What Is Synthetic Asset? Traditional Vs Synthetic Asset

KEY TAKEAWAYS

• Cryptocurrency synthetic assets, also known as "synthetic assets," replicate the value and performance of real-world assets without the need for direct ownership.
• Unlike traditional assets like stocks and bonds, crypto synthetic assets are digital counterparts on the blockchain designed to mimic the characteristics of these conventional assets.
• Crypto synthetic assets come in various forms: synthetic stablecoins, tokenized commodities and equities, leveraged and inverse tokens, and yield-bearing synthetic assets.
• Common use cases for Synthetic Assets include accessing new asset classes, exploring deep or illiquid assets, and enhancing yield generation. 
• Synthetic assets offer benefits such as higher income, transparency,... However, they also come with risks.

1. WHAT IS CRYPTO SYNTHETIC ASSET?

The answer to the question "what is synthetic" is relatively straightforward. Cryptocurrency synthetic assets, also known as "synthetic assets" have the ability to replicate the value and performance of real-world assets such as stocks, commodities, currencies, or even other cryptocurrencies, without requiring users to directly own those assets.
They are created through the combination of technologies such as smart contracts and blockchain technologies. Specifically, on platforms like Ethereum, the capability to create decentralized smart contracts is leveraged to generate these synthetic assets.
These synthetic assets offer numerous advantages, including the ability to create flexible leveraged or derivative financial products, accurately track the prices of target assets, and use collateral to safeguard value. 
This widens the scope of the market and assets accessible to DeFi customers, reducing dependence on traditional intermediary organizations.

Crypto Synthetic Asset also known as crypto or synthetic asset | Source:moneymade.io

2. HOW DOES CRYPTO SYNTHETIC ASSET WORK?

In reality, there are several main ways to create synthetic assets, one of which is issuing them as tokens on the blockchain.
All of these methods are designed to leverage the immutability and transparency of blockchain technology. Thus, investors can verify when synthetic tokens are issued, burned, or traded.
However, we can categorize them into two main types: Synthetic tokens supported by centralized services or companies, and those representing different degrees of decentralization. 
A common example of tokens supported by centralized services or companies is USDC or USDT. These stablecoins are issued by companies holding cash or cash equivalents to ensure the value of the tokens.
Another way synthetic tokens operate is through smart contracts. To tokenize an asset on a blockchain that is not its native platform, individuals need to entrust a custodian to either secure or eliminate that asset as collateral in a 1:1 ratio.
The Wrapped ETH smart contract is an example of executing this process, allowing users to convert ETH to WETH and vice versa, ensuring the values of the tokens.

Creating synthetic assets often involves issuing tokens on the blockchain | Source:bitstamp.net

3. TRADITIONAL VS CRYPTO SYNTHETIC ASSETS: WHAT ARE THE DIFFERENCES

Conventional assets refer to tangible or monetary entities such as stocks, bonds, and commodities traded within established financial markets. 
On the other hand, crypto synthetic assets are digital representations created on blockchain technology with the aim of mirroring the value and behavior of these traditional assets.
The key disparity between traditional and crypto synthetic assets lies in their physicality or form—traditional assets exist in a physical or paper-based state, whereas crypto synthetic assets exclusively exist in a digital form within blockchain networks. 
While crypto synthetics offer advantages in terms of accessibility, liquidity, and programmability compared to traditional assets, they also entail distinct risks and complexities.

The key disparity between traditional and crypto synthetic assets lies in their physicality or form | Source: anneconnelly.medium.com

4. HOW MANY TYPES OF CRYPTO SYNTHETIC ASSETS?

Crypto synthetic assets manifest in diverse forms, encompassing synthetic stablecoins, tokenized commodities and equities, leveraged and inverse tokens, and yield-bearing synthetic assets.

4.1. Synthetic stablecoins

Synthetic stablecoins, for instance, are digital tokens designed to replicate the value and stability of fiat currencies like the U.S. dollar or the euro. sUSD, a synthetic stablecoin on the Synthetix platform, exemplifies this category by offering users a stable form of digital cash pegged to the value of the U.S. dollar.

Synthetic stablecoins are digital tokens crafted to mimic the value and stability of fiat currencies | Source: dev.rootstock.io

4.2. Leveraged and Inverse Tokens

Leveraged and inverse tokens, another category of synthetic assets, are designed to amplify or counteract price changes of an underlying asset. BTC3L from Binance Leveraged Tokens, for instance, aims to produce daily returns three times higher than the price of Bitcoin, magnifying both profits and losses.

Leveraged and inverse tokens, another type of synthetic asset, aim to magnify or offset price fluctuations in an underlying asset | Source: binance.com

4.3. Yield-Bearing Synthetic Assets

In the DeFi ecosystem, yield-bearing synthetic assets generate returns for holders through staking or lending, offering opportunities for passive income. An illustration is cDAI from the Compound protocol, where holders can participate in lending operations and earn interest over time, qualifying it as a yield-bearing synthetic asset.

Yield-bearing synthetic assets generate returns for holders via staking or lending, providing opportunities for passive income | Source: tangem.com

4.4. Tokenized Commodities and Equities

Tokenized commodities and equities involve the representation of real-world assets such as gold, oil, and stocks on blockchain networks. An example is sOIL on the Synthetix platform, which tracks the price of crude oil, enabling investors to gain exposure to price changes without physically holding the commodity.

