Why you should trade synthetic assets?

Benjamin D. - Founder

Synthetic assets make it easier for you to trade various financial assets (e.g. stocks, commodities or precious metals). They can be traded at any time, thanks to the decentralized network structure of the distributed ledger (DLT - also known as blockchain) - without you having to wait until the stock exchange opens or you have access to it. The hurdle of registering with a broker is eliminated. Access to this market is available to anyone with an internet connection.

Usual trading venues have their fixed trading hours. This is not necessary, because the decentralized network is not bound to any place or time. For example, it may happen that you would like to buy a stock that is not available on trading venues in your country. Or you simply have trouble finding a suitable broker and can't find your way through the forest of fees and technical terms.

Synthetic assets reflect the price, not the actual asset. In the case of a share, for example, this is the right to a say in the company. But most investors have no interest in that at all. You can use this simplified way to quickly and cheaply buy e.g. shares of all kinds of companies. Even if they are not tradable on stock exchanges in your country. Inexpensive because you don't pay any percentage on the order itself, but only the transaction fee to transfer the token to your account, no matter how high your investment is.

What financial instruments you can trade as synthetic assets?

It is in the nature of distributed ledger technology to create a digital world on which virtual and physical assets can be traded. The easiest way to do this is with native and therefore purely virtual crypto assets. This is because Bitcoin, for example, has no equivalent in the real world and is traded entirely via the DLT. Theoretically, however, any asset can be synthesized as long as someone is willing to put up collateral for it.

With all synthetic assets, there is an underlying asset, which is the price of the good it represents. This is true for stocks, commodities, precious metals and much more. For example, you can buy gold or oil as a synthetic asset. Instead of buying a barrel of oil, you can trade a security that tracks the price of oil, not the oil itself.

With assets that are mapped 1:1 physically to digitally, there needs to be an entity to ensure that the actual asset is stored somewhere. This is where the familiar trust issues arise that exist with value assets in general. Someone who sells you an option on gold, for example, has to hold that gold physically. You can have it verified. Ultimately, you can't be sure until you exchange the option. That may work with gold, but it gets more difficult with oil. The transport and storage costs alone wipe out parts of your profits. This can be a negative incentive for retailers not to own the goods in the first place. Or to outsource this storage to other service providers. The result is a non-transparent network in which goods are often traded that have not even been taken out of the ground or harvested (precious metals, raw materials).

What are synthetic assets?

Synthetic assets, therefore, do not represent a claim on the actual asset. If you speculate on the price of oil, you cannot use it to demand a barrel of oil. But since the asset represents the price, you can certainly buy "real oil" from its value.

Now the question surely arises why you should buy something that is basically nothing more than a digital paper with a price. We have already mentioned the most obvious advantages above. Furthermore, the tokens on a DLT make the asset itself divisible. So you are able to buy 0.01 shares. This is not easily possible with unit shares. If, for example, you are only interested in price increases for an asset and would like to sell it sooner rather than later anyway, synthetic assets are excellent for you.

What influence do synthetic assets have on real goods?

Since the assets only represent the price, but not the good itself, one might think that they have an isolated existence. This is not the case. Stocks, for example, could be traded as unit shares or as synthetic assets in DLT. Both ways are determined by supply and demand, and thus the price of both. Whenever there is a difference between them, there are enough traders who strive to make up this price gap. In the best case, the price of a synthetic share could be higher than that of the unit share. This would give you the opportunity to switch to a unit share at a discount and make a profit. This also always affects the price of the "real share". In relative terms, this will rarely be the case for small investors, or the differences will be so small that this only comes into play in larger amounts of shares. This market mechanism ensures that prices do not diverge.

How are the synthetic assets backed by assets?

Since the synthetic asset does not obligate the issuer to hold the real asset, the question arises as to how it is backed. The principle is used in some places in the decentralized financial world. This is achieved through what is called collateral. This can be done simply with a common national currency. You can issue a share X at the value of 600$ if you deposit 3000$ as collateral at the same time. This ensures that there is always much more collateral than the value to be issued.

A collateral works similar to a mortgage. So-called pools take care of the sufficient capital. In pools, many participants are grouped together to achieve higher liquidity. Collateral is collected for a whole amount of synthetic assets. The process is controlled by a smart contract. This is a contract whose statutes are written in code. It cannot be changed and acts autonomously when certain specified events occur. All participating parties rely on this contract.

What happens if the coverage is no longer sufficient?

For example, if the coverage of, say, 500% is no longer sufficient, the collateral must be increased. In other words, the coverage must be increased. Then the issuer has to refinance in order to get his stake back later. If he does not do so, his collateral is liquidated and one of the synthetic assets disappears from the pool. This ensures that no uncovered assets can be in the pool.

What would happen in a crash?

In the worst case scenario, the countervalue could also lose so much value that the system would be threatened with collapse. In this case, there is an additional instance of collateral that once again secures the smart contract. This is done through asset shares in the contract itself. So if the assets in the pool should also lose value, a kind of board of directors of the smart contract takes action. It acts like a group of shareholders of the issuing company of securities. If their role to maintain the value is no longer fulfilled, their shares are sold on the market against more stable collateral. Because of the binding contract, this happens automatically. This would also burden their assets. Therefore, they are rewarded by interest for the stability of the smart contract. The more stable the price is against the collateral, the higher their profit is. Through this constellation, all participants have a distinct interest in ensuring that value stability is always guaranteed. Should this instance also fail, an automatic emergency switch is flipped, shutting down the entire execution of the contract and exchanging all assets for their collateral. In this case, the synthetic assets would no longer be tradable until stability is restored.