A brief analysis of the potential and risks of crypto synthetic asset platforms such as UMA and Synthetix

Written by Justin Mart, Coinbase Ventures

Most decentralized finance (DeFi) applications today are like replicas of traditional financial products. Tokens can be exchanged, borrowed or loaned in the money market, and even traded on exchanges using margin and leverage.

But DeFi is far from that. Blockchain is a global open platform that essentially carries programmable value assets. Sooner or later, DeFi will produce truly unique products that have no connection with the traditional world.

Let’s look at one possibility: synthetic assets.

What are synthetic assets?

Synthetic assets are a new type of derivative. Derivatives are assets whose value is derived from a different asset or benchmark. Just like futures and options, buyers and sellers trade contracts that track the future price of an asset.

DeFi has made some adjustments on this basis: "Synthetic assets" are digital tokens of derivatives. Derivatives are customized financial contracts that obtain positions in specified assets or financial products, and synthetic assets are the tokens of these derivatives.

Therefore, synthetic assets have the following unique advantages:

• Permissionless creation: Blockchains like Ethereum allow anyone to build synthetic assets

• Easy to use and transferable: Synthetic assets can be freely transferred and traded

• Global liquidity pool: The global nature of blockchain itself allows anyone in the world to use

• No centralization risk: no centralized medium with control privileges

A few examples

Synthetic assets tokenize physical assets and bring them into the blockchain world, giving them all the advantages mentioned above. Imagine that anyone in the world can buy a token that tracks the S&P 500 index and use it as collateral in other DeFi products such as Compound, Aave, MakerDAO, etc. This model can be extended to gold or rice, TSLA stocks, SPY index, Treasury bonds, and so on.

There are also refreshing new financial instruments that are no longer out of reach, such as the pop culture market, meme culture market, personal token market, etc., which can all be traded through synthetic assets.

Considering that any asset can be synthesized and introduced into the blockchain, the potential market size is huge. For reference, the global stock trading market size reached 32.5 trillion in the first quarter of 2020. In theory, part of this market can be turned into synthetic assets, and anyone can trade freely in the global liquidity pool without restrictions.

Special case: Trading shit

At the end of 2019, a few developers came up with an idea and released a prototype: What if there was a synthetic asset that could track the amount of urination and defecation on the streets of downtown San Francisco? More urination and defecation on the streets, token holders profit. Less urination and defecation, token issuers profit. Use an oracle to report the amount of urination and defecation.

This token market can incentivize the local government of San Francisco. If the San Francisco city government issues "shitcoins", it will incentivize the government to clean the streets and make a profit. On the contrary, if the streets do not become cleaner, citizens who buy "shitcoins" can at least make a profit and compensate for the negative emotions.

This is just a simple example of the potential of synthetic assets and the market where “everything can be tokenized.”

The most common synthetic asset platforms

Universal Market Access (UMA)*

UMA is a synthetic asset protocol that allows anyone to recreate traditional financial products, novel crypto assets, and more.

On the UMA platform, two counterparties can use and create arbitrage financial contracts without permission. The contracts are secured by economic incentives (collateral) and executed through Ethereum smart contracts. The characteristics of Ethereum's global open blockchain greatly reduce the barriers to entry and bring about a "universal market use" protocol.

Currently, UMA community members are focusing on first building a tokenized yield curve (such as yUSD, Chain News Note: UMA's yUSD product has now been renamed uUSD).

In addition, anyone can create any type of financial contract on UMA. For example:

• Crypto asset contracts: crypto asset futures tokens, yield curves, perpetual swaps, etc.

• Tokens that track crypto or DeFi metrics: e.g. BTC market share, DeFi TVL chart, DEX market share, or any other metric

• Traditional financial products: US and global stocks (TSLA or APPL tokens), private pension plans, insurance and annuity products

• Novel products: "Shit" trading, pop culture, meme culture, etc.

UMA is positioned as a novel and creative "long-tail" financial market protocol. Like the "shitcoin" transaction, this contract can fundamentally improve the incentive scheme. This is innovation from zero to one.

Note: UMA is one of the companies invested by Coinbase Ventures

Synthetix

Synthetix is ​​a protocol that creates global liquidity for Ethereum synthetic assets. Synthetix facilitates the generation and trading of a wide range of asset types, including crypto assets, stocks, and commodities, all on-chain.

Tokens that track the price of such assets can be bought and sold in the Synthetix ecosystem, mixing collateral, staking, and transaction fees. Importantly, the Synthetix ecosystem has become governed entirely by a DAO structure, with the SNX token at the core of the entire ecosystem. SNX can be staked to generate collateralized synthetic assets while accumulating transaction fees. SNX can also be used for DAO community governance.

As a leading synthetic asset platform in the DeFi ecosystem, Synthetix has issued more than $150 million in synthetic assets, mainly the platform's stablecoin sUSD, with a market value of nearly $100 million.

Synthetix currently mainly provides synthetic assets of sETH and sBTC crypto assets, as well as sDeFi and sCEX index tokens that track a basket of assets. The success of synthetic assets on the platform is mainly due to its unique market design, where assets are traded based on oracle quotes, so there is no slippage in buying and selling.

Other platforms

There are many other synthetic asset platforms that have made some choices and are being developed according to their own unique design concepts, such as Morpher, DerivaDEX, FutureSwap, DyDx, Opyn, Hegic or Augur.

Note: DerivaDEX is one of the companies invested by Coinbase Ventures

in conclusion

As the Ethereum and DeFi ecosystem matures, synthetic assets become possible as new primitives. Now is just the beginning, and don’t ignore the inherent risks:

• Smart contract risks: Smart contract vulnerabilities can be exploited, and synthetic assets are the main target of attack

• Governance risk: Most platforms are governed by centralized participants and are relatively unproven at scale.

• Oracle risk: Many synthetic assets rely on oracles to function properly, which brings its own trust assumptions and failure modes.

• Platform risk: Ethereum and other underlying blockchains will encounter capacity issues. The more efficiency is needed, the busier the network may be, and the worse the situation will be. Inefficient fee markets, front-running transactions or griefing attacks will all become problems.

But there is always a balance between potential and problems. Synthetic assets represent the future of the existing financial market towards an open and globalized future, and are themselves important primitives. Going further, we will see the innovation behind the "everything can be tokenized" market.

We have the potential to use these primitives to build entirely new financial markets that fundamentally shift incentives and change the way we live.