Synthetic Assets: The Game Changer in Decentralized Finance

by | Dec 19, 2020 | Industry | 0 comments

Synthetic assets are standard investment vehicles in traditional finance. As the world economy is shifting to distributed systems and token-based applications, the masses gain access to investment channels previously available to expert traders only. Since synthetic assets have found their way into the crypto world, it is time to dive into how crypto synthetic assets work and the products you can access today. The article begins by analyzing synthetic assets’ traditional context before highlighting some of the latest crypto synthetic assets. 

The Traditional Context of Synthetic Assets

Synthetic refers to a group of assets that reflect the returns of another asset. The returns you earn from synthetic assets are facilitated by a combination of other financial tools, like options, futures, and swaps, which echo an underlying asset. Underlying assets, in this case, can be bonds, stocks, commodities, fiat, interest rates, or an index. 

Instead of generating returns by directly trading assets, like stocks and bonds, synthetic assets make returns from other investment products based on the underlying asset. Therefore, you can also refer to them as derivatives. 

To explain this better, assume you bought a call option and sold a put option on the same stock. Basically, you are simulating the returns of that stock without owning it. The illustration shows how an investment company can hedge its risk instead of buying and selling the stock. Instead of putting all your money in a single investment asset, you can leverage synthetics, which comprise multiple investment vehicles. 

Moreover, you can integrate synthetics into your investment portfolio to suit your needs. For example, you can create a strategy with specific cash flow patterns, maturities, and risk profiles. 

Common Definitions

Synthetic investment product: A type of investment using derivatives, implying all cash flows generated by the synthetic product, are actually derived from other assets. You can also describe synthetics as their own asset class. 

Synthetic assets: A combination of assets that echo the impact and value of an underlying asset.

Derivative: A contract made by two or more parties that creates value from the performance of another asset.      

Types of Traditional Synthetics  

Option spreads.

Structured products, such as collateralized debt obligation (CDO).

Some investments in real estate.

Guaranteed investment contracts. 

Example of Crypto Synthetic Product

Abra 

Abra is an investment platform where you can use digital currencies as collateral to create synthetic assets. The Abra platform is fully decentralized, meaning that it is open to all internet users. This presents a significant difference between traditional synthetic assets and their crypto counterparts. 

The Abra synthetic model currently uses Bitcoin and Litecoin-based smart contracts. These smart contracts enable them to provide a more seamless experience for investors who want to purchase, sell, or hold digital assets.  

By downloading the Abra wallet, you are basically taking a short position on Bitcoin or Litecoin while taking a long position on the hedged asset. On the other hand, Abra takes a long position on Bitcoin or Litecoin while shorting the hedged asset. Like many traditional synthetic products, the company hedges price movement risk by borrowing an equal amount of assets from a crypto broker.  

“The implications for this technology are enormous and could eventually lead to creating crypto-backed representations of all kinds of value, including traditional securities. As cryptocurrencies continue to grow in terms of both market capitalization and use cases, a crypto-collateralized synthetic currency model could also provide the underpinnings of a global crypto bank.” – Abra.

N/B: This article is meant for educational purposes only. Kindly conduct your own research and seek professional advice before investing, particularly in the complex synthetic asset markets. 

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