Synthetic Assets on Blockchain
VeradiVerdict - Issue #118
One of the largest limitations of traditional financial markets is the lack of digital access; much of financial bookkeeping and trading is ultimately executed by extremely centralized institutions, which prevents everyday users from things like fractional asset ownership, 24/7 trading access, permissionless access (e.g., no KYC/AML), lower costs, and more.
Digitizing ownership of real-world assets and their value would present significant use to traders looking for price exposure, without having to physically own assets. To address this, Terraform Labs launched the Mirror protocol, which allows users to create synthetic assets on the Terra blockchain that track the value of real-world assets (like US equities).
Mirror’s synthetic assets are called mAssets, and can be minted by entering into a collateralized debt position (CDP), where a user supplies a minimum of 150% of the real-world asset’s value in Terra USD (UST) or other mAssets to the protocol. These assets can be traded in various automated market makers (AMMs) on both Ethereum and Terra, and their price is updated every 30 seconds by a decentralized price oracle operated by Band Protocol.
To facilitate the protocol’s operation, Mirror rewards users that supply liquidity to AMMs that execute trades with mAssets with ownership of the MIR governance token. The MIR governance token will be distributed at a constant rate over the next four years to a total supply of 370.575 million MIR and is on a deterministic inflation schedule. MIR holders also receive 0.25% of trading fees collected by the Mirror protocol and have governance rights, like whitelisting synthetic assets and adjusting parameters like the collateralization ratio.
Prior to Mirror, the most popular approach to synthetic assets that track real-world assets was Synthetix, which operates similarly. The critical difference between Synthetix and Mirror however, is that Synthetix requires SNX tokens as collateral, whereas Mirror requires the Terra USD stablecoin or other mAssets; due to the volatility of SNX, this means Synthetix requires a 750% collateralization ratio compared to Mirror’s 150%, which makes Synthetix significantly less capital-efficient.
Ultimately, Mirror provides an extremely promising model for digital assets that can track real-world assets and circumvent some of their structural limitations, enabling things like fractional asset ownership, permissionless access to the largest markets in the world, and more. This step towards digitizing the “real-world” economy on the blockchain is hopefully one of many in creating a more customizable, open financial system.
Digitizing “Real World” Assets
The advent of the blockchain, blockchain-centric trading strategies, and decentralized finance has demonstrated the value of digital bookkeeping, custody, and execution for different financial assets. Digitizing these workflows on the blockchain greatly increases financial access, composability, automatability, and security –– all of which are key in creating a more open, trusted financial system.
Unfortunately, US securities today don’t have a streamlined solution for digitizing these workflows and/or executing them on the blockchain. This prevents several key innovations in the financial sector –– for instance, there is no clear, standardized digital method to track ownership stakes of property (e.g. 50% of the value of a house), which could be a game-changer for democratizing property ownership and real estate investing. Several third-party services exist to query the prices of US equities and other assets in real-time, but there are not many solutions that actual tie digital assets to real-world assets.
How do we bring these assets to the blockchain?
Recently, Terraform Labs launched the Mirror protocol, which enables users to create synthetic assets on the blockchain that track the value of real-world assets (e.g. US equities, like $TSLA and $AAPL). The idea behind the protocol is to offer an on-chain complementary asset to real world assets, which allows traders anywhere to access price exposure on the blockchain without actually having to physically own or move the real assets.
How do these synthetic assets actually work?
Mirror’s fungible synthetic assets are called mAssets and are native to the Terra blockchain. To mint an mAsset for a corresponding real-world asset, users must open a position on Mirror and deposit a minimum of 150% of the real-world asset’s value in the form of Terra stablecoins, like Terra USD (UST), or existing mAssets; this acts as the synthetic asset’s collateral. For a real-world asset with ticker X, the corresponding mAsset would have the name mX (e.g. $TSLA’s synthetic asset would be mTSLA).
Every 30 seconds, the Mirror protocol also reads in real-time data for the price of the underlying asset through a decentralized price oracle -- the Oracle Feeder. This allows the mAsset to track the value of the real-world asset in what is effectively real-time. The value correlation between mAssets and their real-world equivalents is further bolstered by arbitrage opportunities for market participants, who can mint and burn mAssets to take advantage of price discrepancies between the Oracle Feeder price and the current price on AMMs like TerraSwap and Uniswap. The protocol remains solvent by liquidating a user’s collateral via a discount auction if the collateralization ratio falls below 1.5, or when the real world asset appreciates and/or the collateral depreciates. Users can also burn mAssets by burning the equivalent amount of assets they received when they opened their position on the protocol, which allows them to then access the stablecoins/mAssets they deposited as collateral. Users are charged a 1.5% fee when closing a collateralized debt position with Mirror, the funds of which are distributed to liquidity providers (see below).
These mAssets are then tradable on automated market-makers (AMMs) on public blockchains like Ethereum and Terra, which makes it simple to issue and buy/sell these synthetic assets.
Many have already proposed new use cases for the protocol’s technology. Injective is looking to launch a decentralized stock futures trading protocol, with mAssets representing each equity; this would be the first decentralized futures trading protocol of its kind. Some are exploring Mirror’s potential to enable yield-bearing stocks: essentially, yield farming for stocks, where holding an asset can get you more of that same asset. The use of mAssets in money market protocols (e.g., Compound) as collateral is also promising. For example, mAssets representing major US tech equities are significantly less volatile than many of the altcoins that can be deposited into money market protocols on Ethereum as collateral. This improves capital efficiency for LPs to money market protocols because they can deploy capital (mAssets) at a lower collateralization ratio compared to altcoins, which have a proclivity for sharp price swings in volatile market conditions -- triggering unexpected liquidations.
