01 Overview of Synthetic Assets

Two types of synthetic assets

There are two types of synthetic assets in Crypto:

• One is the copy or mirror image of assets, that is, the assets themselves exist, but are chained or copied on another chain.

• Another kind of synthetic asset is to directly create an asset that did not exist in the past. It can be a synthetic index, it can be the capitalization of cash flow, such as computing power contract tokens, or the tokenization of risk measurement.

Asset replication: mainly solves the problem of cross-platform usability, such as the accessibility of stocks, the demand for cross-chain assets, etc.

Direct synthesis: Provide returns/risk exposures that have market demand but have not yet been met, and this exposure is directly tokenized.

main mechanism

The main operating mechanisms of synthetic assets are: oracle machine, liquidator, price linkage, synthesis (mint) and destruction (burn).

The oracle machine has two functions: one is to quote assets, such as Synthetix's synthetic asset transaction price. The second is to provide price instructions for debt monitoring. When the debt collateral is insufficient (for example, the ratio of loaned debt to collateral is lower than a certain threshold), the liquidation procedure can be initiated. For example, the oracle block of MakerDao is to determine whether the CDP is safe and whether it will trigger liquidation due to price changes.

A liquidator is a type of role that will liquidate a problematic loan. For example, when the CDP ratio is lower than the threshold, the external liquidator can directly intervene, deposit insufficient Dai, and obtain a part of the collateral ETH at a discount. The liquidation process is more profitable, and there will be competition among liquidators. Synthetix did not have a liquidation mechanism earlier, and later added a liquidator mechanism in the Altair upgrade in 2020. The liquidator mechanism provides a price guarantee, and also forms a warning function, so that the CDP mortgage party has the motivation to maintain the mortgage rate level, and the lost CDP (such as the loss of the private key) can be cleaned up in time to maintain the overall level. There are also many types of liquidation mechanisms. For example, the UMA protocol adopts a price-free liquidation mechanism. The oracle machine will only be used when there is a dispute. It is similar to the final referee of the dispute mechanism, because tokens are also price-free. simplifies the use of oracles.

Commonly used price-linked mechanisms include: over-collateralization, automatic liquidation of problematic CDPs, supply adjustments, emergency shutdowns, etc.

The process of synthesis and destruction is relatively straightforward, that is, staking coins, returning coins and ending low-voltage positions.

give upgive up

Asset replication only reproduces the price performance of assets, and basically gives up other rights to assets. For example, voting, governance, dividends, etc. of stock synthetic tokens, interest of bond synthetic tokens, debt claims, etc. As far as stocks are concerned, as many stocks as a company issues, voting rights are divided into as many shares. Synthetic assets create synthetic stocks, and voting rights cannot be distributed to synthetic assets. This is a general problem with synthetic assets of the Asset Copy class.

At present, this is within the acceptable range: 1. The underlying assets themselves are high-risk assets, and users only care about price fluctuations; as far as stocks themselves are concerned, few users focus on dividends and governance, and users are even less concerned after converting to crypto synthetic assets. Care; 2. The intervention of DeFi, giving up some rights will be compensated by other mechanisms, such as stable currency can have interest, because it is generated from real lending, and the interest is still high, while the US dollar is almost interest-free. Synthetic tokens can also be mortgaged. For example, BTC is a zero-yield asset, but wBTC can participate in mining.

Directly synthetic assets do not have this concern, and the attached rights are constrained by the agreement. For example, computing power tokens require returns on computing power, and risk-graded tokens are the required returns on risks. Directly synthetic assets represent various benefits that have not been and will be capitalized in the blockchain world.

Risk 2 - Price decoupling

Synthetic assets cannot truly peg the price of the original asset, such as the decoupling of the stable currency to the US dollar, and the synthetic stock is separated from the original stock price. This requires the built-in peg mechanism of the protocol to solve it, and it is all in the experiment.

