For years, the powers that be on Wall Street have toyed with questions about whether it would be feasible to move the stock market onto a blockchain, the underlying technology behind cryptocurrencies.
The innovators in the fast-moving world of decentralized finance—or DeFi—aren’t waiting around to see how those discussions unfold. Instead, they’ve built synthetic versions of equities that track some of the world’s biggest companies. In essence, the anti-establishment ethos of the crypto world is being applied to a rough facsimile of the stock market.
Fake versions of Tesla Inc., Apple Inc., Amazon.com Inc. and other big stocks, as well as a few popular exchange-traded funds, have been created by the projects Mirror Protocol and Synthetix over the past year. The tokens, and the programming that allows them to trade, are engineered to reflect the prices of the securities they track without any actual purchases or sales of the real stocks and ETFs involved. So far, volumes are just a tiny fraction of those on regulated exchanges. But for crypto enthusiasts, the potential upside is huge.
The synthetic shares join a strange new world of assets such as digital artwork and highlights of NBA games now trading on blockchains. Yet, unlike the modern art and dunks of the non-fungible token universe, these instruments raise questions about how they fit into a global stock market and brokerage industry governed by thousands of pages of rules from dozens of countries.
At the moment, it’s a case of innovation that’s way ahead of regulation.
Which is exactly how Do Kwon likes it. The co-founder and CEO of Terraform Labs, the South Korean company that created the Mirror Protocol on its Terra blockchain, Kwon fancies himself as a sort of modern-day Robin Hood of finance—in the mode of Vlad Tenev or Chamath Palihapitiya. DeFi “is so powerful in unlocking financial services for disenfranchised people around the world,” he said via email, that “it’s better to move fast and break things. Waiting for fragmented regulatory frameworks to crystallize before innovating is counterintuitive.”
Synthetic Assets
For Kwon and other proponents of these new synthetic assets, avoiding the various rules and barriers of the financial world is a feature, not a bug. It opens up opportunities for wealth creation currently only available to a fortunate few, he said. Users can trade the tokens anonymously 24 hours a day, seven days a week, from anywhere, unhindered by capital controls, “know your client” rules imposed on broker-dealers, and other frictions of the traditional financial system.
Kwon said Terraform Labs doesn’t generate any revenue from fees charged on the Mirror Protocol. Those go to users as an incentive to provide liquidity. Rather, the firm profits via a cryptocurrency it created that tends to increase in value as projects like Mirror grow in popularity.
So how exactly do these synthetic equities work? Well, it’s complicated.
But to oversimplify, under the Mirror Protocol, the idea is to keep prices of the synthetic—or “mirrored”—equities in the ballpark of the real thing by offering incentives for traders to arbitrage price discrepancies and manage the actual supply of tokens. Users can create, or “mint,” new tokens when prices are too high by posting collateral, and destroy, or “burn,” tokens when prices are too low, driving the price up or down.
Through these incentives, the “synths closely track the price of the real-world asset,” Kwon said. “But they’re still only tokens on a blockchain providing explicit price exposure.”
‘Trojan Horse’
The tokens trade on decentralized, automated markets like Uniswap and Terraswap, which allow users to buy and sell the assets directly on the blockchain—a different model than centralized crypto exchanges run by the likes of Coinbase Global Inc. and Binance.
So far, trading volumes likely aren’t high enough to cause executives at Nasdaq or the New York Stock Exchange to lose much sleep. Mirrored Apple tokens, for example, have a market capitalization of about $34 million, according to Coinmarketcap.com. That compares with about $2.3 trillion for the real stock, and is around 1/1,000th the size of the novelty cryptocurrency Dogecoin.