As 2022 draws to a close, the premier lineup in the DeFi landscape largely consists of synthetic asset platforms (SAPs). An SAP is whatever platform that enables users to mint synthetics, which are derivatives whose values are pegged to existing assets in real fourth dimension. Equally long as oracles can supply a reliable price feed, synthetics can correspond whatsoever asset in the world and take on its price — exist it a stock, commodity or crypto nugget.

As such, SAPs finally bridge the gap between emergent DeFi platforms and legacy finance, allowing investors to place their bets on any nugget anywhere, and all from the cozy confines of their favorite blockchain ecosystem. Decentralized and operating on Ethereum's layer ane, SAPs would announced to be crypto's next major growth catalyst. However, unlike for sound money and verifiable artwork, in the world of collateralized lending, decentralization and secure ownership only make up half the equation.

Collateralized debt

In traditional finance, instruments of collateralized debt are amid the world'due south almost prominent financial assets, boasting a cumulative valuation of well-nigh $1 trillion. Most people know them as mortgages — a term whose etymology traces back to thirteenth-century France and which translates, literally, as "death pledge." Perhaps morbid or melodramatic to the average individual, but to the many millions who lost their retirement accounts, life savings, homes and livelihoods in the backwash of the 2008 financial crunch, the terms "expiry pledge" and "collateral damage" are not only appropriate but par for the course in carrying the anguish and desperation that look those who partake in collateralized lending without get-go understanding the risks and ramifications that come with it.

Here's the gut-wrencher: To receive a loan, a debtor puts forward collateral that becomes contractually locked with a creditor, who may seize the collateral in the event the debtor becomes unable to service the debt. Unfortunately, servicing collateralized debt is not every bit simple as making punctual involvement payments, as the value of the underlying collateral may deviate drastically in response to volatility in the broader market — like the sudden collapse of the U.S. subprime housing sector. If the value of a debtor's collateral falls below a predefined threshold, the creditor — be information technology a bulge-bracket banking company or decentralized protocol — has the right to assume possession and liquidate the collateral at market value to compensate the outstanding loan master. If the term decease pledge is too much to breadbasket, you might well call it the rug pull of a lifetime.

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Whether issued on Wall Street or the Ethereum blockchain, the risks involved with collateralized financial products cannot be merely decentralized away. Liquidation triggers are fundamentally rooted in exposure to the volatility of a broader macroeconomic surroundings, which neither developers nor financiers can control.

MakerDAO's lesson for DeFi space

Have MakerDAO, for case, an uncommonly decentralized SAP whose collateralized stablecoin DAI is pegged meticulously to the U.Southward. dollar. On the surface, Maker offered an enticing opportunity for investors, who could stake their otherwise dormant crypto holdings to mint a synthetic dollar. Stable though DAI may exist, the distributed collateral pool that backs information technology is composed of some of the world'south most volatile assets — namely, Ether (ETH) and Bitcoin (BTC).

To forestall crypto market downturns from triggering mass liquidations, the Maker protocol requires over-collateralization to the tune of 150%. In other words, users just receive two-thirds of what they inject into the protocol in dollar terms, a model that neither appeals to traders nor supports acceptable capital efficiency in the ecosystem. To add insult to injury, the ever-volatile crypto market proved Maker's steep collateral requirements insufficient in March 2022, when a 70% drawdown liquidated Maker users beyond the board for losses totaling over $6 million.

Learning from Maker's hardships, prominent SAPs have taken boosted measures to prevent catastrophic mass liquidations on their platforms. Or, more accurately, they've taken more of the aforementioned measure: Mirror Protocol requires collateralization levels of upwards to 250%, and Synthetix demands an audacious 500% from users. Of course, over-collateralization of this magnitude is hardly sufficient to compete with traditional finance, where centralized brokerages provide meliorate metrics hand-over-fist. But there'southward some other trouble, likewise.

To crypto traders for whom exorbitant collateralization requirements and liquidation risks are unpalatable, it makes more sense to ditch SAPs altogether and buy constructed stocks and bolt in secondary markets. As a outcome of the shift in demand, pregnant pricing premiums now persist for many synthetics, thereby eroding the existent-world parity they were designed to uphold and again pushing users back to traditional finance, where they can purchase the avails they want less the brazen crypto markup.

The demand for change

At this stage, DeFi has reached a plateau and is stagnating. Meaningful progress demands a radical tokenomic model for collateral management that redefines the relationship between capital efficiency and risk exposure. Every bit the eloquent Albert Einstein professed almost a century agone:

"No problem tin be solved past thinking at the aforementioned level of consciousness that created it."

On this accord, SAPs currently remain fixated on upgrading and enhancing collateralization models — that is, optimizing what already exists. None dares to broach the realm of radical transformation.

As 2022 dawns and crypto enters a new yr, an innovative collateralization model volition take DeFi by tempest. Rather than locking excess collateral into a contract, users will exist able to burn collateral to mint synthetics at an even ratio. That means dollar-for-dollar, saturday-for-sat, one-to-one, users get out what they put in — and they'll never get liquidated or margin called.

The cardinal element that underpins such a model is a native token with an elastic supply. When a user showtime burns an SAP'south native token to mint synthetics there is little do good to be perceived. But when the aforementioned user burns synthetics to re-mint native tokens on the style out, SAP's burn-and-mint protocol works its magic. Any deviations that exist between the user's original burned collateral and minted synthetics will be taken care of past the protocol, which marginally expands or contracts the supply of the native token to comprehend the difference.

A radical new paradigm, the burn-and-mint collateral model does away with the drawbacks of liquidations and margin calls without decimating the capital efficiency or price parity that give synthetics their power in the first place. In the yr alee, as degens and number crunchers of all creeds continue along on their quest for yields, the capital of the crypto mass market will drift to platforms that adopt diverse iterations of burn down-and-mint mechanisms.

Equally the DeFi landscape experiences its side by side major transition, all eyes will turn to liquidity management. Deep liquidity stands to be the critical component that will allow SAPs to facilitate large-volume exits from their ecosystems without producing unacceptable volatility. On DeFi platforms where collateral management has been a business concern of the past, liquidity management volition split up DeFi's next iteration of blueish-fleck SAPs from those that do not make the cut.

This article does non contain investment communication or recommendations. Every investment and trading move involves risk, and readers should deport their ain enquiry when making a determination.

The views, thoughts and opinions expressed here are the author's lone and do non necessarily reflect or represent the views and opinions of Cointelegraph.

Alex Shipp is a strategist, writer and thought leader in the digital nugget space with a background in traditional finance, economics and the emerging fields of decentralized finance, tokenomics, blockchain and digital avails. Alex has been professionally involved with cryptocurrency since 2022 and currently serves every bit the main strategy officer of Offshift, where he contributes to platform tokenomics, produces content, and conducts business development on behalf of the projection. As an skilful in private decentralized finance (PriFi), he has presented at major industry events, including EthCC and Dystopia Labs' Playful Summit.