For example, the peg mechanism used by stablecoins:

• USD-collateralized stablecoins rely on confidence in the US dollar, as well as a two-way arbitrage mechanism for redemption and redemption

• Encrypted asset-backed stablecoins rely on confidence in over-collateralization and liquidation mechanisms

• Algorithmic stablecoins rely on supply regulation and economic incentives

The NF mechanism is a part, and the confidence and sense of participation brought by the mechanism are the most important. The problem faced by many algorithmic stablecoins is that the function of regulating supply fails when the price is too low, because the confidence of participation is greatly reduced.

The risk of price decoupling always exists, because these mechanisms are not tightly coupled, so it is normal to be attacked. The most common attack dimension is oracle attack. For example, Synthetix suffered an oracle attack in 2019. Combining synthetic assets and DeFi protocols that rely on oracle machine quotes are at risk of being attacked by oracle machines.

Risk 3 - Collateral

There are two main risks of collateral: one is being liquidated, and the second is the opportunity cost of overcollateralization.

The seller of the synthetic asset, that is, the borrower of the synthetic asset, needs to deposit the underlying asset accepted by the agreement into the smart contract. Because many synthetic asset agreements are connected to the liquidation mechanism, when a certain mortgage ratio cannot be completed, it will be liquidated. Of course, a debt contract like CDP also bears the risk of parameter changes. For example, the holding of CDP requires a stable fee rate, and this fee rate is changing. It is unpredictable through DAO decision-making. Or liquidation penalties, changes in the debt ceiling, etc.

More risks come from opportunity costs, because most of the collateral is over-collateralized, and over-collateralized is equal to locked-in liquidity. After liquid mining comes out, the collateral has the potential to be mined, and there will be an annualized rate of return of tens of thousands. As a seller of synthetic assets, you need to calculate the opportunity cost. The agreement party also uses mining to give rewards while staking. For example, in Synthetix, pledge SNX to generate sUSD, and then you can get the transaction fee share of Synthetix.Exchange and the inflation reward of SNX (similar to staking of PoS chain)

Advantages of Synthetic Assets

• Censorship-free issuance paradigm: anyone can issue a specific synthetic asset under an off-the-shelf protocol

• Global liquidity: Synthetic assets can be traded directly on exchanges, and decentralized exchanges provide a convenient place to directly realize point-to-point transmission

• Low-friction transactions: Synthetic assets enjoy the same low costs and constraints as other crypto assets

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02 The role of synthetic assets - to meet specific and practical needs

The function of traditional synthetic assets is very simple and direct, it is to meet the risk exposure needs of customers, which usually cannot be provided by standard products. The basic design is the addition of multiple derivatives, or an underlying asset plus derivatives, and most of them are customized by investment banks. That is to say, there is demand first, and investment banks use the tools at hand to help customers create a synthetic asset. For example, in the creation of synthetic convertible bonds, ordinary debts + bullish options are synthesized into a fitting convertible bond. A few examples of traditional synthetic assets may be instructive for Crypto synthetic assets.

Alibaba's Synthetic Stock

Alibaba was listed in the United States in 2014. Due to various reasons, investment bank Merrill Lynch failed to participate in the IPO process. So Structured Products created a derivative product that allowed clients to "acquire" shares in Alibaba even before it went public. This product is a synthetic product. The long position in its components is the stock of Softbank, and the short position is the stock of other listed companies held by Softbank, such as Sprint, Yahoo Japan, KDDI, etc. The net exposure of this product is Alibaba stock + some small stocks. In this way, customers can obtain Alibaba's pre-IPO valuation in advance. Moreover, investors have also benefited a lot. After the listing, they can unlock this product and buy the underlying shares. ML also earns considerable income due to complex operations and product design.

iShares A50 Index Fund

Before the opening of RQFII, international investors who invested in the mainland China index had to go through iShares A50. Although this is an ETF, it is also a synthetic product. The A-share connection product (CAAP, a class of derivatives) used fits the A50 The index fills the gap that overseas investors cannot access the A-share index. Later, due to the opening of RQFII, ETFs that can really invest in stocks appeared, and their competitiveness became weaker. However, at a certain point in time, it was a very necessary and only investment method.

