Research Summary: Sok: Synthetic Assets, Derivatives, and On-Chain Portfolio Management

TLDR

  • Synthetic assets are decentralized finance (DeFi) analogues of derivatives in the traditional finance (TradFi) world—financial arrangements which derive value from and are directly pegged to fluctuations in the value of an underlying asset (ex: futures and options). Synthetic assets occupy a unique niche, serving to facilitate currency exchange, giving traders a means to speculate on the value of crypto assets without directly holding them, and powering more complex financial tools.
  • Unfortunately, the academic literature on this topic is highly disparate and struggles to keep up with rapid changes in the space. We present the first Systematization of Knowledge (SoK) in this area, focusing on presenting the key mechanisms, protocols, and issues in an accessible fashion to highlight risks for participants as well as areas of research interest.
  • This paper takes a broad perspective in establishing a general framework for synthetic assets, from the ideological origins of crypto to legal barriers for firms in this space, encapsulating the basic mechanisms underpinning derivatives markets as well as presenting data-driven analyses of major protocols.

Citation

Rahman, Abrar, et al. “Systematization of Knowledge: Synthetic Assets, Derivatives, and On-Chain Portfolio Management.” arXiv preprint arXiv:2209.09958 [q-fin.GN] (2022).

Core Research Question

What are the basic motivations, mechanisms, risks, and regulatory structures underpinning derivatives markets in decentralized finance?

Background

  • Derivatives: financial arrangements which derive value from and are directly pegged to fluctuations in the value of an underlying asset (ex: futures and options)
  • Synthetic Assets: blockchain-based tokenized analogue of derivatives
  • Oracles: data feeds that query the off-chain underlying asset data while applying measures to reduce tracking error
  • Yield Optimizers: cryptocurrency and synthetic asset management tools and protocols using data-driven approaches to maximize performance and revenue
  • Portfolio Management: the act of cultivating and growing a collection of assets aiming towards a particular risk profile. Protocols in this space allow users to invest in many tokens, which reduces the risks or failures to invest in a single token.

Summary

  • The potential advantages of asset tokenization include: reduced geographical barriers, reduced reliance on middlemen, enhanced accessibility through fractional ownership, improved asset liquidity, improved transaction efficiency, and an expanded investor base.
  • Though not derivatives in the strictest sense of the term, stablecoins are a popular choice for DeFi traders, serving to: hedge against volatility in standard tokens, facilitate forex/derivatives trading with synthetic currencies, or as the underlying tokenomic mechanism underpinning a decentralized liquidity pool or yield optimizing protocol.
  • DeFi markets do not share the same protections that their centralized counterparts offer. Banks pay dues to the Federal Deposit Insurance Corporation (FDIC), which backs deposits as a guard rail against bank runs. The FDIC was established by 1933 Banking Act (Glass-Steagall), enacted in the middle of the Great Depression, during which fully a third of American banks failed.
  • There is no intermediary with the legal purview to monitor markets for fraud and manipulation, prevent money laundering, safeguard deposited funds, ensure counterparty performance, or make customers whole when processes fail. DeFi markets, platforms, and websites are not registered as Swap Execution Facilities (SEFs).
  • On the federal level, some crypto finance platforms are now being regulated as securities. This opens a vast world of existing legislation and case law, potentially opening the floodgates to litigation against Web3 financial service firms. The Securities and Exchange Commission (SEC) has taken increasingly aggressive action to protect investors and consumers in this space.
  • On May 3, 2022, the SEC nearly doubled the size of its Crypto Assets and Cyber Unit, with around 50 dedicated positions. Since its creation in 2017, the unit has brought more than 80 enforcement actions related to fraudulent and unregistered crypto asset offerings and platforms, resulting in monetary relief totaling more than $2 billion.
  • DeFi markets for derivatives may not be legal under the Commodity Exchange Act (CEA), a U.S. law that governs such products and requires them to trade only on regulated designated contract markets (DCMs), according to Commodity Futures Trading Commission (CFTC) Commissioner Dan Berkovitz in a speech to the Asset Management Derivatives Forum.
  • Outline of a Typical Derivatives Protocol
    • Choose a real-world asset (ex: USD, ETH, TSLA, Gold, etc.) to underlie the synthetic derivative asset.
    • Leverage oracles: data feeds that query the off-chain underlying asset data while applying measures to reduce tracking error.
    • Create (“mint”) synthetic asset and start trading!

