Synthetic assets are digital assets that derive their value from an underlying real-world asset. They are transforming the cryptocurrency industry by providing new ways to gain exposure to diverse asset classes and risk profiles. As synthetic assets become more mainstream, they are changing the game for investors by offering a range of benefits as well as risks. This blog explores the key concepts around synthetic assets, their importance in crypto, benefits, risks, and use cases. We will also discuss how they are impacting the industry, and examples of synthetic assets in the market today.
What are Synthetic Assets
Synthetic assets are digital assets that derive value from underlying real-world assets. Created through financial contracts and derivatives that replicate the risk/return profile of physical assets. Easily tradeable and adjustable investment instruments that allow exposure to diverse assets. Bundled packages of an asset’s attributes (risks, returns, income, etc.) for simplified investing. Available for assets that are otherwise illiquid, inefficient to hold directly, or restricted access. Often issued on blockchain platforms for transparency, security, fractional ownership, and programmability.
Changing how investors access and interact with a wide range of assets in the financial markets. Enabling new levels of customization, liquidity, and portfolio optimization for many types of assets. Both opportunities and risks require close monitoring of counterparty credit risk, tracking errors, and other key metrics. Transforming capital markets by disintermediating access to assets and poised to greatly expand the investable universe.
Importance of synthetic assets in the crypto industry
Synthetic assets are important in the crypto industry for several reasons:
- They expand the range of assets available for investment. Synthetic assets provide exposure to real-world assets like stocks, commodities, currencies, bonds, etc. This allows crypto investors to diversify their portfolios.
- They enable niche and illiquid assets. Crypto synthetic assets can be created for almost any asset, even those that are too niche, illiquid, or risky to invest in directly. This opens up more opportunities for risk-seeking crypto investors.
- The liquid and adjustable nature of synthetic assets makes them easier to use for rebalancing risk across a crypto portfolio. Investors can quickly adjust exposures as needed.
- Synthetic assets provide an on-ramp for accessing new types of assets with typically lower costs, lesser paperwork, and more flexibility than traditional investments.
- They advance DeFi and open finance. Synthetic assets are a key building block of decentralized finance (DeFi) and open fractional ownership of assets. They help bring more assets and investment strategies onto blockchain-based platforms.
- The new possibilities around bundling, customizing, and automating assets are spurring innovation in synthetic and digital assets. New products are being created to meet investor demands.
- Tools for selecting, structuring, monitoring, and optimizing synthetic assets provide more sophisticated options for actively managing crypto investment portfolios.
- Synthetic assets can provide income streams, options, and other benefits that may not be possible through direct asset ownership alone. More ways to generate yield are opened up.
Benefits of Synthetic Assets
Here are the key benefits of synthetic assets:
- Accessibility. Synthetic assets provide access to niche, illiquid, or restricted assets that would otherwise be difficult for most investors to access. A much wider range of assets can be included in investment portfolios.
- Liquidity. Defi synthetic assets are typically very liquid, allowing positions to be adjusted quickly and easily. Underlying asset exposures can be liquefied through derivatives and secondary market trading.
- Diversification. By bundling assets together into single investment instruments, synthetic assets make it simpler to build diversified portfolios that include alternative assets. New asset classes and risk profiles can be achieved.
- Fractional ownership. Crypto synthetic assets often represent fractional or partial ownership in underlying assets. They provide a way to own assets that have high dollar costs or minimums through proportional sharing.
- Customization. The components of synthetic assets can be customized to meet specific investment objectives. Tailored exposures, risk levels, return profiles, income needs and more can be designed as needed for individual investors or investment strategies.
- Yield generation. Some synthetic assets provide potential for income, interest payments, fees or other yield that could exceed what might be generated through direct ownership of the underlying asset. Additional yield streams can be created.
- Transparency. Defi synthetic assets often provide transparency into the underlying assets, terms, counterparties, and other key aspects that determine risk and return. Counterparty risk can be better understood and monitored.
- Low costs. Synthetic assets frequently have lower costs than directly purchasing and managing the underlying assets. Fees, expenses, minimums, and other frictions are reduced through bundling and passing through attributes of the underlying assets.
- Market flexibility. It is easier to adjust synthetic asset allocations and exposures based on market conditions, relative valuations, or other factors. Positions can stay optimized over time based on market dynamics.
- Automation. Some crypto synthetic assets provide features for automation, algorithmic management, rebalancing, and portfolio optimization based on selected guidelines or parameters. Automated management is more feasible.
Risks of Synthetic Assets
Here are some key risks to consider with synthetic assets:
- Counterparty risk. The counterparties underlying a synthetic asset like an issuer, platform, or custodian could default on their obligations, putting investor capital at risk. Care must be taken to choose reputable counterparties with a stable financial position.
- Tracking error. The performance of a synthetic asset may not perfectly track the underlying asset, introducing additional risk due to deviation from the target. Tracking error needs to be properly monitored and managed.
- Complexity. Synthetic assets can be complex financial instruments with many interacting components. The risks may not be fully understood by unsophisticated investors, leaving them vulnerable to unfavorable outcomes. Only investors with relevant financial experience should consider them.
