Synthetic Asset

What Is a Synthetic Asset?

A synthetic asset is a tokenized financial instrument that mimics the price behavior of another asset without holding that asset directly. Instead of buying gold, oil, or foreign stocks, a user locks crypto collateral into a smart contract and mints a token whose value is pegged to the target asset through oracle price feeds. The synthetic token can then be traded, used as collateral in other protocols, or held for price exposure.

Traditional finance has used synthetic instruments for decades: options, futures, and contracts-for-difference (CFDs) all provide exposure to an asset without ownership. Blockchain synthetics bring this concept on-chain, making it permissionless and globally accessible. Anyone with sufficient collateral can mint a synthetic token representing the S&P 500, the price of gold, or even the inverse of Bitcoin's price.

Synthetics differ fundamentally from fiat-backed stablecoins, which hold reserves of the actual underlying asset. Asset-referenced tokens backed by real reserves carry custodial risk but avoid liquidation mechanics. Synthetics carry no custodial risk from a reserve holder but introduce collateralization and oracle risks instead.

How It Works

Synthetic asset protocols follow a common pattern: lock collateral, query a price oracle, and mint a token. The protocol ensures the system remains solvent by requiring more collateral than the value of minted synthetics, and by liquidating undercollateralized positions.

Minting Process

Creating a synthetic asset involves several coordinated steps:

1. A user deposits collateral (typically ETH, stablecoins, or protocol-native tokens) into a smart contract vault
2. The protocol queries an oracle for the current price of the target asset
3. Based on the collateral value and the required overcollateralization ratio, the contract calculates how many synthetic tokens the user can mint
4. The synthetic tokens are minted to the user's address, creating a debt position
5. To reclaim collateral, the user must return (burn) the synthetic tokens plus any accrued fees

Collateral Ratios

The collateral ratio determines how much backing is required per unit of synthetic asset. A 150% ratio means $150 of collateral is needed to mint $100 worth of synthetic tokens. This buffer protects the system against price volatility.

Different protocols use different ratio structures. Some use a single fixed ratio, while others employ a hybrid collateral ratio that adjusts based on market conditions or the type of collateral. Higher ratios increase safety but reduce capital efficiency: more collateral sits locked and unproductive per dollar of synthetic exposure.

// Simplified collateral ratio calculation
collateral_ratio = collateral_value / synthetic_debt_value

// Example: $3,000 ETH collateral, $1,800 synthetic gold minted
collateral_ratio = 3000 / 1800  // = 1.667 (166.7%)

// If ETH drops to $2,500:
collateral_ratio = 2500 / 1800  // = 1.389 (138.9%)
// Below 150% minimum -> eligible for liquidation

Liquidation Mechanics

When the collateral ratio of a position drops below the protocol's minimum threshold, that position becomes eligible for liquidation. Third-party actors called "keepers" or "liquidators" monitor the blockchain for undercollateralized positions and close them for a profit.

The liquidation process typically works as follows:

1. A keeper detects a position with a collateral ratio below the liquidation threshold
2. The keeper submits a transaction to the protocol, repaying some or all of the position's synthetic debt
3. The protocol transfers the corresponding collateral to the keeper, plus a liquidation bonus (typically 5-15%) as incentive
4. The remaining collateral (if any) is returned to the original position holder

During sharp market downturns, many positions can become undercollateralized simultaneously. As keepers liquidate and sell collateral, the selling pressure further depresses prices, triggering more liquidations. This feedback loop is known as a liquidation cascade and has caused significant losses in protocols like MakerDAO during Black Thursday (March 2020) and similar events.

Oracle Price Feeds

Oracles are the bridge between off-chain asset prices and on-chain smart contracts. Synthetic asset protocols query oracle networks (such as Chainlink or Pyth) to determine the current price of the target asset. This price determines minting capacity, collateral ratios, and liquidation eligibility.

The oracle architecture varies: some protocols use a single oracle source, while others aggregate prices from multiple providers to reduce manipulation risk. Time-weighted average prices (TWAPs) smooth out short-term fluctuations, but introduce latency that sophisticated traders can exploit through front-running.

// Pseudocode: oracle-dependent liquidation check
function checkLiquidation(vault) {
  const collateralPrice = oracle.getPrice(vault.collateralAsset);
  const syntheticPrice = oracle.getPrice(vault.syntheticAsset);

  const collateralValue = vault.collateralAmount * collateralPrice;
  const debtValue = vault.syntheticDebt * syntheticPrice;

  const ratio = collateralValue / debtValue;

  if (ratio < MIN_COLLATERAL_RATIO) {
    return { liquidatable: true, ratio };
  }
  return { liquidatable: false, ratio };
}

Notable Implementations

Synthetix

Synthetix is the largest synthetic asset protocol, operating primarily on Ethereum and Optimism. Users stake SNX tokens as collateral and mint sUSD (synthetic USD), which can then be exchanged for other synthetic assets (sETH, sBTC, synthetic equities) through the protocol's exchange. Synthetix uses a pooled debt model: all stakers collectively back all synthetic assets, meaning each staker's debt fluctuates based on the aggregate performance of every synthetic in the system.