Method

  • We performed dozens of deep dives into whitepapers and protocol usage guides in order to get a comprehensive picture of the DeFi derivatives market, the core techniques and design principles that underly each approach within the space, and the risks involved for all stakeholders involved. We supplemented this architecture and theory content with news articles on the relative performance of each protocol.
  • In order to get as many diverse perspectives and approaches as possible, we did not restrict our chosen technologies to major protocols alone, but also looked at smaller-scale DAOs and niche projects as well.
  • For synthetic asset protocols, we present analyses of Synthetix, Mirror (and the fall of the Terra stablecoin), and Anchor Protocol.

  • For on-chain oracles, we examined Chainlink and UMA (short for Universal Market Access).

  • For decentralized exchanges (DEXs), we looked at dYdX (including a walkthrough of their insurance fund and deleveraging procedure), Deri Protocol, Lyra (built on Synthetix), Vega, and Thales.

  • For yield optimizers, we performed a deep dive into: Yearn Finance, Abracadabra Money, Harvest Finance, and Autofarm Network.

  • Finally, for portfolio management suites, we looked at Coinbase, TokenSets, Enzyme, PieDAO, Hord, and DHedge.

  • Additionally, we used Dune Analytics to build a liquidation dashboard with the following key performance metrics. On the books, we have Total Value Locked (TVL), Assets Under Management (AUM), Collateralization Ratios, Trading Volume, and Profits. Additionally, various user engagement metrics can be used: active users (Daily: DAU, Monthly: MAU), new users, active traders / stakers / farmers / token holders (governance, voting, delegator) / investors (for portfolio management protocols).

  • A Dune analytics database for these metrics can be found at DeFi Monthly Active Users. Metrics relating to risk management, including collateral ratios and liquidations can be found at dYdx Liquitations.

Results

  • Synthetic Assets: Basic Mechanisms
    • Liquidation threshold: using a collateral ratio to manage the synthetic assets generation and destruction (liquidation)
    • Staking: depositing a cryptocurrency coin or token into a liquidity pool or yield farming protocol.
    • Governance risk: in traditional companies, activist investors can buy shares and vote to tilt the company’s direction as they desire. DeFi protocols with governance tokens are similar, except governance systems are launched at the very inception of a protocol’s life cycle, which can create greater vulnerabilities for a hostile takeover and/or drastic changes to the policies of a protocol.
    • Scaling solution: For a block to become part of a blockchain, every miner must execute all the included transactions on their machine. To expect each miner to record each and every financial transaction for a global asset market is unsustainable. Potential solutions being implemented include proof-of-stake and Layer 2 chains (ex: optimistic roll-ups).
  • Price Divergence Reduction Methods
    • Oracles: Track the real-time price of the pegged/collateralized assets and port all the data on-chain.
    • Oracle risk: Many DeFi protocols require access to secure, tamper-resistant asset prices to ensure that routine actions such as liquidations and prediction market resolutions function correctly. Protocol reliance on external data feeds introduces oracle risk. An “oracle attack” is when malevolent actors target price oracles, manufacturing favorable on-chain exchange rates that allow for arbitrage.
    • Slippage: just as in TradFi, slippage refers to a difference in price between buyer and seller expectations between the time a transaction is requested versus when it executes. Many protocols seek to limit this.
  • Risk Management Strategies
    • Collateralization ratio: a protection of the healthy ratio between the collateralized assets and synthetic assets. With a relatively high collateralized ratio, the synthetic assets are less likely to be liquidated even under extreme market situations.
    • Insurance fund mechanism: By using the insurance fund, the protocols are becoming more resilient to sudden market crashes under extreme circumstances. If the insurance fund is depleted, some protocols can have other mechanisms to prevent further loss of the protocols.
    • Impermanent loss: in most AMM systems, liquidity providers contribute assets to ensure liquidity for traders. If the price of your assets changes drops with respect to when you deposited them, you are exposed to this issue. This dollar value shortfall is known as impermanent loss.
    • Leverage: funds can serve as collateral in other transactions, allowing investors to build increasingly large exposure for a given amount of collateral. Derivatives trading on DEXs intrinsically involves leverage, as options payments take place only in the future. The maximum permitted margin in DEXs can be higher than in regulated exchanges in the traditional financial system.
  • Decentralized Clearance Mechanisms
    • Decentralized liquidation: all the liquidations happen on-chain through executions of the smart contracts. Each liquidator has equal opportunities to participate in the liquidation events of the derivatives.
    • Liquidity Pools: a reserve of deposited funds meant to provide liquidity to a synthetic asset, blockchain, and/or smart contract. There are typically built-in incentives (ex: mining rewards, transaction fees) to incentivize liquidity providers.
    • Order matching: The traders on the decentralized derivatives trading platform are matched based on the information of their orders. The protocols (DYDX, etc) seek to find optimal order matching algorithms.

