## Understanding Full Backed vs. Synthetic Markets in DeFi Decentralized finance (DeFi) protocols, particularly those offering perpetual futures or similar leveraged trading, often feature different types of markets. Understanding the structure of these markets is crucial for comprehending their risk profiles. Two fundamental types are Full Backed Markets and Synthetic Markets. The primary distinction lies in how the market collateralizes positions and manages potential payouts, specifically concerning the relationship between the asset dictating profit and loss (the Index Token) and the asset held in the pool to back long positions (the Long Token). ### Core Concepts Explained Before diving into the market types, let's define some key terms: 1. **Index Token:** This is the asset whose price movement determines the profit or loss (PnL) for both long and short traders in the market. For example, in an ETH perpetual market, ETH is the Index Token. 2. **Long Token:** This is the actual cryptocurrency held within the market's liquidity pool. It acts as collateral backing the value of open long positions and is the asset used to pay profits to winning short positions. 3. **Short Token:** This is the token held in the market's liquidity pool that serves as collateral for short positions. It's typically a stablecoin (like USDC or USDT) and is used to pay profits to winning long positions. 4. **Market Pool / Liquidity Pool:** This refers to the combined collection of Long Tokens and Short Tokens held by the market's smart contract. These pooled assets are used for collateral management and settling profits and losses between traders. ### Full Backed Markets **Definition:** A Full Backed Market is characterized by a structure where the **Index Token is approximately equal (≈) or identical to the Long Token**, and the **Short Token is a Stablecoin**. **Key Characteristic:** The defining feature of a Full Backed Market is that the assets held within the liquidity pool (the specific Long Tokens and Short Tokens) are sufficient to cover the maximum potential liabilities to *all* open positions, even under extreme price fluctuations. This means if the Index Token's price were to go to zero, there would be enough Short Tokens (stablecoins) in the pool to pay out the maximum potential profit to all short positions. Conversely, if the Index Token's price increased dramatically, there would be enough Long Tokens in the pool to cover the maximum potential profit for all long positions (or, more accurately, the stablecoin pool would be sufficient to pay out those long profits, backed by the value held in the long token). The term "Full Backed" signifies that the market's potential obligations are fully collateralized by the assets it holds. **Note on "Approximately Equal":** The condition allows for slight variations where the Long Token is a derivative tightly pegged to the Index Token. A common example is using Wrapped ETH (WETH) as the Long Token when the Index Token is native ETH. Since their values are designed to be 1:1, the market functions as if they were the same asset for backing purposes. **Example: ETH/WETH/USDC Full Backed Market** * **Index Token:** ETH * **Long Token:** WETH (≈ ETH) * **Short Token:** USDC (Stablecoin) * **Pool State:** Contains 100 WETH and 200,000 USDC. * **Open Positions:** Total open interest consists of 90 WETH worth of Long Positions and 180,000 USDC worth of Short Positions. * **Current Price:** 1 ETH = $2000 **Scenario Analysis:** 1. **ETH Price Goes to $0:** * Maximum theoretical profit for all Short positions = 180,000 USDC (assuming they shorted near the $2000 price). * Available Short Tokens (USDC) in the pool = 200,000 USDC. * *Result:* 180,000 USDC (Max Liability) < 200,000 USDC (Available Assets). The pool can cover maximum short profits. 2. **ETH Price Increases 10x (to $20,000):** * Maximum theoretical profit for all Long positions is equivalent to the value gain on 90 WETH. The absolute maximum payout occurs if positions were opened near $0, requiring roughly 90 WETH worth of value. (Note: Long profits are typically paid in the Short Token - USDC. The check ensures the system *holds* enough value in its designated Long Token relative to these potential USDC payouts). * Available Long Tokens (WETH) in the pool = 100 WETH. * *Result:* 90 WETH (Max Liability Value) < 100 WETH (Available Assets). The pool holds sufficient WETH backing relative to the maximum long profit potential. **Conclusion:** In both extreme scenarios, the pool holds sufficient assets (WETH and USDC) to cover the maximum potential payouts to either long or short positions. Therefore, this ETH/WETH/USDC market is **Fully Backed**. ### Synthetic Markets **Definition:** A Synthetic Market is one where the **Index Token is *not* equal (≠) to the Long Token**. The Short Token is typically still a stablecoin. **Key Characteristic:** The crucial difference is the mismatch between the asset determining PnL (Index Token) and the primary asset held to back long positions (Long Token). Because these are different assets, their prices can diverge significantly. This creates a risk that the value of the Long Tokens held in the pool may become insufficient to cover the potential profits owed to long positions, especially if the Index Token dramatically outperforms the Long Token. The market provides *synthetic* exposure to the Index Token's price movements without holding that specific token as the main collateral for longs. This introduces a potential solvency risk if the backing assets (Long Tokens) don't appreciate enough to cover liabilities generated by the Index Token. **Example: DOGE/WETH/USDC Synthetic Market** * **Index Token:** DOGE * **Long Token:** WETH (≠ DOGE) * **Short Token:** USDC (Stablecoin) * **Pool State:** Contains 100 WETH and 200,000 USDC. * **Open Positions:** Total open interest consists of 360,000 DOGE worth of Long Positions and 180,000 USDC worth of Short Positions. * **Current Prices:** 1 DOGE = $0.50, 1 WETH = $2000 **Scenario Analysis:** 1. **DOGE Price Increases 10x (to $5), WETH Price Stays at $2000:** * Maximum theoretical profit for all Long positions: If traders longed 360,000 DOGE near $0, their profit when DOGE hits $5 would be approximately 360,000 * $5 = $1,800,000. This profit is claimable in USDC (the Short Token). * Value of Long Token (WETH) backing in the pool: 100 WETH * $2000/WETH = $200,000. * *Result:* $200,000 (Value of WETH Backing) <<< $1,800,000 (Potential Max Long Profit Liability). **Conclusion:** In this scenario, the potential profit owed to long positions ($1.8M in USDC value, driven by the DOGE Index Token) vastly exceeds the current market value of the WETH held in the pool ($200k) intended to back these long positions. While profits are paid from the USDC pool, the system's overall solvency relies on the backing assets (WETH in this case) maintaining sufficient value relative to the liabilities created by the Index Token (DOGE). Because a significant price divergence creates a situation where the liabilities are not fully covered by the intended backing asset's value, this DOGE/WETH/USDC market is **Synthetic** and **not fully backed**. ### Key Takeaways * **Full Backed Markets** match the Index Token and Long Token (or use tightly pegged equivalents), ensuring pool assets can cover maximum potential liabilities. This generally offers a lower-risk structure for the protocol's solvency. * **Synthetic Markets** use a different Long Token than the Index Token. This allows protocols to offer exposure to assets they don't hold directly as the primary long collateral but introduces risk if the Index Token's price significantly outperforms the Long Token's price, potentially leaving the market undercollateralized against large long position profits. Understanding this distinction is vital when evaluating the risks and mechanisms of DeFi trading protocols. Full Backed markets prioritize direct collateralization, while Synthetic markets introduce leverage on asset correlation, carrying additional systemic risk.