Underlying Assets

Underlying assets are categorized by their physical nature. Tangible assets have a physical form, like real estate, commodities (gold, oil), or art. Intangible assets are non-physical, such as intellectual property, carbon credits, or financial instruments like stocks and bonds. In DeFi, the underlying is often a cryptographic asset like Bitcoin or Ethereum, which is digital but not physical.

The value of an underlying asset is determined by market forces of supply and demand. Price discovery occurs on exchanges (e.g., NYSE, CME, Binance). Valuation methods vary:

• Commodities: Spot prices from futures markets.
• Stocks: Discounted cash flow analysis.
• Real Estate: Comparable sales and income approaches.
• Cryptocurrencies: Order book depth on spot exchanges. The volatility of the underlying directly impacts derivative products.

This refers to how the asset is held and transferred. Traditional finance uses centralized custodians (DTCC for stocks, vaults for gold). Blockchain-native assets are settled on-chain via smart contracts, with custody managed by private keys. Tokenized real-world assets (RWAs) bridge both, using a custodian to hold the physical asset while a blockchain token represents ownership, with settlement occurring on-chain.

Many underlying assets produce yield, which is passed to holders of derived tokens. Mechanisms include:

• Cash Flow: Dividends from stocks, rent from real estate.
• Staking Rewards: Native protocol rewards for securing Proof-of-Stake blockchains (e.g., ETH staking).
• Lending Interest: Interest paid by borrowers in DeFi money markets.
• Rebasing: Algorithmic supply adjustments in some stablecoins. The yield source is a critical risk factor.

Assets exhibit correlation to broader markets, influencing portfolio strategy. High correlation assets (e.g., tech stocks) move with their sector. Low/negative correlation assets (e.g., gold, certain stablecoins) can act as hedges. Key risks include:

• Market Risk: Price volatility.
• Counterparty Risk: Failure of a custodian or issuer.
• Smart Contract Risk: Bugs in on-chain representations.
• Liquidity Risk: Inability to sell at a fair price.

Traditional Finance (TradFi):

• Equities: Apple stock (AAPL).
• Commodities: West Texas Intermediate (WTI) crude oil.
• Debt: US Treasury bond.

Decentralized Finance (DeFi):

• Native Crypto: ETH, the underlying for staking derivatives (stETH).
• Stablecoins: USDC, backed by cash & treasuries.
• Tokenized RWAs: RealT tokens (representing real estate equity).

LP tokens (e.g., Uniswap v3 NFTs, Curve LP tokens) represent a user's share in an Automated Market Maker (AMM) pool. They are composable underlying assets that themselves represent a basket of tokens and accrued fees.

• Convex Finance/Stake DAO: Accepts Curve LP tokens to boost CRV rewards and governance power, a process known as vote-locking.
• Yearn Finance: Uses LP tokens as deposit assets in yield-optimizing vaults that automatically compound trading fees and reward emissions.
• Angle Protocol: Uses Uniswap v3 LP positions as collateral to mint its stablecoin, agEUR.

Vault tokens from yield aggregators (e.g., Yearn's yVault tokens, Balancer Boosted Pools) are underlying assets that represent a claim on a strategy's compounded returns.

• Yearn yVaults: A yvDAI token represents a deposit in a strategy that automatically seeks the highest yield for DAI across lending protocols.
• Balancer Boosted Pools: Pool tokens (bb-a-USD) automatically reinvest yield from underlying Aave deposits to reduce impermanent loss for liquidity providers.
• Set Protocol: Creates tokenized baskets (Sets) that can themselves be deposited as the underlying asset for leveraged strategies or index funds.

Assets that originate on one blockchain but are represented on another via a bridge (e.g., Wrapped BTC, Multichain assets). Their value is derived from the canonical asset on the native chain.

• Wrapped BTC (WBTC): Bitcoin tokenized on Ethereum, used as premium collateral in lending protocols due to its deep liquidity and perceived store of value.
• LayerZero OFT / Wormhole: Enable native cross-chain assets that maintain canonical representation across multiple ecosystems, becoming underlying assets in omnichain DeFi applications.
• Chainlink CCIP: Secures cross-chain messaging to ensure the accurate representation and redemption rights of bridged underlying assets.

The primary risk is that the smart contract representing the underlying asset (e.g., an ERC-20 token) contains vulnerabilities. A bug or exploit in the token contract can lead to loss of funds, even if the protocol using it is secure. This is a form of dependency risk.

• Example: A token with a flawed transferFrom function could allow unauthorized withdrawals from protocol vaults.
• Mitigation: Protocols perform due diligence, often requiring audits for listed assets.