Discussion and Key Takeaways

  • We establish a general framework for understanding the construction and utility of synthetic assets and apply this understanding towards demystifying the underlying mechanisms, principles, and risks of leading financial tools.
  • We highlight three high-profile synthetic asset protocols: Synthetix, Mirror, and Anchor Protocol. We further comment on the most prevalent derivatives trading platforms in the status quo: dYdX, Deri Protocol, Lyra, Vega, and Thales. This broad scope entailed a focus on the mechanisms, incentives, risks, and legality of these protocols as opposed to a more technical deep dive.

Implications and Follow-Ups

  • Future research into derivatives protocols can build upon this work, incorporating new developments and challenges to the space as they emerge.

Applicability

  • Synthetic assets and derivatives protocols are a fundamental building block for the DeFi space, a key asset category emerging as a natural consequence of the growing maturity of technologies and user demands at the intersection of cryptocurrencies and traditional financial products.
  • This systematization of knowledge has put a magnifying glass to the diverse range of DeFi protocols which build, supply data to, trade, or otherwise incorporate crypto derivatives.
  • We begin with a wide perspective on the crypto space, the ideological underpinnings thereof, and the regulatory backlash and market uncertainties it is presented with.
  • We establish a general framework for understanding the construction and utility of synthetic assets and apply this understanding towards demystifying the underlying mechanisms, principles, and risks of leading financial tools

This work was done under and supported by the Center for Responsible, Decentralized Intelligence—an interdisciplinary research hub affiliated with UC Berkeley Engineering, Blockchain @ Berkeley, the Haas School of Business, Berkeley Law, the Sutardja Center for Entrepreneurship and Technology, Berkeley Data Science, and the Simons Institute for the Theory of Computing.

All opinions, findings, and conclusions, or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of our partner organizations.

We would like to give a special thanks to Dawn Song, Christine Parlour, and Yongzheng Jia for their guidance throughout this project.

7 Likes

Where does FTX and Alameda’s trading fit into this framework? Do these types of mechanisms introduce new forms of risk? What kind of regulatory issues do you think might emerge from this year’s collapse or near collapse of giants like 3AC, Blockfi and FTX?

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Thanks @abr For this research summary is very much importance and needful in our economic at large,most especially synthetic assest they are a new asset class that are made possible by block chain technology,
This is how it works: instead of using contract to link the values of an underlying asset and derivative product,they tokenize it.this means That crypto synths can replicate the movement of any asset in the market whether it is a stock or currency this is very important because is very fast and easy, Blockchain, is the technology at the heart of cryptocurrency,this means that all data is saved on a distributed ledger, which enables the whole crypto community of assets to recognise who owns what.but my question is if a crypto assets value were to plummet and everyone holding that asset tried to sell at the same time what is the possibility that there will be no accumulated loss and how do we reduce it,then what can be done in other to stabilise it incase this kind of thing occurs thank you.

Hi @Abr, for your efforts in this research paper, I just wanted to share my understanding or view in this paper, but I would comment basically on the risks associated with Synthetic Assets, firstly, Synthetic assets are new primitives made possible by the maturation of Ethereum and the DeFi ecosystem. But we are just at the beginning, and should not be blind to the inherent risks, for the purpose of clarity and understanding let quickly point out these risks.

. Smart contract risk:

Exploits in smart contracts are possible, and synthetic assets could be strong targets

. Governance risk: These platforms are mostly often governed by their decentralized participants, which remains relatively untested at scale

.Oracle Risk: Many synthetic assets rely on oracles to function properly, which carry their own trust assumptions and failure modes

.Platform risk: Ethereum and other underlying blockchains may struggle at scale, and perform worse the moment you need them most. Fee markets can be inefficient, and frontrunning or griefing attacks could be challenging.

However, Synthetic assets represent open and global access to existing financial markets, itself an important primitive.

We can potentially use these primitives to construct novel, new financial markets that can fundamentally align incentives and change the way we live our lives.

1 Like

Thanks for this foundational work @abr.

I’m happy that the DeFi derivative is getting some attention on SCRF. This is my first time seeing a post on the topic (I hope I’m still up to date :joy:).

