Synthetic

A synthetic is a financial instrument that simulates other instruments. In other words, the risk/reward profile of any financial instrument can be simulated using a combination of other instruments.

Synthetic is the term given to financial instruments that are engineered to simulate other instruments while altering key characteristics. Often synthetics will offer investors tailored cash flow patterns, maturities, risk profiles and so on. Synthetic products are structured to suit the needs of the investor.

Synthetics are comprised of one or more derivatives, which are assets that are based on the value of an underlying asset and include:

  • Forward commitments: Futures, forwards, and swaps

  • Contingent claims: Options, credit derivatives such as credit default swaps (CDS), and asset-backed securities

KEY TAKEAWAYS

  • A synthetic is an investment that is meant to imitate another investment.

  • Synthetic products are custom designed investments that are created for large investors.

There are several reasons why synthetics are useful to multiple participants in the “decentralized finance” (DeFi) ecosystem.

Scaling assets

One of the biggest challenges in the space is bringing real-world assets on-chain in a trustless manner. One example is fiat currencies. While it’s possible to create a fiat-collateralized stablecoin like Tether, another approach is to gain synthetic price exposure to USD without having to hold the actual asset in custody with a centralized counterparty. For many users, price exposure is good enough. Synthetics provide a mechanism for real-world assets to be traded on a blockchain.

Scaling liquidity

One of the main issues in the DeFi space is a lack of liquidity. Market makers play an important role here for both long-tail and established cryptoassets, but have limited financial tools for proper risk management. Synthetics and derivatives more broadly could help market markets scale their operations by hedging positions and protecting profits.

Scaling participation

While synthetics have traditionally been available to large and sophisticated investors, permissionless smart contract platforms like Ethereum allow smaller investors to access their benefits. It would also allow more traditional investment managers to enter the space by increasing their risk management toolset.