What are synthetic crypto assets?

Synthetic crypto assets represent a type of crypto derivative that allows people to gain indirect exposure to real-world assets via blockchain-based tokens.

Traditional derivatives such as futures and options are tradeable financial contracts that represent underlying assets. These assets might be company stocks, fiat currencies, or commodities such as crude oil and wheat.

Derivative contracts closely track the market price of these underlying traditional assets, allowing investors to profit from changes in price without needing to directly take custody of the assets themselves.

If you want to learn more about these financial products, you can check out our Kraken Learn Center article What are crypto derivatives?

Synthetic crypto assets offer many of the same benefits as the traditional derivatives market, while also including the transparency and accessibility benefits of blockchain technology too.

Abra and Synthetix were among the earliest decentralized finance (DeFi) protocols to introduce the concept of tokenized derivatives to the crypto market.

These DeFi protocols facilitate the creation of synthetic assets built on top of blockchain networks. These include Ethereum (ETH), Litecoin (LTC), and Bitcoin (BTC).

A key benefit of using decentralized infrastructure is that anyone can create virtually any kind of synthetic asset, without fear of censorship or geographic restriction. 

Synthetic assets also allow crypto investors the opportunity to gain indirect exposure to other asset classes without needing to leave the cryptocurrency ecosystem.

Using the popular crypto project Synthetix as an example, users can create tokenized derivatives — known as "Synths" — for a wide range of assets including cryptocurrencies, indices, commodities, fiat currencies and much more.

Let's take a look at how to create synthetic crypto assets, using the Synthetix platform — one of the first platforms created for trading tokenized derivatives.

While there may be small variations from one platform to the next, the process is generally the same.

To mint (create) new synths on the Synthetix platform, users must first deposit an amount of Synthetix Network Token (SNX) into a staking smart contract which also exists on the platform.

These deposited tokens act as collateral, which is used to back up the value of the newly minted synthetic assets.

The Synthetix protocol uses overcollateralization to mitigate market volatility risk. 

This overcollateralization feature means that the amount of SNX tokens staked must be at least 5x the value of the synthetic assets at all times.

If the value of the real-world asset represented by the Synth rises sharply, SNX stakers would need to increase their collateralization by staking more SNX, or consequently burn Synths.

Burning refers to the process of permanently removing tokens from circulation.

Decentralized blockchain oracles such as Chainlink (LINK) provide smart contracts with price data. Synths track the prices of the assets they derive their value from using this data.

As a reward for helping to maintain the system, SNX stakers receive a portion of the trading fees charged to Synthetic decentralized exchange DEX users. This helps to incentivize them to create Synths and lock away SNX tokens.

Similar to providing assets to a liquidity pool, an SNX staker must burn their Synths to unstake their SNX tokens. A staker can only do this if the 5x collateralization ratio is maintained.

Other platforms such as Universal Market Access (UMA) and MakerDAO (MKR) follow a similar system as Synthetix, whereby a user mints synthetic assets by depositing digital assets into a smart contract as collateral.

• Inclusivity: Before synthetic assets, retail investors from certain jurisdictions may not have had access to certain asset classes. Traditionally, accredited and institutional investors were only allowed to trade derivative products. But now, anyone can indirectly gain exposure to these financial markets with just a smart device and an internet connection.
• Decentralization: The decentralized nature of these synthetic asset protocols means there are no human intermediaries to deal with. Smart contracts manage the collateralization, minting, and burning processes. This feature prevents censorship or discrimination and opens up synthetic assets to a global market of potential traders.
• Diversification: Tokenized derivatives can technically allow crypto users to diversify into any synthetic asset imaginable. This benefit can help reduce exposure to crypto market volatility.
• Indirect exposure: By holding blockchain-based tokens instead of the underlying asset itself, crypto users don't need to manage multiple accounts, or deal with third-party custodians. Oftentimes, a single crypto wallet can collectively manage these types of tokens.

Kraken makes it easy to participate in the decentralized financial economy.

Whether you are looking to purchase cryptoassets before using them in a sythetic protocol or looking to convert your crypto holdings back into cash, Kraken makes it easy.

Kraken offers trading on the most popular DeFi assets as well as the most popular cryptocurrencies in the market today.