Synthetic tokens in the context of cryptocurrencies refer to a type of asset that mimics the value of another asset but exists within the blockchain ecosystem. 

They are called “synthetic” because they are created to simulate the financial exposure to a real-world asset (like gold, stocks, fiat currencies, or other cryptocurrencies) without requiring actual ownership of that asset. 

This is achieved using smart contracts on blockchain platforms, primarily on Ethereum but also on others.

Why Do They Exist?

1. Accessibility

Synthetic tokens make it easier for people around the world to gain exposure to a wide range of assets without the need for traditional brokerage or banking accounts, or dealing with regulatory and geographical restrictions.

2. Financial Innovation

They allow for the creation of complex financial products, including derivatives like futures and options, in a decentralised environment.

3. Efficiency and Lower Costs

Trading synthetic tokens can be more efficient and less costly than their traditional counterparts, as they leverage blockchain technology to streamline transactions and reduce fees.

4. Market Completeness

By enabling exposure to a wide range of assets, synthetic tokens contribute to a more complete and interconnected financial market within the crypto ecosystem.

5. Decentralisation

Synthetic assets embody the decentralised finance (DeFi) principles, offering an alternative to centralised financial systems and increasing market participation without intermediaries.

How Are They Created?

The creation of synthetic tokens typically involves a few steps and components, mainly through the use of smart contracts on decentralised platforms. 

Here’s a simplified breakdown:

1. Smart Contracts

At the heart of synthetic tokens are smart contracts, which are self-executing contracts with the terms of the agreement directly written into code. These contracts govern the creation, management, and settlement of synthetic assets.

2. Collateralisation

To mint synthetic tokens, a user usually needs to lock up collateral in a smart contract. This collateral is often in the form of the platform’s native token or another widely accepted cryptocurrency.

The amount of collateral required is typically overcollateralised to account for price volatility and ensure the value of the synthetic token is adequately backed.

3. Oracles

Price oracles play a crucial role by providing real-time price feeds of the underlying assets to the smart contracts. This ensures that the synthetic tokens’ value remains pegged to the actual assets they represent.

4. Liquidity Pools

Some synthetic asset platforms use liquidity pools to facilitate trading and provide liquidity. Users can earn rewards by providing liquidity to these pools.

5. Governance

In many DeFi projects, the creation and management of synthetic tokens are also governed by the community through a decentralised governance process. Token holders can vote on key parameters like collateralisation ratios, types of synthetic assets available, and platform upgrades.

Synthetic tokens are an exciting innovation in the field of decentralised finance, offering new opportunities and challenges for both investors and regulators. 

Their ability to bring a wide array of assets into the blockchain space opens up the traditional financial markets to a broader audience, fostering inclusivity and innovation.

Synthetic Token Example

A notable real-life example of a synthetic token is “sUSD,” which is part of the Synthetix network. 

Synthetix is a decentralised finance (DeFi) protocol built on the Ethereum blockchain that allows for the creation of on-chain synthetic assets (Synths) that track the value of real-world assets. 

sUSD is a synthetic token that aims to mimic the value of the US dollar, offering users a way to gain exposure to USD’s value fluctuations without holding actual dollars.

How sUSD Works

– Creation

sUSD is created by locking up collateral in the Synthetix network, usually in the form of the native token of the Synthetix platform, SNX. Participants must over-collateralise, providing more value in SNX than the sUSD they wish to mint to account for price volatility.

– Usage

Once minted, sUSD can be used within the Synthetix ecosystem and broader DeFi space for trading, lending, borrowing, and other financial transactions, just like any other cryptocurrency. It allows users to trade against other synthetic assets on the Synthetix exchange without the need for a traditional intermediary.

– Price Stability

The value of sUSD is pegged to the US dollar, aiming to maintain a 1:1 ratio. This peg is maintained through the use of oracles that provide real-time price feeds of USD to the Synthetix platform, ensuring that sUSD’s price reflects current market conditions.

Why It’s Important

sUSD represents a significant advancement in the DeFi space by providing a bridge between traditional finance and the burgeoning world of decentralised finance. 

It allows users to hedge against cryptocurrency volatility, trade in global markets, and access a stable digital currency without needing a bank account or facing the regulatory hurdles associated with traditional finance. 

The existence of sUSD and similar synthetic tokens exemplifies the potential of blockchain technology to create complex financial products that are accessible, efficient, and interoperable.

sUSD vs USDT

Investing in sUSD (a synthetic token) versus USDT (a stablecoin directly backed by USD) involves different considerations, risks, and potential benefits. 

While both aim to mirror the value of the US dollar, their underlying mechanisms, use cases, and implications for investors vary significantly. 

Here are some reasons why someone might choose sUSD over USDT, despite the apparent necessity for over-collateralisation in the case of sUSD:

1. Decentralization and Trust:

– sUSD

It operates within a decentralised finance (DeFi) framework, leveraging smart contracts on the Ethereum blockchain. 

This minimises reliance on central parties for operation and oversight, potentially reducing the risk associated with centralised control and management failures.

– USDT

As a centralised stablecoin, USDT’s value and backing are managed by a single entity (Tether Limited). 

This centralisation introduces counterparty risk, including management failure, regulatory action against the issuer, and concerns about the full backing of tokens with USD.

2. Exposure to DeFi and Yield Opportunities:

– sUSD

Holding sUSD allows investors to participate directly in the DeFi ecosystem, accessing various financial services like lending, borrowing, and yield farming, which might offer higher returns than traditional financial products.

– USDT

While USDT can also be used within the DeFi space, sUSD is specifically designed for integration into the Synthetix platform and other DeFi protocols, potentially offering more seamless utility and innovative financial products.

3. Collateral and Investment Strategy

– sUSD

Investing in sUSD through overcollateralization with SNX or other crypto assets allows investors to remain exposed to the underlying collateral’s potential price appreciation. If the value of SNX or the collateral increases, investors could benefit from the price appreciation while still having access to stablecoin assets.

– USDT

USDT investment is primarily a bet on stability, with the main advantage being the preservation of value rather than speculative growth. Investors do not have the opportunity to benefit from underlying asset appreciation in the same way.

 4. Risk and Reward Dynamics

– sUSD

The over-collateralisation requirement and involvement in the DeFi space introduce a different risk profile, including smart contract risk, systemic risk within the DeFi ecosystem, and the volatility of the collateral asset. 

However, these risks come with potential rewards related to the growth of the DeFi sector and the appreciation of collateral assets.

– USDT

The primary risk associated with USDT revolves around the trust and solvency of its issuing company and the transparency regarding its USD reserves. 

The reward is mainly the stability and liquidity it offers, making it a safer haven during market volatility but with limited upside beyond that.

Conclusion

Choosing between sUSD and USDT depends on an investor’s risk tolerance, investment strategy, and interest in participating in the DeFi ecosystem versus seeking stability and liquidity in a digital form of USD. 

While sUSD offers innovative DeFi integration and the potential for higher returns through collateral appreciation, it comes with higher risks. 

In contrast, USDT offers a more straightforward approach to achieving stability, albeit with centralisation risks.