Protocols rely on price oracles to determine the value of underlying assets for functions like lending, liquidation, and minting synthetic assets. If an asset's price feed is manipulated (oracle attack), it can cause catastrophic failures.

• Example: An attacker artificially inflates the price of a collateral asset to borrow more than its true value.
• Common Targets: Assets with low liquidity or on-chain DEX price feeds are more vulnerable to flash loan-enabled manipulation.

When an asset is used as collateral, its price volatility creates direct risk. A sharp price drop can trigger liquidation events, where a user's position is forcibly closed, often at a penalty.

• Key Metrics: Volatility, liquidity depth, and correlation with other assets in the protocol.
• Black Swan Risk: Extreme, unforeseen market events can cause correlated crashes across multiple asset types, overwhelming liquidation mechanisms and leading to bad debt for the protocol.

The nature of the asset's custody impacts risk. Non-custodial assets (native tokens, standard ERC-20) are controlled by the user's private keys. Custodial or wrapped assets (e.g., wBTC, staked derivatives) introduce counterparty risk with the custodian.

• Bridge Risk: Wrapped assets from other chains depend on the security of the cross-chain bridge. A bridge hack can render the underlying asset worthless on the destination chain.
• Regulatory Risk: Custodial assets may be subject to freezing or seizure by the issuing entity or regulators.

In DeFi's money Lego ecosystem, underlying assets are often re-hypothecated across multiple protocols. A failure or de-pegging of a widely used asset (e.g., a major stablecoin) can create systemic risk, causing cascading failures.

• Contagion: A critical asset losing value or functionality can impact lending markets, DEX liquidity pools, and derivative protocols simultaneously.
• Protocol Dependency: Assessing which protocols and how much Total Value Locked (TVL) depends on a specific asset is crucial for risk analysis.

Many underlying assets are governance tokens or have upgradeable contracts. This introduces risks from the asset's own governance process.

• Malicious Governance: Token holders could vote to mint unlimited supply, change fee structures, or otherwise devalue the asset.
• Admin Key Risk: Assets with proxy contracts controlled by a multi-sig or admin key present centralization risk; the key holders could upgrade the contract to malicious code.
• Due Diligence: Users must audit not just the protocol, but the governance mechanisms of the assets they deposit.

An asset pledged by a borrower to secure a loan or mint a synthetic asset. In DeFi, collateralization ratios determine how much value must be locked relative to the borrowed/minted amount. Common examples include:

• Over-collateralization: Required in protocols like MakerDAO, where $150 of ETH might be locked to mint $100 of DAI.
• Cross-collateralization: Using one asset (e.g., a portfolio of tokens) as collateral for multiple positions.

A tokenized derivative that tracks the price of an underlying asset without requiring direct ownership. Synthetics replicate exposure through oracle price feeds and collateral backing. Key mechanisms include:

• Delta-neutral positions to maintain price peg.
• Synthetic protocols like Synthetix, which use a pooled collateral model.
• Perpetual futures contracts on DEXs, which are synthetic derivatives of spot prices.

A critical data feed that provides external, real-world information (primarily price data for underlying assets) to a blockchain. Oracles are the bridge between off-chain assets and on-chain contracts. Design patterns include:

• Decentralized Oracle Networks (DONs) like Chainlink, which aggregate data from multiple sources.
• Price feeds for assets like BTC/USD, which smart contracts rely on for liquidation and minting functions.
• Oracle manipulation is a key security risk, making reliability paramount.

The process of creating a blockchain-based digital representation (token) of rights to an underlying asset. This enables fractional ownership, programmability, and on-chain trading. Examples include:

• Real-World Assets (RWA): Tokenized treasury bills, real estate, or commodities.
• Wrapped Assets: Like Wrapped Bitcoin (WBTC), which represents Bitcoin on the Ethereum blockchain via a custodial model.
• Security Tokens: Digital securities that represent equity or debt, subject to regulatory compliance.

A continuous stream of price data for an underlying asset, supplied by an oracle to a smart contract. It is the lifeblood of DeFi protocols for accurate valuations. Critical for:

• Liquidation engines: Determining when a collateralized position is undercollateralized.
• Minting/burning synthetic assets: Ensuring the peg to the underlying asset's value.
• Decentralized exchanges (DEXs): Providing pricing information for liquidity pools and perpetual swaps.

A key distinction in valuation mechanics. The spot price is the current market price for immediate settlement of the underlying asset on a traditional or centralized exchange. The oracle price is the on-chain reference price used by smart contracts, which may lag or diverge due to:

• Oracle update latency (e.g., every block vs. heartbeat).
• Manipulation resistance techniques like time-weighted average prices (TWAP).
• Market dislocation events, creating arbitrage opportunities between CEX and DEX prices.