CDS（Credit Default Swap）

A broader example is credit default swaps CDS. Buyers and sellers reach an agreement on a specific series of bond default events. The buyer of the default swap pays a certain "premium" to the seller. Assuming credit risk, the buyer will sell the defaulted bond to the seller at face value. This gives buyers the motivation to go long on risky assets and avoids credit risks. Because of the direct avoidance of credit default risk, CDS has been widely welcomed by the market since it solved a very necessary pain point, which reflects the ability of product design and the precision of market fit.

Therefore, synthetic assets can be created without demand, but the real vitality is the creation with demand. We can divide the role of synthetic assets into the following levels:

• Aggregation of liquidity and capital: Synthetic assets can create standardized products, and standardized products mean that they can carry large amounts of liquidity, such as synthetic indices.

• Composability: Due to the standardization of tokens, it means that they can be divided and combined, and the synthetic tokens can be overlapped to form more diversified products, such as creating a reverse protection token against fluctuations in computing power.

• Reduce costs: Standardized protocols can reduce costs and reduce transaction friction.

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03 The main direction of synthetic assets

3.1 The Largest Synthetic Assets - Stablecoins

Stablecoins are the earliest type of synthetic assets, but the anchored asset is a special kind of currency. The mechanism of the stable currency is relatively simple. There is almost no need for a stable mechanism to mortgage the US dollar. If it is a digital asset, an over-collateralization mechanism must be added. Without collateral, algorithmic stablecoins need to be designed to curb inflation and deflation. Starting in 2020, a class of elastic supply stablecoins began to emerge. The mechanism of an elastically adjusted stablecoin relies on adjusting the supply, and rebase may cause the entire market value to rise and fall suddenly.

• The problem with algorithmic stablecoins is that when the price is too low, the confidence to continue participating is extremely reduced. Currency prices like ESD/BasisCash have been in shock. However, Frax, which adopts gradual steps and combines algorithm stability and mortgage mechanism, is relatively stable. Frax is a relatively special algorithmic stablecoin in terms of composition, that is, the collateral is a combination of existing relatively stable stablecoins and equity tokens. Under the two-way exchange mechanism, FRAX can be freely exchanged with a*USDC+(1-a)*FXS. 0

• Stablecoins have never given up on innovation since their inception, and now almost no one doubts the role of US dollar-collateralized stablecoins. Digital asset-backed stablecoins are also basically possible, but algorithmic stablecoins still have a long way to go. Mining and other modes have made algorithmic stablecoins popular for a while, but their stability still needs to be verified.

• protocol class

protocol class

The earliest synthetic asset protocol Synthetix

Synthetix is ​​one of the earliest synthetic asset protocols, which coincidentally was originally transformed from a stable currency. Since 2018, a large number of algorithmic stablecoin projects have been born in the market, many of which have fallen silent. Some like basis quietly rose at the end of 2020, and some like Synthetix began to transform at the end of 2018.

Synthtix is ​​the first batch of DeFi that started liquidity mining: Although liquidity mining originated from the listing of COMP tokens on Compound in June last year, Syntheix can be counted as an earlier batch (starting in 2018). Because the liquidity of synthetic assets is low, and mint synthetic assets require a high mortgage ratio, which has been continuously reduced (750%->600%->500%), so syhthetix has given pledgers higher returns, which is also a guarantee The price of SNX is stable. Synthetic s-assets are somewhat more attractive than buying s-assets directly. About half of SNX is currently mortgaged in the network.

