Synthetic Stocks: The Real Deal, Or Just A Fad?

As the popularity of Decentralised Finance (DeFi) proliferates, blockchain developers seek to provide new opportunities for investors using a novel structure of finance. Synthetic stocks, which grant users exposure to numerous assets while eliminating traditional barriers to entry, are among the latest forms of such innovation. In essence, synthetic assets refer to the tokenized clone of traditional financial assets. This ‘clone’ rests solely on a blockchain, however. Generally, synthetic assets can represent tech stocks, currencies, commodities, and even precious metals. Since they are blockchain-based, DeFi has become a home to these assets. In fact, the integration of blockchain technology which brings automation and removes the need for intermediaries is what makes synthetic assets so innovative. Courtesy of the blockchain, traders can enjoy exposure to traditional assets without the need to worry about the drawbacks a centralised platform brings. In addition, the decentralised nature of DeFi largely removes the troubles commonly emanated from regulatory bodies. Do Kwon, CEO and co-founder at Terraform Labs, the company behind Mirror Protocol, emphasised the nature of the quickly developing space:

“DeFi is so powerful in unlocking financial services for disenfranchised people around the world. It’s better to move fast and break things.Waiting for fragmented regulatory frameworks to crystallise before innovating is counterintuitive.”

How Synthetic Assets Work

Similar to derivatives in traditional finance, synthetic assets are digital assets with their price pegged to other real-world assets—such as TSLA or AAPL. Also referred to as “synths,” these assets track and provide the returns of traditional assets without requiring access to the real-world asset. 

Since synthetic stocks are derivatives, their value is derived from an underlying asset through smart contracts. Therefore, one can use these assets to trade the movement of price and value of traditional assets.Synthetic assets are typically created in the form of ERC-20 smart contracts that run on the Ethereum blockchain. They are different from options and other forms of traditional derivatives in that they tokenize the relationship between the derivative product and the underlying asset. 

On the other hand, traditional derivatives are financial contracts that create terms for an asset and its price. This allows DeFi users to leverage synthetic assets in the use of various trading strategies. For instance, hedging, which is a popular strategy in binary options trading, allows users to offset losses and manage risks by taking positions in derivatives. Such strategies are also used in DeFi's world of synthetic assets.

Advantages of Synthetic Assets

Synthetic assets carry a number of unique advantages. While there are no specific citizenship requirements to participate in the stock market, there are certain needs that investors must satisfy. Non-US persons must provide identification documents, pass Know Your Customer (KYC) screening, and comply with a number of laws that are intended to protect US interests. 

However, synthetic assets feasibly provide investors of any location or jurisdiction exposure to the price action of stocks, commodities, and currencies. To trade these tokens, users would hardly need any of the requirements to enter the US equities market. This makes synthetic assets a favourable alternative for foreign investors experiencing barriers to entry. Moreover, synthetic assets are openly tradeable and transferable, meaning anyone can send and receive them using standard crypto wallets. The only need is access to the internet and a bit of technical know-how. Since DeFi is always on, synthetic tokens can be traded 24/7. This is in great contrast to traditional markets, where trading is limited to specific days and specific hours.

In addition, with synthetic assets, there are no central party restrictions or risks. This is in stark contrast to the recent reddit-fueled GME drama when thousands of retail investors were unable to sell select securities due to restrictions imposed by stock brokers such as Robinhood. In such cases, these controlling parties can halt or even execute trades—keeping their primary interest in mind, without prioritising the trader.

Disadvantages of Synthetic Assets

Probably the most noticeable drawback of these tokens is that they never grant ownership of the underlying asset. A trader can earn profit and get exposure to the price of an asset, but this is merely a representation of the actual real-world asset. Therefore, synthetic assets holders do not obtain shareholder rights, votes, or access to dividends (if applicable).In addition, at times, scalability might also become an issue since DeFi is largely in an experimental phase. When minting synthetic assets, users should strive to choose the most suitable blockchain.

Despite being powerful, Ethereum is still prone to scaling issues and network congestion. Though they are typically much faster, transactions can take up to four hours to process via Ethereum, with average transaction fees breaching $20 throughout a number of days in early 2021. This is in stark contrast to the traditional payments world where credit card payments are facilitated seamlessly, showing the adolescent state that blockchain technology continues to remain in.

Lastly, DeFi is very vulnerable to hacks and exploits. Despite disrupting legacy finance, decentralised finance is still in the preliminary stages. In other words, no matter how cautious a project might be, a single breach can lead to the loss of all funds. One recent hacker stole more than $600 million in digital assets—though they were later returned as the “white hat” hacker prioritised the development of the network over his own riches.

Still, all of this is also true with synthetic stocks, which are—after all—a DeFi project.

Popular Synthetic Protocols

The most popular synthetic protocol in terms of total value locked is Synthetix, with over $1.8 billion in total value locked. Synthetix, which is the biggest derivatives protocol on the Ethereum blockchain, was the first project to introduce synthetic assets and bring this innovation to DeFi.

Synthetix reflects assets in the form of “sAssets” on the blockchain. As of now, the platform supports over 30 synths which range from cryptocurrencies, fiat currencies, indexes, and commodities like gold. The project also aims to add synthetic DeFi tokens for popular protocols like Aave, Uniswap, Polkadot, and Compound to its list of offerings.Following Synthetix, the second most popular synthetic asset protocol is Mirror, with over $1.7 billion in TVL. Mirror Protocol, which aims to grant everyone intuitive access to global markets, mirrors traditional assets in the form of “mAssets.”

These mAssets are a representation of the real-world asset that is pegged at a 1:1 ratio. Currently, the protocol reflects 14 real-world stocks on the blockchain. These tokenized assets include mTSLA, mTWTR, mNFLX, mAAPL, mAMZN, mGOOGL, mMSFT, and more. Other more prominent synthetic asset protocols include Uma, DAFI, and DEUS. Each of these projects offers a range of different synths, including stocks, currencies, commodities, and more. 

Conclusion

While there are many advantages to synthetic assets, there are also many downfalls and risks. Perhaps the most likely user of synthetic assets would include an individual who faces significant trouble when trying to access traditional securities through a broker such as Robinhood. For the investors who do not face such barriers to entry, it will likely take some time before the benefits of synthetic assets outweigh their risks—which are not entirely present in the traditional financial realm.