi.
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Synthetics In DeFi
We can map this concept to DeFi with one word: tokenization. While tokenization is not synthetic exposure in and of itself, the mechanism of tokenization unlocks the potential for synthetics at scale.
Let’s drill down a bit.
In DeFi we can set the stage for synthetic exposure by taking an asset and creating a token that represents that asset. Think of the process like taking a rental car and representing it with a pink slip. The car is rented and moves around — but the renters don’t own it, she who has the pink slip owns it. The pink slip is a proxy for the car. But what if I wanted to allow fractional ownership in that car? More specifically, I wanted a group of people to come together to buy a car that we could then rent to produce a cash flow. Yes I could draw up a beefy legal document that says as much and directs cash flow in accordance with our agreement. But what if one investor wants out? What if another wants in? What if I want to own two shares of the car instead of one?
Glad you asked!
If I tokenize the fractional ownership in the car, well then, we can just trade tokens. It is outside of the scope of this article to get into the technical architecture that we would need to pursue in order to make this happen, suffice to say, we could do it. Each one of those tokens would represent fractional ownership. The legal document that states who was issued tokens at first could then be updated as the tokens trade from party to party. If the car is sold, and let’s say all token holders voted that the offered price for the car was acceptable, we could then burn the tokens and send each token holder a payment commensurate with their respective portion of the fractional ownership.
HERE’S WHERE WE SEE POTENTIALITY FOR THE POWER OF SYNTHETICS: I don’t want to fractionally own the car. Instead, I want access to the cash flow that fractional ownership would give me — and I want it only for the summer in a specific geography. Why? Because I am in the resort business and I know that more tourists will be coming to my area to enjoy the weather. My earnings are seasonal and if I can grab a portion of earnings that are related to my core business but that do not require a huge capital outlay — that may be very interesting. So I lease fractional ownership of some rental cars from the airport in my area and I diversify my income.
We are seeing this foundation be laid in DeFi as we utilize particular technical token architecture to unlock liquidity in illiquid assets such as buildings, boats, art, airplanes, etc. Marketplaces are popping up, companies are issuing, and investors are owning these assets. This is what an NFT initially is at its core.
While tokenization will certainly enable synthetic exposure to an illiquid asset, what is perhaps most interesting is the power that synthetic representation unlocks with traditional liquid assets.
Here at TTLG we are big fans of the Mirror Protocol. So let’s use that platform as an example of synthetics being actively traded today.
Mirror Protocol
The Mirror Protocol has been established to build a platform that can reflect the value of TradFi equities through tokenization.
Mechanically the process is pretty simple. The Mirror Platform uses what is known as an “oracle” to retrieve price data on an asset. Think of an oracle as a data stream whose only job is to report a specific action back to a platform. In this example, it is the price of an asset. The oracle can be “aimed” at a reputable source for asset pricing, say a stock exchange’s API, and real time pricing data is then relayed back to the Mirror Platform. Participants on the Mirror Platform are then able to interact with the asset at an accurate price as if they owned the actual equity that is being observed. In this way, there is a new market that has been created that seeks to mimic the price action of the original market. This new market, through a variety of pricing mechanics that are outside of the scope of this article, then trades the asset. Mechanically creating this synthetic is pretty straightforward, but the reason that it matters is the punchline.
Why Blockchain Powered Synthetics Are The Future
The idea of a market is that buyers and sellers come together and through the process of supply and demand they “discover” what any given item being transacted is actually worth. The value of anything is only the last price that someone has actually paid. In TradFi our markets are completely massively broken — and thus the pricing mechanisms are also massively broken. Stock buybacks, the FED, market front running by the likes of Citadel by way of Robinhood, these forces have become the norm. Manipulation is at an all time high and is only getting worse.
This is why everyone is looking around in 2021 thinking “something is not right.” The globe is stumbling through a pandemic and public markets are at an all time high? Some of the most valuable companies are not profitable? How is this possible?
We can argue that valuation methodologies have changed, we can compare notes on what should or should not be legal market participation, we can even argue the semantics of what constitutes front running and market manipulation…all of that is fair game. But what cannot be argued is that from a statistical point of view the more data that any given input has in making a determination, the more accurate the determination. And the more varied those observations, the better the final result.
Here’s the punchline — by creating synthetic assets empowered by blockchains we are enabling exponentially more real world market participants to engage trading and thus price discovery. These are real world people or companies who were otherwise boxed out of the market — and now because of synthetics — the marketplace is extended so that it is within their reach.
Extrapolating into the scale that DeFi suggests, we can now provide access to billions of people that otherwise would not have access to these assets. Additionally, those billions of additional perspectives make the marketplace more efficient. While it is true that currently the anchored oracle observation may be from a source that might be manipulated (i.e. a public stock market), without too much imagination, we can ponder that as these synthetic assets stoke additional price discovery we can circulate that information back into the original stock exchange as a data point. Imagine an index that takes the weighted average of all synthetic price information and provides that back to TradFi as a signal. That’s pretty powerful. And it speaks directly to why DeFi is the future: Price discovery in a financial market is not only what happens inside big glass buildings on Wall Street, price discovery involves us all directly or indirectly. DeFi provides a mechanism for exponentially more people and companies to meaningfully participate in financial markets. The more people and companies that participate, and the more assets they have to participate with, the more efficient financial markets will become.
Pandora’s box is opening and it looks like we will use DeFi to continue to pry the lid and instruments such as synthetics to ensure that what’s inside achieves maximum velocity as it exits.
What will seem like total chaos for the suits that have guarded that box on Wall Street, will be new opportunity for the rest.
- TTLG Crew
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