Synthetic Asset Platforms (SAPs) fill the gap between the new DeFi platforms and the older financial systems. They enable investors to invest in any asset from the blockchain ecosystem. At the end of 2021, SAPs will dominate the DeFi landscape.
However, despite the apparent growth potential of SAPs, there are pitfalls beyond the obvious benefits of decentralization and security of ownership.
Collateralized debt, globally, has a combined valuation of around $1 trillion. Collateralized lending comes with certain risks, and it is important to understand them.
If the value of collateral, pledged against debt, falls below a defined threshold, the creditor can assume ownership of the collateral. The creditor can then liquidate the collateral to recover the loan principal that is outstanding.
Collateralized financial products, even those on the ETH blockchain, come with the same risks. The triggers for liquidation are linked to the volatility of the prevailing macroeconomic environment.
Risks of Collateralization
Consider the case of MakerDAO. MakerDAO is a decentralized SAP with the collateralized stablecoin DAI. DAI is pegged to the US dollar. DAI is, however, collateralized with volatile assets such as ETH and BTC.
To guard against mass liquidations triggered by the volatility of the crypto market, over-collateralization of up to 150% is practiced. However, in 2020 even this proved inadequate, and Maker users were liquidated with total losses amounting to $6 million.
Learning from Maker’s experience, now SAPs are over-collateralizing by up to 500%. The very high collateralization and the liquidation risks drive crypto traders towards synthetic stocks and secondary markets. This has caused price increases in synthetics. All this is driving investors back towards traditional finance.
There is an urgent need for change in DeFi through better collateral management. SAPs are, therefore, currently focused on evolving better collateralization models.
The burn-and-mint model of collateral does away with several of the current drawbacks while maintaining capital efficiency. As DeFi navigates this transition, attention also needs to be paid to liquidity management.
For DeFi platforms, after solving collateral management problems, liquidity management will differentiate the next iteration of SAPs.