- Illiquidity. Although Defi synthetic assets aim to provide more liquidity than underlying assets, they are not necessarily liquid themselves. Extreme market conditions could temporarily or permanently reduce the ability to exit positions easily. Liquidity risks should be evaluated for the specific asset.
- Legal and regulatory. The legal framework around synthetic assets is still evolving. There is a possibility of regulations hampering or even banning certain types of synthetic assets, creating legal risks for investors. Regulation needs to be followed carefully based on jurisdiction.
- Expense. While lower cost is a benefit of Defi synthetic assets, there are still fees associated with service providers, platforms, licenses, and other operational expenses. It is deducted from potential returns. Expenses should be weighed against any cost savings versus direct asset ownership.
- Information asymmetry. Platforms or sponsors may have access to information not available to public investors, creating an imbalance. There is a risk of the interests of the counterparties not being fully aligned with investors. Transparency helps mitigate but does not eliminate this risk.
- Incentive misalignment. The economic incentives underlying a synthetic asset may not properly incentivize the counterparties to operate the asset in the best interests of investors. Misalignment could lead to unfavorable outcomes, highlighting the importance of evaluating counterparty incentives before investing.
- Manipulation. There is a small possibility of manipulation or even fraud with complex financial products like some synthetic assets. Proper due diligence and consideration of regulatory oversight can help detect signs of manipulation but do not eliminate the risk completely. Trustworthy counterparties and transparency reduce this risk.
Synthetic Assets Use Cases
Here are some common use cases for synthetic assets:
- Gaining exposure to new asset classes. Synthetic assets provide an easy way to gain exposure to asset classes like commodities, real estate, fine art, collectibles, etc. that can diversify a portfolio beyond traditional stocks and bonds.
- Accessing niche or illiquid assets. Defi synthetic assets can bundle together illiquid assets or provide fractional ownership in niche assets. These assets are otherwise difficult for most investors to access. More opportunities are opened up.
- Enhancing yield generation. The components of synthetic assets can be structured to produce higher income yields or other benefits than holding the underlying assets directly. Additional sources of return and yield can be achieved.
- Managing risks. Different assets can be combined into synthetic assets with customized risk profiles. Higher or lower volatility and other risk metrics can be engineered based on investment objectives. Risks are bundled and distributed to meet specific risk tolerances.
- Optimizing returns. The attributes of underlying assets like options, income payments, fees or other benefits can be structured within synthetic assets to optimize total return potential. Alternatives to maximize returns for the risk budget can be evaluated.
How Synthetic Assets are Changing the Game
Synthetic assets are fundamentally changing investing in several important ways:
- Democratizing access. Synthetic assets make a wider range of assets accessible to more investors, not just those with large portfolios or high net worth. Nearly any investor can gain exposure to new asset classes and opportunities.
- Enabling customized exposure. It provides tools for easily customizing exposure to assets based on specific investment objectives, risk tolerances, return needs, etc. One-of-a-kind positions can be designed to meet unique goals.
- Fostering DeFi growth. Decentralized finance applications are being built on synthetic assets, driving significant growth in open finance options. New ways of investing, lending, borrowing, trading and more will continue proliferating. Interoperability across DeFi platforms is enhanced.
- Facilitating portfolio rebalancing. Frequent rebalancing of allocations across assets, risks, sectors, factors, and other dimensions is simplified using synthetic assets. Optimization of a portfolio is an ongoing process that aligns with changing needs and opportunities.
- Promoting experimentation. With lower costs, risks, and barriers to entry, synthetic assets allow investors to experiment with new investment strategies.
Examples of synthetic assets
Here are some examples of synthetic assets:
- Synthetic stocks: Represent equity ownership in companies. Can gain stock exposure without direct purchasing or shorting of shares.
- Synthetic bonds: Provide fixed income returns and characteristics of bonds. Can access bonds that are otherwise restricted or have lower denominations.
- Synthetic commodities: Bundle together commodities like oil, gold, crops, etc. into single assets. Allows commodity diversification and Customized commodity allocations.
- Synthetic real estate: Represents fractional ownership in real estate properties. Enables real estate investing with lower capital requirements and more diversification.
- Synthetic DeFi assets: Enables DeFi strategies and protocols around lending, borrowing, trading, and other financial primitives at a lower cost. Experiments with DeFi can be done with greater efficiency.
- Crypto synthetic assets: Bundles several cryptocurrencies or crypto sectors together into one asset. Allows easier and more efficient diversification across cryptocurrency market risks with a single trade.
Conclusion
Synthetic assets are a new frontier in the world of finance and the crypto industry. These assets offer a range of benefits, including increased accessibility, flexibility, and diversity. However, they also come with some risks, such as potential liquidity issues and counterparty risk. Despite these challenges, the use cases for crypto synthetic assets are vast and varied, including everything from tokenizing real-world assets to creating entirely new financial instruments. As the industry continues to evolve, it’s clear that synthetic assets are changing the game and paving the way for a more decentralized, accessible, and innovative financial future.
