What is a Synthetic Asset

Synthetic assets refer to tokenized derivatives that are pegged to the value of another asset, generally issued on the blockchain. Broadly speaking, wrapped tokens and stablecoins also fall under the subclass of synthetic assets (since they are pegged to the prices of other assets), but what people usually refer to as synthetic assets are derivatives that are pegged to the prices of other assets via oracle price feeds.

Synthetic assets typically require DeFi protocols to help users issue them and exist on a blockchain in the form of standardized tokens. The Synthetix protocol (, formerly known as Havven Payment Protocol ), is the earliest DeFi protocol to invent such derivative trading tools. In theory, any asset whose price can be provided by an oracle can be minted into a tokenized synthetic asset.

For easier understanding, everyone can think of protocols like Synthetix as a large casino, where the game offered is: players use chips to simulate stock and crypto trading.

How does synthetic asset work? What is the principle of synthetic assets?

The operation of synthetic assets involves two steps: asset collateralization (minting) and trading. To facilitate understanding, we will explain from the perspectives of two types of market participants.

Minter (borrows and bears debt)

What to do: Over-collateralize a certain asset (their native asset/ETH) in the protocol to mint synthetic stablecoins, for example, over-collateralize 750% of $SNX to mint $sUSD, which is similar to a collateralized loan but only allows borrowing stablecoins like sUSD. After issuing sUSD, the system records a ledger for the minter: how much debt they owe, what percentage of the total receivables (total debt) they occupy, and the value of the collateral.

What can be obtained after collateralization:

• Some synthetic stablecoins;
• Earn certain transaction fees (proportional share);
• Bear certain variable debts.

What can be done after obtaining:

• Become a synth trader, speculate on other synthetic assets or hedge their debt risk (see below);
• Become a market maker in the OTC synth market;
• Sell directly on the OTC market.

Minters like Alice obtain chips (sUSD equivalent) through official casino channels, while the casino’s way of issuing chips is by over-collateralizing its own stocks to mint. The system keeps accounts for minters, specifying how many chips they create and their share. Meanwhile, the total value of collateralized stocks must be at least 7.5 times the value of the chips. To incentivize players to use official channels, the casino distributes transaction fees proportionally to minters.

Example: Alice has $75,000 worth of SNX, pledges it to Synthetix, and mints 10,000 sUSD. Synthetix then records: assets $75,000 SNX, liabilities $10,000 sUSD, collateral ratio 750%. Alice has started earning fees proportionally. She can also become a trader, trading sUSD for other synthetic assets, or hold her position, or choose to sell sUSD on the OTC market, such as providing liquidity in Uniswap for sUSD/USDC.

Risks: All minters share a constantly changing total debt pool. If the total debt keeps rising, the debt allocated to each account also increases, risking liquidation.

All synthetic assets together form a large chip pool, whose value should be exactly equal to the total debt value on the ledger, hence called the debt pool. It’s not hard to see that the total debt fluctuates with the number, types, and pegged prices of synthetic assets. Meanwhile, the total collateral value should always be maintained at at least 7.5 times the total debt pool. The changes in the debt pool are proportionally shared among all minters, and each time the system directly updates their debt balance (even though the initial borrowing amount is fixed).

In reality: When minting or burning sUSD, the system issues/destroys special tokens representing their debt shares to track the debt pool. A minter’s debt share is calculated as their debt token balance divided by the total supply of debt tokens.

When their debt balance decreases, their collateral ratio increases, allowing the minter to mint new chips to lower the ratio. When their debt increases, their collateral ratio decreases, and they can destroy some chips or add collateral to raise the ratio. If the collateral ratio becomes too low and no timely action is taken, the system will forcibly liquidate.

Therefore, Alice’s $10,000 debt balance is variable. Suppose the total debt pool is worth $20,000, and the value of sBTC synthetic asset increases by $5,000, raising the total debt pool to $25,000. Since Alice’s debt share is 50%, she must share half of the new debt, i.e., $2,500. After the increase, Alice’s new debt balance becomes $12,500. Alice incurs a net loss of -$2,500. If Alice does not add collateral or burn some sUSD, her collateral ratio will fall below the required 750%, but still above the liquidation threshold.

