An Introduction to Synthetic Derivatives.

If you have ever been involved in financial markets, you have probably heard about derivatives.

Derivatives are financial instruments or securities that are designed to match the real-world value of an underlying asset without the holder of the derivative actually having to own the underlying asset.

Derivatives are simply contracts and do not have any value in and of themselves, but rely on their underlying assets to derive their value.

These assets may be a single asset or a group of assets. Derivatives may contain bonds, stocks, cryptocurrencies, commodities, frat currencies, interest rates, or market indexes. They may also contain a combination of some of these.

Derivatives are wildly popular in financial markets, and many traders and market players invest heavily in the derivatives market. The derivatives market is the most valuable market in the world and is worth more than the stock, cryptocurrency, and bond markets combined.

Going by high-end estimates, the total market size of all derivatives is estimated to have a notional value of $1 quadrillion. In comparison, the stock market, cryptocurrency market, and bonds market have a combined value of just over $200 trillion.

History of Synthetic Derivatives

Derivatives have existed for millennia. The oldest known example of a derivative was recorded by the Greek philosopher, Aristotle. It was a contract transaction involving olives. According to Aristotle, Thales, another ancient Greek Philosopher, made a profit off the transaction.

A more modern example of derivatives is bucket shops, but those were outlawed in 1936. Bucket shops allowed people to gamble on the prices of stocks or commodities like oil and grains before the U.S. Supreme Court ruled them to constitute securities fraud.

Despite having a history shrouded in some underhandedness, derivatives are completely legal, and a legitimate way to hedge risk and make profits.

Synthetic derivatives are an offshoot of traditional derivatives. They have become increasingly popular as the cryptocurrency market has gained more mainstream appeal and greater mass adoption.

What are Synthetic

Derivatives?

Synthetics are, as implied in their name, synthesized or artificial derivatives. While traditional derivatives are often built off of physical or digital assets like commodities, stocks, bonds, cryptocurrencies, and so on, synthetic derivatives are tied to derived assets.

They are essentially a derivative of a derivative.

To illustrate what synthetic derivatives are, think about a sport like football. Football is a real sport played by real people and with real outcomes. The sport, football, can be likened to an underlying asset like commodities, stocks, and bonds.

Then there are fantasy football teams that are derivative of actual football teams and are made up of a combination of players taken from the different football teams and combined into one team. This fantasy team's performance is based on the real-world performance of the players in that fantasy team. A fantasy team can be likened to a derivative.

Now imagine another fantasy team that is based on the performance of the first fantasy team, and you have a synthetic derivative. Investors use synthetic derivatives to mimic financial products to drive economic growth and profits. Synthetic derivatives are highly customizable and are often used by large-scale investors. They are also designed to match the cash flows of a single security.

Summarily

Synthetics are an important element in the financial marketplace. In the cryptocurrency space, they allow investors to trade traditional assets without having to leave the digital ecosystem.

While many platforms exist that allow investors to securely trade synthetics, these platforms come with major pitfalls.