INTRODUCTION
An uproarious and brutal battle is looming on the financial horizon. And it has been brewing for quite some time now. Battling for supremacy in this fight are the Decentralized Financial systems built on the blockchain against the so-called legacy financial systems. And the underlying root cause for this epic battle - synthetic assets.
You see, folks like SEC Chair Gary Gensler, FED Chair Jerome Powell, and the other regulatory legal eagles have finally come to the harsh realization that cryptocurrency synthetic assets in tokenized format are just the same as regular assets - only better.
Having reached this realization prompted the following remark from Gensler in July of 2021:
It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These platforms — whether in the decentralized or centralized finance space — are implicated by the securities laws and must work within our securities regime.
[U.S. Securities and Exchange Commission. Prepared Remarks of Gary Gensler, Chair of the Securities and Exchange Commission, Before the American Bar Association Derivatives and Futures Law Committee Virtual Mid-Year Program. (Accessed November 7, 2021)].
Gensler then concluded his remarks with the following warning:
We will continue to use all of the tools in our enforcement toolkit to ensure that investors are protected in cases like these.
[Id.].
WHAT ARE SYNTHETIC ASSETS AND WHAT IS THEIR ROLE IN THIS CRUSADE?
WHAT ARE SYNTHETIC ASSETS?
One of the best definitions available for what a synthetic asset is follows:
Synthetic assets are essentially tokenized derivatives. In the traditional financial world, derivatives are representations of stocks or bonds that a trader does not own but wants to buy or sell. In essence, if you want to profit from the price fluctuations of a stock that you don’t own, you can do this through a derivative. Synthetic assets, or tokenized derivatives, take this process one step further by adding the record for the derivative on the blockchain and essentially creating a cryptocurrency token for it.
[Alexandria. Synthetic Assets. (Accessed November 7, 2021)].
For example, a synthetic share of Tech Giant Microsoft can be bought and sold for the same price as a traditional share on NASDAQ. Now consider the priorities of an average stock trader - profit margins, accessibility and privacy. Is the purchase of a real share going to be preferred by an average trader over a synthetic share?
Once the synthetic markets expand the answer must be no. With current blockchain privacy, would not the average trader prefer to purchase synthetic shares at a fraction of the cost, anytime during the day, night, or day of the week (including holidays!)? Furthermore, taking into consideration technological expansion of synthetics, it is just a short matter of time before these traders can stake the synthetics to earn interest or use as collateral for a loan [in fact, to an extent Mirror Protocol is already performing this].
Decentralization grants open-access to a global community of investors. Before products such as Abra, Synthetix and UMA became available, only a select few institutional investors could access the global derivatives market. Now, anyone with a smartphone and an intermediate understanding of the synthetic asset underworkings can access these powerful investment vehicles.
[Kuznetsov, N. Crypto Synthetic Assets, Explained. (Accessed November 7, 2021).
THE CURIOUS ROLE OF SYNTHETICS
The fear of that which is unknown. "With cryptocurrency synthetic asset platforms opening the doors to derivatives for thousands of new investors, only time will tell what kind of impact a potential flood of new cryptocurrency-collateralized derivative contracts will have on the traditional financial landscape." [Id.].
Yes my friends an epic battle is looming between decentralized blockchain technologies and legacy financial systems that will go down in the annals of economic financial history. These two sides have already drawn their respective lines in the sand. Gensler's remarks set forth above constitute only the SEC's opening salvo in this war. And the looming battle will be a powerful reminder to both sides that it is the systems of exchange that instill assets with value, not vice versa.
However, the resulting ramifications are clear. The rise of synthetic assets level the field permitting legacy centralized institutions and decentralized blockchain technologies to compete for both investors and capital. An age of a free market for markets will be born.
What exactly is meant by this and why is it so important? When the situation becomes such that the asset side of the equation is fixed (in other words, where the same identical asset exists on multiple diverse platforms), the marketplaces themselves compete against one another for the largest daily trading volume share. Then it becomes the final determination of the traders as to which system, the centralized legacy or decentralized blockchain, will survive and become home to the investable asset.
So, they become the biggest and most fearful threat to the various National Governments and Central Banks these emerging fiat backed stablecoins (yes, they are synthetic in nature). And this threat is real. Who wouldn't prefer a fiat backed stablecoin over fiat when the stablecoin provides 24 hour access, low cost transfers internationally, high rates of interest earnings, and a redemption rate to traditional fiat of 1:1.
Stablecoins drive a hard marketplace bargain, even for the most skeptical among us. So much so in fact, the U.S. Congress entered the foray with its two cents in the form of the legislative proposal of the Stable Act [see, H.R. 8827. Stablecoin Classification and Regulation Act of 2020. (Accessed November 7, 2021)]. The Stable Act would essentially require the issuers of stable coins to obtain the identical bank charters as their centralized counterparts.
History has demonstrated that legacy financial institutions can be ruthless when faced with threatening competition. They either seek out and acquire, or, sabotage the competition. With the current rise of synthetics it is not hard to see legacy financial's aversion to them. And this will only worsen with the further growth of synthetics. As the decentralized protocols begin to mainstream and grow more user friendly, their superior offerings will shift demand away from the legacy platforms former exclusive assets and direct them into decentralized digital synthetics.
THE UNKNOWN FUTURE FOR SYNTHETICS
As the demand for synthetics exceeds that of their traditional counterpart, investors will be forced to decide what makes an asset real in the first place. Ultimately, these investors will be called on to decide which direction the free market is to travel, centralized legacy or decentralized blockchain. From a realistic standpoint the very existence of which market is to survive is in the balance.
As this objective crisis deepens, governments and financial institutions will most certainly rally the troops. It is easy to envision a future where: the SEC will fight for the elimination of synthetics; Congress will act to regulate stablecoin issuers from threatening the traditional banking elite; the CFTC will act to limit derivative protocols; and, FinCEN will continue to fight all who value user financial privacy.
Only time will produce an outcome.
CONCLUSION
As it is impossible to undo the technical innovations made in the area of finance, the brewing war set forth above will necessarily have to be decided. Until that day comes, the future will be faced with very rough roads to travel.
The Pandora's Box containing the curse of financial innovation has already been breached by the likes of Mirror Protocol, Synthetics, Compound and the like. But whatever this future may bring. it will once and for all permanently tear down the wall separating the worlds of traditional centralized finance from the world of emerging decentralized financial blockchain protocols. Hopefully, we will together witness the birth of a new free financial order springing forth from the current state of chaos.