The difference from traditional casinos is the counterparty: traditional casinos profit from player-to-player bets, taking a commission. In this DeFi protocol, the assets of stakers are against the overall volatility of all synthetic assets, so when the overall market rises, the house paying out to players is actually the minters themselves.

Using over-collateralization for two reasons:

• Collateral assets are highly volatile, and over-collateralization reduces the risk of insufficient collateral value. If the collateral value drops too much, the system will liquidate the collateral before reaching the minimum requirement.
• Total debt is highly volatile. Even if collateral assets are stable, rapid increases in total debt can risk insufficient collateral.

Synth traders

Conditions: Hold synthetic assets, so minters can directly become traders.

Players who do not want to go through official channels to get chips (and do not want to bear debt) can buy chips OTC directly. Some synthetic assets have liquidity in external AMM pools (such as sUSD/USDC in Curve, sETH/ETH in Uniswap), which can be purchased directly.

What can they do:

• Speculate on synthetic assets to earn price differences.

Advantages:

• Reduce friction costs compared to trading spot assets. If you want to speculate on gold but do not want to hold physical gold, because holding physical gold involves many hassles and costs—considering specific trading venues, storage costs, transportation, security risks—you can choose to trade synthetic gold $sXAU tokens, which track gold prices via Chainlink oracles and perform in line with physical gold. If you want to go long BTC, short ETH, or go long XRP in complex combinations, without using centralized exchanges, buying synthetic assets like sBTC, iETH, sXRP, etc., greatly reduces operational friction.

• No slippage when trading synthetic assets. Since prices are derived from oracles, holders do not need to worry about liquidity issues, and trades do not incur slippage.

Trading process: Real synth trades do not occur directly between players but involve system accounting, burning, minting, and re-accounting. All prices are from external oracles; synths themselves do not have independent markets.

With chips (sUSD), players can buy stocks or crypto assets by paying chips, based on external real-world prices (from oracles). When players think their stocks have appreciated enough for profit-taking, they can exchange their tickets back for chips. The system updates accounts internally.

Example: Alice has 10,000 sUSD and wants to buy all sETH. The system first burns Alice’s 10,000 sUSD ➡, updating total sUSD supply (-10,000) ➡, then gets ETH exchange rate from oracle (say, $1,000) ➡, charges fees ➡, mints approximately 10 sETH and sends to Alice’s wallet ➡, then updates total sETH supply (+10).

Hedging debt fluctuation risks (for minters only)

Synthetix has a special synthetic asset that tracks the total debt pool index, allowing minters to hedge against losses caused by rising total debt.

Common synthetic asset protocols and their assets:

• Synthetix: on Ethereum, requires over-collateralized ETH (150%) or native token SNX (750%) to mint synthetic assets.
• sUSD, sBTC, sETH, sBNB, etc.: pegged to fiat or crypto prices.
• iBTC, iETH, etc.: inversely pegged to crypto prices (equivalent to 1x short).
• sXAU, sXAG, etc.: synthetic assets pegged to commodities.
• Linear Finance: over-collateralized native token LINA (500%) to mint synthetic assets.
• lUSD, lADA, etc.
• Mirror Protocol: on the original Terra Classic chain, built by Terra Labs, over-collateralized UST (150%-200%) to mint mAssets, generally linked to real-world assets. However, in August 2022, Band Protocol announced the permanent suspension of price feeds for Terra Classic, including Mirror Protocol. Without oracle price feeds, the protocol ceases operation.
• mAAssets: usually linked to stocks, e.g., mAAPL, mTSLA.
• Synthetify: on Solana, similar to Synthetix, over-collateralized native token SNY to mint synthetic assets.
• xSOL, etc. **$INIT **