Adopt dynamic debt ratio: General mortgage projects adopt static debt ratio. That is, as long as the ratio between the collateral, such as the price of Ether, and the loaned debt is not lower than the liquidation line, there will be no problem with the debt and it can be redeemed at any time. However, Synthetix adopts a dynamic debt ratio. For example, in the process of minting sUSD, the initial requirement is 500%. After that, if the price of SNX falls and the mortgage ratio drops, the platform will require users to make additional mortgages to ensure that the mortgage ratio is greater than or equal to 500% at any time. The worst case of doing this is that Minter needs to have the demand to mortgage SNX at any time (but it can increase the buying pressure of SNX), and the other is that Minter will not liquidate its position unless it cannot keep up with the adjustment rhythm. Some other DeFi collateral DeFi protocols have a liquidation line requirement.

Debt pool-based exchange: In addition to mint assets, Synthetix also provides a debt pool-based exchange. There is no counterparty and liquidity pool, and we only have one central counterparty - the debt pool. When trading sUSD to SBTC, it is equivalent to the debt pool withdrawing sUSD and printing the same amount of sBTC. The debt pool is actually a shared debt, because s asset price changes, from the initial mortgage process to price changes, all debts will be redistributed on different minters, so even if you do nothing, personal debts will also be due to s assets change due to transactions.

For traders, this can be used to express the preference of a certain type of asset. For example, if you are optimistic about BTC, you will print sBTC, so that the price of sBTC will rise and the profit will increase. Due to the dynamic adjustment, more SNX will be saved, and if there is an increase in debt, more SNX mortgages will be required. What kind of s assets are printed in exchange for sUSD is very particular.

MirrorProtocol built on Terra

Mirror is a synthetic asset protocol built on the Terra network, and the synthetic assets it issues are called mAssets. mAsset will mimic real asset price changes. The minting of mAsset is completely decentralized, can accept various types of collateral, and guarantees a sufficient amount of collateral. The UST trading pair of mAsset can be established on Terraswap, an exchange on Terra. Mirror also has its own Mirror token, which allows liquidity providers to be rewarded.

There are four types of roles in Mirror:

Trader: Users who buy and sell mAsset on Terraswap, the portfolio is exposed to synthetic assets.

Minter: People who actually manufacture synthetic assets will enter into a CDP agreement with the agreement, and the mortgage assets must be higher than the minimum requirements of mAsset. Therefore, minter is effectively short the synthetic asset. Collateral can be withdrawn as long as the collateralized equity ratio is higher than the minimum requirement. Minter can adjust the collateral ratio by burning mAssets or adding more collateral

LP: LP adds the same amount of mAsset and UST to the corresponding Terraswap pool, which will increase the liquidity of synthetic assets. LP can obtain more pool income by obtaining LP certificates.

Staker: Mortgage LP tokens and MIR tokens to obtain MIR tokens. LP token holders can obtain MIR to benefit from inflation, and MIR staking can obtain CDP fees. If users stake MIR, they can participate in governance and have certain voting rights. Governance is the entry of new mAssets into the whitelist and the change of parameters.

Oracle feeder: used to provide accurate and accurate external quotations, and is the only account that can update asset prices. It is very important to the entire operation, and the community will carefully select and replace through governance. Currently using the Band protocol.

The main difference between Mirror and Synthetix lies in the mortgage assets. Synthetix uses the volatile SNX token for mortgage, while Mirror uses the stable UST token, so the mortgage rate is quite different. But UST is not Mirror's ecological token, so the tradeoff lies in the choice between function and ecological development.

Universal Synthetic Asset Protocol UMA

UMA is a synthetic asset issuance protocol through which any synthetic asset can be issued. There are currently 11 projects above, which are divided into three categories: Digitally Native Index, Yield Dollar, and Synthetic Asset Exchange.

Tokens that create special functions DigitallyNative Index is the most interesting category, Domination Finance tracks the market share of Bitcoin, ETH/BTC tracks the ratio of ETHBTC, uGAS finally Ethereum gas fee, uSTONKS tracks the stock popularity of Wall StreetBets, yCOMP Can be long and short COMP tokens, etc. UMA has created a range of products adapted to specific needs, making good use of the properties of synthetic products.

