Since bitcoin went mainstream a few years ago, the popularity of ‘crypto’ has risen significantly, which in turn has made the early adopters of cryptocurrencies, incredibly wealthy.
Although bitcoin was considered as something of a novelty for a considerable time, since seeing the returns that can be made from cryptocurrencies, more investment firms have started investing in crypto markets and exchanges.
As a way to maximise their potential returns, some sophisticated investors and hedge funds are turning to synthetic cryptocurrency or ‘crypto synths’. But, what exactly does this mean, and how can such trades be executed?
Understanding synthetic assets and derivatives
Before discussing synthetics, it’s important to understand derivatives. Derivatives are assets that derive their value from an underlying asset or index. For example, if the value of a particular derivative is tied to an asset via a contract, hedge funds can trade the movement of that value through financial instruments like futures and perpetuals.
Synthetic assets are derivatives but, instead of using contracts to link the values of an underlying asset and a derivative product, they tokenise it. This means that crypto synths can essentially replicate the movements of any asset in the market, whether that be a stock, a currency, or a commodity.
To understand synthetics and how they can be used as part of a successful trading strategy, one must first understand derivatives. These are assets where the value is directly linked to that of an underlying asset, such as stocks, commodities, bonds, currencies or stock indices - sometimes via a contract. Hedge funds can make trades based on the movements of a derivative by using financial instruments such as futures and perpetuals.
Crypto synthetic assets are another type of derivative, but rather than linking their values to underlying assets with contracts, they tokenise it. Crypto synthetics, then, can replicate the movements of any asset on the market, whether that be a stock, currency or commodity. This means that hedge funds can use cryptocurrencies, rather than fiat currency, to invest in the price movements of assets on traditional markets. For example, through the use of crypto synthetics, one could invest their bitcoin in the movements of company stock, such as Tesla and Google or a commodity such as gold or oil.
How do crypto synths work?
Synthetic cryptocurrency provides users and the wider market with the advantages of decentralisation – eliminating a lot of the administrative protocols of turning an asset into cash.
Because crypto synthetics can be made up of several assets without actually owning those assets, traders can access the price movements of various assets and markets without leaving the cryptocurrency ecosystem. This means that investors can follow the price movements of an asset, using their crypto capital rather than fiat currencies such as the US Dollar.
Most transactions these days are accomplished with the help of technology, which is merely a facilitator of those transactions. For a transaction to be executed successfully, companies still have to navigate the legalese of jurisdictions, competing financial markets and different standards.
Blockchain, the technology at the heart of cryptocurrency, means all that data is saved on a distributed ledger, which enables the whole crypto ‘community of assets’ to recognise who owns what.
Synthetic cryptocurrencies then enable the tokenisation of essentially any asset, which means any asset on any market can be brought onto the blockchain, which would potentially unlock unprecedented levels of liquidity all over the world.
The benefits of trading synthetic crypto
Increased liquidity is one of the biggest benefits that comes with trading synthetic cryptocurrencies. As crypto markets are still relatively new, the liquidity of crypto-only exchanges is somewhat limited compared to traditional markets. That said, it’s worth noting this is less applicable to more popular cryptocurrencies like bitcoin and ethereum.
Liquidity should be a key concern for every kind of investor, from retail traders and individual traders to investment firms with large capital, as a lack of ability to liquidate an asset can leave investors struggling to sell their position.
For example: if a crypto asset’s value were to plummet and everyone holding that asset tried to sell at the same time, the lack of liquidity would likely affect how quickly it can be sold. In theory, this could mean that the value of the said asset would deteriorate rapidly and a trader’s sell order could take significantly longer to be executed because not enough other people are interested in buying it. When trading on a large scale, the accumulated loss of such an event could be huge.
As synthetics can be traded on any cryptocurrency exchange, they are more liquid, which means traders will benefit from fair asset prices, market stability, accurate technical analysis and quicker transactions.
Other than basic buying, selling and derivatives trading, synthetic assets could create an almost-infinite number of markets and asset combinations.
How to trade synthetic cryptocurrencies
To trade synthetic cryptocurrencies, hedge funds would first need to determine whether they can actually access cryptocurrency exchanges and make synthetic trades through both their prime broker and their trading platform.
As the market for synthetic cryptocurrencies is still in its infancy and can be rather complex, any hedge fund with little to no experience of trading crypto synths would do well to seek the advice of an expert in the field.