BeInCrypto explores the arrival of DLT-based synthetic derivatives in the crypto industry and evaluates the potential advantages synths could have for the space.
‘Tis the season, alt season specifically. Led by the industry’s number two cryptocurrency, ethereum (ETH), the altcoin market is posting all-time highs on a regular basis.
Several relative new-comers to the cryptocurrency scene, such as aave (AAVE), SushiSwap (SUSHI) and Alpha Finance Lab (ALPHA), saw rapid growth last month — both in terms of development and price.
It seeks to achieve this by integrating decentralized ledger technology (DLT) with the financial products mentioned above.
These days, synthetic derivatives — an advanced financial product used in risk management — are gaining popularity.
In this piece, BeInCrypto explores the arrival of DLT-based synthetic derivatives (synths) in the cryptocurrency industry. We evaluate the potential advantages synths could have for the space, as well as outline some disadvantages.
We also take a look at some of the specific use cases in the DeFi space and comment on what we think the future will hold for synths.
But first, what are derivatives and their synthetic counterparts?
Firstly, a derivative is a type of financial product that tracks the value of an underlying asset.
You may have heard of futures or options. These are types of derivative that give the holder buying — or selling — rights, at a specific time in the future. Futures obligate the holder to make the purchase, whereas options do not.
For example, Daniel is a dogecoin (DOGE) miner. He wants to buy new mining equipment in two weeks when he gets paid $500. He knows how much he can spend and what he would get if he bought the equipment now.
Daniel wants to make an agreement with Mint, a mining company, to purchase five MintMiners at $100 a piece in two weeks.
If Mint offers him a futures agreement, it would obligate Daniel to pay $500 in two weeks for the five miners. However, Daniel could also request the option to buy but not the obligation, in case he changes his mind.
For this type of agreement, Mint would charge a premium paid up front which acts as a deposit for the miners. If Daniel chose not to buy, he would lose this deposit.
From derived to synthetic
A synthetic derivative takes this one step further. Their value tracks a particular asset or derivative, but does not necessarily confer buying rights.
Take a synth of MintMiner (xMintComp) components. It tracks the value of those components rising when they become more expensive, and vice versa.
If the price of those components went up 20% in two weeks, Mint would want to sell MintMiners for 20% more to maintain profit levels. But Mint would be obligated to sell the five miners to Daniel at $500, even though they wanted to charge $600.
Instead, Mint could buy xMintComp for $500 when making the agreement with Daniel. If the price of components increases by 20%, Mint could sell xMintComp for $600 when Daniel’s future expires, pocketing the extra $100 to cover the extra cost.
Advantages & disadvantages for finance
The example above outlines the most common use case for synths in traditional finance. They allow contract holders to hedge against the volatility of an underlying asset to reduce losses. Mint avoided a potential loss selling a MintMiner below an acceptable rate.
However, an exchange, including those for synths, require there to be two parties: one to buy, one to sell. Mint has to find a party to sell the synth too.
Sure, in the case above, a budding investor might expect the rise in components to continue, therefore ensuring the synth continues to create value.
However, synths can also track “junk.” In 2007-2008, the global financial system collapsed in large part due to investors investing in “mainstream” synths whose value was tied to “junk” assets.
When investors realized what they had invested in, they quickly tried to sell their contracts but found no buyers. Without any underlying assets, the contracts became worthless.
In DeFi however, synths have evolved to track several on-chain and market phenomena.
Controlling gas price with synths
It is a monthly futures synth that “settles” (reaches its expiry date and a trade is forced) at the median gas price (GAS) of all Ethereum transactions for the month.
Such a tool is apt given the current state of the Ethereum network. Gas fees on the network soared to over $70 on decentralized exchanges (DEXs), earlier n February, following ETH setting a new all-time high.
Fees that high make the development and usage of the Ethereum network extremely expensive.
uGAS allows developers and farmers to set the price of GAS for at least 30 days into the future. This could make costs foreseeable, and hence manageable.
Swapping volatility for profit
As well as attempting to fix the gas volatility problem, the team is putting their expertise towards solving market volatility more generally, with uVOL. uVOL is to volatility what uGAS is to gas.
Specifically, uVOL tracks the volatility of an underlying asset (i.e. uVOL-BTC or uVOL-ETH). Whilst these types of synth have existed in traditional finance for decades, these so-called volatility swaps are new to the cryptocurrency market.
In a market that has volatility at its core, uVOL could provide not just a hedging tool, but a potentially very profitable volatility swap market.
Satoshi’s token release model upgraded
Volatility isn’t just a trader’s worst nightmare, it could have serious consequences for new DeFi projects.
When developers release tokens, either through an initial coin offering (ICO), an initial exchange offering (IEO), or an initial DEX offering (IDO), they often face the “Binance Effect.”
That is, a token, with arguably no proven value, is inflated by enthusiastic (though others might use less sympathetic language) traders. Usually, after a few days, the token settles, but only after a blood-drawing correction.
This inevitably triggers cries of “pump-and-dump,” “scam,” “rug-pull” damaging the reputation of a project from the get-go. For projects that require staking (nearly all DeFi), this could be life-threatening.
Dafi Protocol aims to fix this with a synth that tracks platform demand. The synth, called DFY, attaches to the native token of a new platform (dToken). The synth dToken is then released to the public in return for collateral used for staking.
dToken rewards stakers, as demand for the network (its use and quantity staked) increases. On the whole, this incentivizes long-term participation in a newly released platform, potentially ridding the system of the toxic Binance Effect.
The future of synths
These projects are an attempt to use synths to solve problems in the DeFi space. However, being DLT-based, they also feature the advantages that come with decentralization and smart contracts, namely, everyone has access.
Moreover, other synth platforms allow for on-chain exposure to several “real-world” assets such as commodities and stocks. There are even plans to create fully customizable synths, allowing users to track an asset or phenomenon of choice.
However, this area is still very experimental. The YAM Finance x UMA Project collaboration is only weeks old. Moreover, Dafi Protocol is only releasing its synth, this month.
In reality, both might suffer from liquidity and development issues. However, experimentation is the key to development. And if they do work, well, bye bye GAS at $70, volatility stops, and the Binance Effect.