Others are excited about Mirror’s ability to expand the use cases behind wallets –– instead of simply having custody or accounting of cryptocurrency holdings, users could track other financial assets all in the same place with mAssets, potentially eroding the role of services like Robinhood, eToro, etc.
How do users participate in the Mirror protocol?
At a high-level, there are four main personas in the protocol’s operation: minters, stakers, traders, and liquidity providers (LPs). The Oracle Feeder is also the designated price oracle (currently Band Protocol) for Mirror, which can be changed via the MIR governance model, and serves as an auxiliary persona in Mirror.
Minters are users who actually mint mAssets corresponding to real-world assets by depositing collateral; in effect, they take a short position on the real-world assets, because they intend to sell the mAsset (which has the same value as the real-world asset) without actually owning the real-world asset. However, should they collateralize their position in Terra’s UST stablecoin, they are taking a market-neutral position, and if they collateralize in another mAsset, they are effectively taking a long position.
Traders are users that simply buy and sell mAssets minted by other users on public blockchains. These can be swapped on AMMs like TerraSwap and Uniswap, with more AMMs and central order-book exchanges likely to list mAssets in the future.
LPs deposit equivalent amounts of mAssets and UST on the corresponding TerraSwap pool, which accrues LP tokens proportional to the percentage of the LP’s deposited tokens compared to the whole pool. Trading fees from the pool also serve as an additional reward.
Stakers deposit either LP tokens or MIR tokens to generate MIR token rewards. LP token stakers accrue MIR via MIR’s inflation, and MIR token stakers accrue MIR via the CDP withdrawal fees. Staked MIR tokens enable users to participate in the governance process of Mirror, such as whitelisting mAssets and changing protocol parameters like the over-collateralization ratio.
You can get started with Mirror at their web portal here. At time of writing, the protocol has 76.97 million USD locked in as collateral, and a collective market cap of 38.97 million USD amongst its mAssets. Some of the top real-world assets being tracked and traded include $TSLA, $AAPL, and $GOOGL, indicating that the protocol has already anchored onto popular US equities.
How is it governed?
To facilitate trading mAssets for stablecoins, and vice versa, the Mirror protocol leverages AMMs; this requires a good amount of liquidity, which the platform incentivizes with liquidity rewards. For each trade involving an mAsset in an AMM, a trader must pay a small fee to the Mirror protocol. The protocol then distributes this value in the form of MIR governance tokens; MIR holders earn 0.25% of trading fees.
MIR will be distributed at a constant rate over the coming four years to incentivize liquidity providers in the Mirror protocol. Out of a total fixed supply of 370.575 million MIR, 9.15 million MIR will be distributed to UNI holders and LUNA holders each in an initial airdrop. Other users will be able to farm MIR over the next four years by supplying liquidity to AMMs with mAssets. This dually incentivizes users to supply liquidity to the protocol, because the MIR token will appreciate and also reward holders with a proportion of trading fees collected on mAssets.
Final allocation of Mirror’s 370.575 million MIR tokens (Mirror Docs)
The MIR token also constitutes voting privileges on certain items of governance, like specifying which real-world assets can and cannot have a synthetic analog on Mirror, and also changing protocol parameters like collateralization ratio and trading fees.
Users can provide liquidity for mAsset trading on Uniswap here and Terraswap here. As of writing, the MIR token has a price of $1.11, a market cap of $21.04 million, and a circulating supply of approximately 18.8 million tokens.
How does it compare to other synthetic asset approaches?
Prior to Mirror, one of the most popular approaches towards synthetic assets on the blockchain was Synthetix. Synthetix has a similar offering, where users can open a collateralized debt position to mint synthetic assets. However, to mint assets on Synthetix, users must supply the SNX token while in Mirror, users collateralize with Terra USD or other mAsssets. Because SNX is so volatile, it requires a 750% collateralization; Mirror’s 150% collateralization requirement in comparison provides a key capital efficiency improvement here.
Lower collateralization also means that Mirror is much more capital-efficient than Synthetix, which makes it a more appealing platform for offering decentralized options against the US’s $36 trillion equities market. In short, lower collateralization diversifies the use cases and types of assets that can be tracked on the platform.
Investing is slowly becoming more accessible and decentralized in recent years, especially thanks to the advent of more consumer-facing platforms like Robinhood and Abra that have made it easier for everyday users to engage with markets. Still, several financial markets, like real-estate and US equities, have structural limitations that prevent more individuals from accessing it or leveraging its full value. Blockchain technologies have demonstrated their prowess in implementing and executing a trusted, programmable, secure financial system and have immense potential in expanding access and use cases around traditional financial assets.
The Mirror protocol is one of the most promising technologies that brings the magic of blockchain to the traditional financial industry. With Mirror, users can mint and trade synthetic assets that track the value of real-world assets, enabling 24/7 trading, constant price exposure access, and fractional ownership of these assets on the blockchain. Mirror’s massive market cap of $38.97 million in mAssets, accrued over just a few days, demonstrates the tangible value that the protocol brings to real-world users. Ultimately, Mirror presents an innovative application of blockchain in the traditional financial sector, slowly closing the gap between mainstream and decentralized finance and bringing asset tracking and ownership into the digital age.
- Paul V
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Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. The firm invests in equity, pre-auction ICOs, and cryptocurrencies on the secondary markets. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.