The standard product agreement UMA uses a standard product contract of ExpiringMultiParty (EMP) contract, which allows developers to quickly launch expiring synthetic asset tokens. After the development contract is completed, a complete set of synthetic tokens can be brought online after going through 7 steps.

The UMA protocol also has UMA Tokens, which can be used to resolve its dispute resolution system DVM (Data Verification Mechanism) and to govern the entire protocol. The main purposes of holding UMA tokens are: 1. Use the price demand voting of DVM to get rewards; 2. Upgrade governance rewards for protocol parameter changes.

Core Mechanism-Solving oracle bribery DVM is used to solve the problem of centralization and oracle bribery, and it is an oracle itself. UMA believes that blockchain oracles are hard to avoid being bribed. So demands and economic means. The corruption of the oracle machine requires a cost, namely Cost of Corruption (CoC), and Profit from Corruption (PfC), as long as CoC is greater than PfC. And can calculate CoC and PfC.

• Step 1: To measure the cost of corruption, DVM uses a Schelling-Point voting system and tokenizes voting rights. Token holders vote on contested price points and are rewarded for voting honestly and penalized for failing to do so. As long as there is an honest majority, voters will vote correctly. This means that the cost of corruption is the cost of buying control of 51% of voting tokens.

• Step 2: To measure profits from corruption, all contracts using the system need to be registered with the DVM and report the value that could be stolen if the price feed is compromised (this is the contract-specific PfC value). The DVM then sums the PfC for each contract into a system-wide PfC number.

• Step 3: CoC > PfC mechanism enforced by variable fee policy.

Since corruptors need 51% of the tokens so that the market value (CoC) of 51% tokens > PfC, this requires DVM to continuously monitor the CoC > PfC relationship.

The creation of tokens requires collateral, and UMA also accepts a very wide range of token types as collateral. The UMA protocol itself will not check the adequacy of tokens, but through the token economy, liquidators will be motivated to identify insufficient synthetic token agreements. UMA does not need to track the price data on the chain. According to the founder of UMA, there have been only six disputes since its launch.

Different from the above two agreements, UMA does not use over-collateralization, but uses financial incentives to prompt liquidators to liquidate non-healthy CDPs in a timely manner, that is, to actively manage CDPs instead of waiting for the liquidation line. UMA uses "no-feed price liquidation", through cooperative games, to keep the overall CDP at a healthy level. One advantage is that some long-tail assets (for example, there is no price yet) can also be synthesized, and there will be no quotation barriers.

Hashrate Token Protocol

Computing power tokens are a very interesting category of products, which meet our criteria: 1. Abstract special resources; 2. Make use of token characteristics to make them tradable, negotiable, and priceable; 3. Combining liquidity Mining, so that the computing power output (yield) is also tokenized. The computing power token market and the very potential application of synthetic assets solve the problem of the underlying circulation of the blockchain, and transform the original so-called "cloud computing power" into DeFi and NFT, which has a more decentralized concept.

PoW computing power token MARS

MARS is a computing power derivative token project launched by Coinin Mining Pool. It has BTC mining computing power certificate pBTC35A, ETH mining computing power certificate pETH18C, and governance token MARS. Each pBTC35A is aimed at 1 TH/s Bitcoin computing power, and each pETH18C is aimed at 1 MH/s Ethereum computing power. The underlying computing power is supported by the physical mining machine of Biyin, and the mining income is distributed on the chain. The MRAS protocol is based on Ethereum.

Obtaining computing power income is carried out through staking, pBTC35A can be pledged to obtain wBTC and MARS, and pETH18C can be pledged to obtain ETH and MARS. In addition, providing trading liquidity of pBTC35A and pETH18C on Uniswap can also obtain additional mining income (wBTC, ETH and MARS). The parameters of the mining pool are as follows: electricity fee: $0.0583/kWh, mining pool fee (FPPS): 2.50%, power consumption ratio: 35W/T

BTCST

BTCST is similar to MARS and is also a computing power token protocol. Each token is aimed at 0.1 TH/s, and after staking, you can get the daily bitcoin computing power income.

