, 18 tweets, 5 min read Read on Twitter
1/The launch of synthetic assets on decentralized networks like Ethereum is a major development for #OpenFinance! Let's take a closer look at synthetic cryptoassets and explain what they are, why they matter, as well as some of the risks associated with them.
2/Synthetic assets give investors exposure to an asset/portfolio of assets without actually needing to hold them. This is done using a financial contract with a counterparty. Contracts can be structured in different ways to mimic the effects of interacting with assets directly.
3/A common synthetic asset is a Total Return Swap. Here a counterparty agrees to pay the total return of an asset (such as FB stock) while the other agrees to pay a regular fixed cash flow and post margin/collateral. A swap terminates and settles at a later date in the future.
4/A legacy finance TRS doesn't usually require counterparties to post 100% collateral because they're often financial institutions that trust each other and use the legal system to settle disputes. Still, there is counterparty risk - which doesn't translate well to blockchains.
5/With that in mind, @UMAprotocol designed TSRs to work for crypto. Their first product is USStocks, which is an ERC20 token that represents synthetic ownership of the 500 largest exchange-listed stocks. So now anyone can get exposure to stocks without having to own any directly!
6/How it works:

1. Liquidity providers deposit Dai into a smart contract
2. They maintain a collateralization ratio of > 108.5% of the token price at all times
3. USStocks trades freely until expiry, then any holder can redeem their tokens for Dai at the final settlement value
7/The beauty of this is that it's all done without anyone touching the underlying stocks! Instead, an oracle tracks the price of the index. As prices go up or down IRL, the oracle relays that information to a smart contract and the collateral requirements change in real-time.
8/Liquidity providers then manage their collateral ratios accordingly, which ensures that all of the USStocks token holders will be able to redeem their tokens for Dai at contract expiration. It's an elegant system!
9/It's hard to put into words how important synthetic cryptoassets like USStocks are for open finance.
10/For starters, they make financial markets more accessible. Now anyone in the world can be exposed to the US stock market. That's profound for citizens in developing countries.
11/They're also censorship resistant. If we go back to the example of USStocks - users aren't holding the underlying stocks themselves, so there is nothing that their governments or banks can't take away from them!
12/Worth noting: censorship resistant SAs are perfect for DAOs and other DeFi networks that don't want to rely on trusted 3rd parties. For example, one beneficiary of USStocks will be @MakerDAO's #MCD. Imagine how big the universe of collateral for CDPs can get with synthetics...
13/However, despite all of these positives, there are a number of risks.

i. Synthetic price can decouple from underlying spot price:

14/Another risk:

ii. Liquidity providers can trigger undesirable liquidations in some cases:

15/Another:

iii. The system is not currently capital efficient (e.g. liquidity providers in @UMAprotocol post 108.5% collateral), although this could change in the future with on-chain reputation systems.
16/Another (big one):

iv. Synthetic asset systems rely on oracles for price feeds, which begs the question: why should we trust the oracle?

Here's a good primer on the oracle problem from the @Delphi_Digital team: medium.com/@DelphiSystems…
17/Finally:

v. The creation of synthetic assets is illegal in many countries.
18/While these risks will need to either be solved or mitigated by the community for these systems to be truly safe, I'm excited to see more teams in the #DeFi stack work on synthetic cryptoassets in the coming years! [end]
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