So, someone might ask, “why consider derivatives in the first place?”

CoinGecko, in their book, How to DeFi for Beginners, mentions that DeFi derivatives contribute about 8.2% ($5.82 billion) of the DeFi ecosystem market cap. This data is from April 2021.

You can now agree that this is worth some attention for the investment it holds.

There are three major motivations for using decentralized derivative in DeFi:

  1. Hedging against price volatility of assets
  2. For speculation purposes
  3. To leverage on Crypto tokens.

I will focus on Hedging against price volatility of assets.

Using the recent case of FTX collapse as an example, this is how one could have reduced their losses on the FTT token collapse.

But hey, just like the author of this summary mentioned, using the DeFi derivative is risky. DeFi derivatives are contracts and not assets.

The best way to hedge against risk of price volatility would be using Futures which is a type of derivative. Suppose one had holdings on FTT tokens, and having heard the news of impending FTX collapse, they could have opened a sell trade on Futures using another platform.

Therefore, as the price of FTT token dropped, and the value of their holdings dropped in value, they made profit on the futures trade thus covering up their loss.

3 Likes

Hi @abr, I’m not a big fan of decentralized derivatives, maybe because I haven’t learned much about them or because they seem unpopular. However, your research seems to nudge me into digging more on them.

Being a beginner, I would like to try out one of the protocols you mentioned. I know others here might want that too.

Considering you analyzed about three protocols in depth, which do you recommend for a beginner, and why would you make such a recommendation?

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FTX and Alameda were always inherently subject to the same kinds of systematic trading risks that exchanges and trading firms experience in traditional finance. What happened with FTX was effectively a bank run. Any investor who was surprised at their lack of protections simply must not have been paying attention to DeFi. In the US, TradFi institutions have had their strict compliance and FDIC regulations painted in blood in the wake of the Great Depression.

Our paper covers many aggressive SEC actions up to publication date, and the agency seems hell-bent on having the courts decide that digital tokens are securities. If this happens, it won’t be solely due to the so-called “Lehman effect,” but it may contribute to their resolve. I hope investors look out for exchanges that take measures to limit liability for traders, such as insurance funds, stop measures, and a legal team’s counsel from the outset of protocol design.

If everyone tried to sell at once, loss is inevitable. If few are buying, supply outstrips demand and prices will crash. Crypto offerings are often used as a growth hack to onboard users onto a new network, but it is ultimately that network which may or may not have value, and the token is only a reflection of the confidence the market has in that underlying protocol’s network and community.

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These risks are all covered in depth in the paper, to varying degrees!

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I feel that dYdX would be a wonderful place to start. The service is fairly accessible, and the documentation and protocol design are pretty comprehensive and broadly well-known. This is not investment advice, but it may be a good way to get a feel for how DeFi derivatives trading could or should work.

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Thanks @abr For these responses

excellent post @abr! Blockchain, smart contract enabled synthetic (digital) assets pose fascinating and profound questions to finance & governance, & novel tools.

I was a Lunatic and have a good bit of experience w/ Mirror Protocol which transitioned from Eth to Terra - Mirror & Anchor were the primary dApps on Terra and they were revolutionary, and worked for a period of time. In the end, the failure related to the demise of the stablecoin which enabled the Terra dApp ecosystem and not the synthetic asset mint & marketplace that Mirror provided, or the savings & auto-lending Anchor Protocol. In those heady days, one could buy Luna, swap/bond to bLuna (later, bEth & bAvax) collateralize on Anchor & withdraw UST, then swap to aUST which was pegged to US$ and appreciated at interest rate advertised (15-20%, arguably to lessen over time); and/or go to Mirror Protocol, deposit UST/aUST/bLuna as collateral and mint a variety of mirror assets, mGold mBTC mEth mSol mApple…

The whitepaper for Mirror Protocol v2 (June 2021) is at:

A link to the first whitepaper is found at Appendix.

I haven’t played with the latest round of projects & protocols identified - dYdX (cosmos woot!), Deri, Lyra, Vega or Thales - but will remedy that soon. Shade Protocol, built on Secret, had good bit on synthetic assets with some interesting privacy-enabled twists. This post back before this latest crypto winter from Shade team describes their approach to synthetics, and how it remedies a key problem - that is, the leveraged collateral positions are by their nature on the blockchain transparent, so predatory traders can target those who minted the synthetic position. See Shade Protocol — A Community Series: Synthetics | by Secure Secrets | Medium

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