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Figure: BTCST computing power tokenization process

HashMix

HashMix is ​​a general computing power tokenization solution protocol. It can tokenize the computing power of the traditional BTC/ETH network, and can also tokenize storage mining protocols like Filecoin, which is a cross-chain token transfer protocol. The difference from the above two products is that it will not use the standard computing power bottom layer, so the computing power submitted by various miners will become NFT instead of general ERC20 tokens. Therefore, the computing power of each miner can be very different, which is also in line with the actual situation.

Each NFT represents a different computing power protocol. The authenticity of the computing power is verified by the verifier. The multi-signature wallet controls the payment for purchasing the computing power NFT token. The verifier relies on the protocol token HSM for incentives. In addition, computing power tokens can enter the financial market and be attached with the functions of lending and trading. For example, Fil-type mining computing power has a demand for loans.

Risk Management

The price risk of digital currency has always been great, and users with trading experience can directly go to short protection positions. Many synthetic assets have been designed to be a step up from the real world. For example, for volatility, or for the design of risk stratification. Risk-type synthetic assets are practical and meet the needs of risk aversion, so we expect there will be a market. However, risky tokens are inherently risky, and they also face the risk of being attacked by oracle machines and arbitrage.

Volatility class

Volmex launched an index based on the volatility of Ethereum, and developed a tradable platform based on this index. Users can directly price the market according to the risk of Ethereum (based on the volatility of options), and can hedge the risk of market fluctuations. Or the risk of the entire Ethereum ecosystem. Like the dVIX index issued based on UMA, it can provide similar ETH volatility trading products (volETH), and can also short volatility (ivolETH)

Risk Stratification Agreement

Barnbridge is for risk stratification. It divides the pools of some lending agreements such as Compound into Seniortranche and Junior tranche. Seniors get risk-free interest rates, and Juniors get risky interest rates, but the returns are relatively high. Each type of tranche has a corresponding token sBONDs, jTokens. The solution is to reflect the income of users with different risk preferences when the income of the lending pool changes. This type of product is called Smart Yield Bond.

Another Barnbridge product is the Smart Alpha Bond. Although it is called Bond, SAB itself is not aimed at fixed income, but at any measurable income, such as the stratification of BTC/ETH price fluctuation risk. For example, the price range of ETH is divided into three parts, and each part can bear different benefits. In this way, one ETH can be split into three different tokens, such as jETH/mETH/sETH, so that users of ETH can have greater Optional room.

Saffron adopts a similar structure, making three tiers at the fixed income level: S, AA and A.

asset class

The Charged Particle protocol can inject any erc-20 representative into NFT tokens to "charge" NFT tokens. Because of the cooperation with AAVE, the deposited token can become atoken, that is, a token with interest. If you deposit Dai, it can become aDai. And the type of assets deposited is not limited, it can be ERC20, ERC721, ERC1155. This turns an NFT into an asset package that can cover everything and is truly "synthetic".

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04 Framework and mobility

Hart Lambur, the founder of UMA, sorted out synthetic assets and gave a conceptual synthetic asset formula: mortgage assets + expenditure function = synthetic assets. We think that in addition to the financial meaning, the expenditure function here needs to have another non-financial (mainly governance) meaning, because the right to claim assets actually moves from the right to the left. According to this framework, two types of issues need to be considered:

• Sufficient collateral assets: generally high-quality assets. As well as the smoothness of the oracle mechanism and liquidation mechanism

• Stable expenditure function: how to seamlessly transfer income rights

The real thing to do in synthetic assets is stable currency. The track mainly comes from demand, and stable currency is a demand, and it is a long-term demand. As long as the U.S. dollar system remains unchanged (related to pricing), and the entry and exit channels remain unchanged (related to the relationship between the two worlds), this demand will not change.

We currently feel the most promising: direct synthetic assets that solve real problems, such as computing power tokens, risk tokens, and complex income tokens (such as exotic options).

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