Tokenized commodities and equities represent real-world assets like gold, oil, and stocks on blockchain networks | Source: unicsoft.com

5. CRYPTO SYNTHETIC ASSETS USE CASES

Let's explore a variety of scenarios where Synthetic Assets come in handy:

5.1. Accessing new asset classes

Synthetic Assets provide an easy way to explore new asset classes such as commodities, real estate, art, special collections, etc. This helps diversify investment portfolios beyond traditional stocks and bonds.

5.2. Accessing deep or illiquid assets

DeFi Synthetic Assets can combine less liquid assets or provide ownership percentage in specialized assets. These assets are often difficult for most investors to access directly.

5.3. Enhancing yield generation

Components of Synthetic Assets can be structured to generate higher yields or other benefits compared to holding the underlying assets directly.

5.4. Risk management

Different assets can be combined into Synthetic Assets with custom risk profiles. High or low volatility and other risk indicators can be designed based on investment objectives. Risks are packaged and distributed to meet specific risk tolerance levels.

5.5. Optimizing profit

Characteristics of underlying assets, such as options, interest payments, fees, or other benefits, can be structured within Synthetic Assets to optimize the overall profit potential.

6. BENEFITS OF SYNTHETIC ASSETS

Here are the primary advantages of synthetic assets:

6.1. Accessibility 

Synthetic assets offer access to niche, illiquid, or restricted assets that might be challenging for most investors to reach, expanding the range of assets available for investment portfolios.

6.2. Liquidity

DeFi synthetic assets are typically highly liquid, allowing for swift and easy adjustments of positions. Derivatives and secondary market trading facilitate the liquefaction of underlying asset exposures.

6.3. Diversification 

By consolidating assets into single investment instruments, synthetic assets simplify the creation of diversified portfolios that include alternative assets, enabling exploration of new asset classes and risk profiles.

6.4. Fractional Ownership

Crypto synthetic assets often represent fractional or partial ownership in underlying assets, providing a means to own assets with high costs or minimums through proportional sharing.

6.5. Customization

Components of synthetic assets can be tailored to meet specific investment objectives, allowing for customized exposures, risk levels, return profiles, income needs, and more tailored to individual investors or investment strategies.

6.6. Yield Generation

Certain synthetic assets offer the potential for income, interest payments, fees, or other yields that may exceed what direct ownership of the underlying asset could generate, creating additional yield streams.

6.7. Transparency

DeFi synthetic assets often offer transparency into underlying assets, terms, counterparties, and other crucial aspects that determine risk and return. This transparency aids in understanding and monitoring counterparty risk.

7. RISKS OF SYNTHETIC ASSETS

Here are several significant risks associated with synthetic assets:

7.1. Counterparty Risk

The entities underlying synthetic assets, such as issuers, platforms, or custodians, may default on their obligations, posing a risk to investor capital. It is crucial to select reputable counterparties with a stable financial position.

7.2. Tracking Error

The performance of synthetic assets may not perfectly mirror the underlying assets, introducing additional risk due to deviations from the target. Monitoring and managing tracking errors are essential.

7.3. Complexity

Synthetic assets can be intricate financial instruments with multiple interacting components. Unsophisticated investors may not fully comprehend the associated risks, making them vulnerable to unfavorable outcomes. Synthetic Assets are best suited for investors with the appropriate financial expertise.

7.4. Illiquidity

Despite aiming to provide more liquidity than underlying assets, DeFi synthetic assets may not necessarily be liquid themselves. Extreme market conditions could hinder the easy exit of positions, necessitating the evaluation of liquidity risks for specific assets.

7.5. Legal and Regulatory

The legal framework surrounding synthetic assets is still evolving, with regulations potentially hampering or even banning certain types of synthetic assets. This creates legal risks for investors, requiring careful adherence to regulations based on jurisdiction.

7.6. Expense

While lower costs are a benefit of DeFi synthetic assets, fees associated with service providers, platforms, licenses, and operational expenses still exist. These expenses impact potential returns, necessitating a careful consideration of costs versus direct asset ownership.

7.7. Information Asymmetry

Platforms or sponsors may possess information not available to public investors, creating an imbalance. There is a risk that the interests of counterparties may not fully align with investors. Transparency can help lessen the risk, though it doesn't completely eradicate it.
In that case, you might like Klarda. Klarda is a decentralized financial platform which continuously updates and provides transparent information for owners of cryptocurrency assets on EVM networks.
With the feature name Klarda Portfolio, you can track, evaluate, and optimize your cryptocurrency investment portfolio. Whether you're an experienced trader or new to the cryptocurrency space, Klarda Portfolio conveniently compiles the performance and asset distribution of your portfolio, aiding you in making informed decisions.
In this article, we provided an introduction to the concept of what is synthetics. In conclusion, synthetic assets represent a groundbreaking innovation in the financial landscape, introducing a diverse array of digital instruments that mimic the value and behavior of traditional assets. These assets, built on blockchain technology within the DeFi ecosystem, offer unique advantages such as increased accessibility, liquidity, and customization.