Synthetic liquidity involves the creation of derivatives or synthetic instruments. The best example of this is Synthetix. In Synthetix, you can stake stable crypto assets as collateral and borrow a synthetic asset (usually sUSD) against it. Users are then able to execute trades with the use of the borrowed synthetic assets.
All of these assets are powered by Chainlink oracles, so their pricing is 100% dependent on external markets. Because prices of all synthetic assets are drawn from Chainlink price feeds, the protocol lets you swap to and fro with infinite liquidity and zero slippage. This depth of liquidity is only possible because you’re essentially changing the asset your debt is denominated in.
The drawback of this model is the inability of these markets to ever influence pricing. Since liquidity is virtual and relies on external markets for prices, these DEXes are unable to influence price discovery in any way. However, it’s a great model for bringing traditional assets like stocks and bonds to DeFi, and makes sense for liquid crypto assets.
We recently wrote about Synthetix and their ecosystem in our Pro report here.