This pooled model means that if synthetic gold appreciates while a staker only holds sUSD, the staker's debt increases even though their position didn't change. The model provides deep liquidity (any synthetic can be exchanged for any other at oracle prices with zero slippage) at the cost of shared risk exposure.

Mirror Protocol

Mirror Protocol (now defunct) operated on the Terra blockchain and allowed users to mint synthetic versions of US equities: mAAPL, mGOOG, mTSLA, and others. Users locked UST or LUNA as collateral and minted these "mirrored" assets, which tracked stock prices via oracle feeds. Mirror demonstrated both the promise and peril of synthetic assets: it provided global access to US equities but collapsed alongside Terra's death spiral when UST and LUNA lost their value.

Ethena (USDe)

Ethena takes a different approach to synthetic dollar construction. Rather than using overcollateralization, USDe maintains its dollar peg through a delta-neutral hedging strategy: the protocol holds spot crypto assets and simultaneously opens matching short perpetual futures positions. The short positions offset the price risk of the spot holdings, creating a synthetic dollar without traditional collateral buffers. This approach achieves higher capital efficiency but depends on the availability of futures markets and carries funding rate risk when short positions cost money to maintain.

Use Cases

Synthetic assets unlock financial exposure that would otherwise require intermediaries, geographic proximity, or significant capital.

• Global market access: a user in a country without stock market access can gain exposure to US equities, commodities, or foreign currencies through synthetic tokens, bypassing brokerage accounts and regulatory barriers
• Hedging and risk management: a Bitcoin miner can mint a synthetic short-BTC position to hedge against price declines without selling actual BTC or using centralized derivatives exchanges
• Composability with DeFi: synthetic assets can be deposited into lending protocols, used as liquidity in decentralized exchanges, or combined with other DeFi primitives in ways that traditional financial instruments cannot
• Commodity exposure: commodity-linked synthetics allow on-chain exposure to gold, oil, or agricultural products without the logistics of physical delivery or commodity futures rollovers
• Inverse and leveraged products: protocols can create tokens that track 2x or 3x the price movement of an asset, or tokens that move inversely, enabling sophisticated trading strategies without margin accounts

Risks and Considerations

Oracle Risk

Synthetic assets live and die by their oracle feeds. If an oracle reports an incorrect price, the consequences ripple through the entire system: positions may be incorrectly liquidated, synthetics may be minted at wrong values, or arbitrageurs may drain the protocol. Oracle manipulation attacks have exploited this dependency multiple times. Flash loan-funded price manipulation on low-liquidity oracle sources has drained hundreds of millions from DeFi protocols.

Mitigation strategies include using decentralized oracle networks with multiple data sources, implementing circuit breakers that pause the protocol when prices move abnormally, and applying time delays to price updates. Each mitigation introduces its own tradeoffs: precision decay from smoothing mechanisms, and latency that can be exploited by front-runners.

Liquidation Risk

Position holders face the risk of liquidation during volatile markets, often at the worst possible time. Liquidation penalties (5-15% of collateral) mean that a temporary price dip can result in permanent loss, even if the market subsequently recovers. Network congestion during market crashes can prevent users from adding collateral in time, compounding the problem.

Capital Inefficiency

Overcollateralized synthetics require significantly more capital than the exposure they provide. A 150% collateral ratio means $1.50 locked for every $1.00 of exposure. Some protocols require ratios of 200-750%, making them impractical for large-scale use. This stands in contrast to fiat-backed stablecoins, which achieve a near 1:1 capital ratio by holding actual reserves.

The tension between capital efficiency and safety is fundamental. Algorithmic stablecoins attempted to solve this by reducing or eliminating collateral requirements, but their history of catastrophic failures illustrates the danger of prioritizing efficiency over soundness.

Regulatory Uncertainty

Synthetic assets that track regulated securities (stocks, commodities, currencies) exist in a legal gray area. Regulators in multiple jurisdictions have taken the position that synthetic tokens tracking equity prices constitute securities offerings. Specified stablecoin frameworks and e-money token regulations increasingly distinguish between directly-backed and synthetic instruments, with synthetics often facing stricter requirements.

Synthetic vs. Directly-Backed

Choosing between synthetic and directly-backed asset representations involves tradeoffs across multiple dimensions:

For stablecoins specifically, the market has largely favored directly-backed models: USDC and USDT dominate by market cap, while synthetic and algorithmic alternatives have struggled to maintain reliable pegs at scale. For non-dollar assets where direct backing is impractical (equities, commodities, indexes), synthetics remain the primary on-chain solution. For a deeper look at how stablecoin design decisions affect the broader Bitcoin ecosystem, see the research article on USDB and stablecoin design.

This glossary entry is for informational purposes only and does not constitute financial or investment advice. Always do your own research before using any protocol or technology.