Synthetics are derivative assets whose value can be custom-built to mimic a particular situation.
We refer to a situation because a situation can either be temporary or persistent, in which case we say that something expires or it doesn’t.
Options are synthetics as we say these can be written and sold.
If you wanted to take a position on 1 BTC without forking out 55k, you could long a call and sell a put at the same strike of, say 55k.
In this situation, by longing a call with strike 55k, you’d be purchasing BTC if the spot price is greater than 55k. Conversely, by selling a put, you’re still long on BTC because the put buyer will be short (as he/she hopes to gain a profit if prices fall, while you wish to cash in on the premium). Therefore, if the price fall below 55k, the put buyer will sell the BTC to you at 55k. In both cases, you end up with BTC at 55k by paying the difference between the premium received (selling the put) and premium paid (purchasing call).
Options are just an example of the potential of synthetics. Issuing synthetic assets is no longer the prerogative of investment bankers. Anyone with an internet connection can create synthetic assets without knowing anything other than the price of the asset it’s tracking.
In crypto, several projects have figured out that by locking some collateral capital, you can guarantee the creation of any asset that you can imagine. What used to be a thought experiment is now a reality; you can gain exposure to gold, FX, real-world stocks without the need of a broker that necessarily follows an opening and closing time. However, a synthetic asset position does not give you, on first analysis, the same peace of mind that an actual spot position gives you. You can hold a spot position for as long as you need, while a synthetic position can be liquidated if undercollateralized or if it expires when overdue.
Collateralization drives DeFi value capture, as it represents the value locked in a protocol/platform.
While a relatively big over-collateralization ratio minimizes systemic risks, it might not be sufficient to withstand the violent price action in crypto. This is especially true when the collateral is different from the asset it’s tracking.
Imagine if you have a synthetic position on BTC that you can mint by collateralizing ETH. Let’s assume that the collateral ratio is 2. For every BTC you mint, you need to deposit 110k in ETH.
Now you have 1 BTC.
Suppose that next week BTC goes to 100k while ETH suffers and halves in price. Your collateral suddenly is valued at 55k, but your synthetic BTC is now worth 100k. The collateral ratio has fallen, and now you need 200k to guarantee that the synthetic BTC is liquid if you want to cash out. How do you mitigate this issue? Collateral could be converted to BTC if it falls below a certain threshold, stopping the collateral bleeding.
Synthetics is an up-and-coming section of DeFi as its value derives from composability through payoff engineering. As a result, incentive schemes can be built for example, to align a community around achieving a certain TVL on a platform by distributing synthetic rewards that have binary payoffs based on whether a target is achieved or not.
Although use cases are not limited to trading assets, you could build a contract with its conditions tied to payoffs that incentivize the parties to comply with the agreement through oracles that observe the state of the world.
Therefore, synthetic assets are a compelling human invention that seeks to create what exists but are too expensive to buy outright and arguably makes abundant what is scarce.