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A Brief History of Synthetic Assets and Financial Derivatives
Synthetic assets, or financial derivatives, aren’t a new phenomenon. In fact, as far back as 600 B.C.E in ancient Greece, humans have relied on them extensively for trading, speculation, and hedging.
Put simply, a derivative is any asset that derives its value from a separate underlying asset or basket of assets. A synthetic asset is simply a tokenized derivative which instead of using traditional contracts, leverages the power of the blockchain and the broader crypto ecosystem.
The First Derivatives
The first financial derivatives were akin to forward contracts which enabled the purchaser of goods to lock in a fixed price at the time of agreement, while taking delivery at a later stage.
While rudimentary in their design, early derivative contracts transformed trade, enabling buyers and sellers to agree on the price of sale for goods like olive oil, grain and rice, without having the need to actually exchange the underlying asset until a future date, reducing the risk of price volatility.
This had obvious benefits for both parties. Buyers of goods could secure a steady stream of materials, providing certainty over their supply chain and input costs. Sellers of goods, on the other hand, were given the ability to secure future sales without having to bring the goods with them, while also having greater certainty over their order flow and inventory management.
Additionally, buyers and sellers could both transact using ‘fair letters’, effectively redeemable coupons which could be exchanged at a bank for money, allowing merchants to avoid keeping large amounts of gold or fiat currency on them as they traveled to and from various marketplaces, reducing the risk of robbery. Transactions were even sometimes recorded in clay tablets and were afforded legal and counterparty protections by the prevailing laws of the land.
Facilitating Global Markets
As civilizations evolved and became more sophisticated, so too did the markets that operated within them. In the early days, most merchants would buy derivative contracts like forwards with the intention of taking possession of the underlying commodity at expiry. However, as derivative markets started to evolve and grow, they became more structured and standardized. This led to an explosion in popularity and trading frequency or ‘volume’, especially for speculative purposes.
No longer were derivatives purely the domain of merchants and traders just looking to secure the flow of goods and commodities for their homes and businesses. Speculators were beginning to get involved as new cash-settled, rather than physically-settled contracts for intangible and financial assets were emerging.
Derivative contracts were soon being offered on company profits, bonds, and even on the outcome of whether a ship and its cargo would arrive at port on time. Additionally, as trading activity was shifting from various decentralized marketplaces to singular centralized buildings called bourses - the earliest examples of centralized financial exchanges - the contracts traded would often change hands multiple times before their expiry, which led to the creation of a vibrant secondary market. This all laid the groundwork for today’s financial, commodity and derivatives markets.
Derivatives Today
Fast forward several hundred decades, and today we continue to see the derivatives market evolve and flourish.
From the National Stock Exchange in India, to the CME Group, and the NASDAQ, the total gross market value of the derivatives markets exceeds $558 trillion USD and is valued as high as $1 quadrillion USD.
To put this into perspective, the total gross market capitalization of the US equity market is $53 trillion USD while the value of gold is $12.36 trillion USD, and cryptocurrency a mere $2 trillion USD.
Whether it’s stock options, foreign exchange swaps, or bitcoin futures, today there is no shortage of ways for investors, traders and businesses to express their particular views on the market using derivatives.
Futures and Forwards
Both futures and forwards contracts are similar and enable the purchase and/or sale of an asset at a specific price on a specific date in the future. While forwards are customizable and trade over-the-counter (OTC), meaning they are structured by the two counter-parties involved, futures are standardized and trade on exchanges.
It is the centralization and standardization of futures markets which enable both volume and liquidity as they provide greater accessibility for participants across the world to access markets including equities, commodities, foreign exchange and cryptocurrency.
Options
Options are derivative contracts which provide buyers/sellers with the right but not the obligation to buy/sell an asset in the future. A call option is an offer to buy an asset at a set price called the strike price, while a put option is an offer to sell an asset at the strike price. To enter into these agreements, options traders pay an upfront fee called a premium.
Both types of options provide market participants with the means to speculate on the future price of an underlying asset while also offering a way to protect or hedge against price volatility.
Swaps
Swaps are used by market participants to exchange or ‘swap’ one source of cash flow for another over a set period of time. These derivative contracts are primarily used to hedge risks in changes to foreign exchange rates and interest rates.
CFDs
CFDs or ‘contracts for differences’ are derivative contracts which track the underlying value of another asset like a stock or cryptocurrency and pay the difference between the opening price of the contract and the closing price.
The Next Frontier
Today, there is more opportunity than ever before to trade and speculate on markets using derivatives, and the emergence of cryptocurrency and DeFi is augmenting this even further through the use of synthetic assets.
Synthetic assets, which trade on the blockchain, offer traders various benefits to traditional derivatives including added security and traceability, while also providing a layer of anonymity if desired. The immutability of the blockchain also removes counterparty risk.
Additionally, the fractionalization or ‘tokenization’ of previously inaccessible and illiquid assets like fine art and collectibles, or even the creation of synthetic digital versions of US or Chinese listed equities, is creating new and exciting frontiers for trading and investing.
Horizon Protocol is the gateway to these possibilities, leveraging the power of on-chain trading of synthetic assets via smart contracts on the blockchain. Our synthetic assets, known as “zAssets”, can track the price movement and risk reward profiles of almost anything, from NFTs, REITs to gold, bitcoin and oil.
Over time, as civilization has advanced, accessibility to derivatives markets has become easier for everyday people. Horizon Protocol has been created with this in philosophy in mind - we want to give anyone, anywhere, access to derivatives markets, and this is why we are building on BNB Chain, so we can offer our users the speed and dependability that is currently lacking on the Ethereum blockchain.
Whether transactions are recorded on the blockchain or on clay bricks, derivatives and synthetic assets have played a fundamental role throughout history, and Horizon Protocol is the next step in this evolution.