Synthetix is among the most complicated decentralized protocols I’ve studied. I admire the tech but am not a fan of the SNX token because it feels like a lot can go wrong.
What is Synthetix?
Synthetix is a decentralized protocol for issuing synthetic assets.
What are Synthetic Assets?
A synthetic asset is an asset that tracks the value of an underlying asset. For example, sUSD (Synthetic USD), mimics the value of USD.
In traditional finance, options, futures, swaps, etc are combined to create synthetic assets that imitate the value of another asset. For example, buying a call option and selling a put option would give one the same exposure as owning stock but with far less capital allocation.
Synthetic assets on Synthetix are called “Synth”. Synths can be one of five types:
1. Fiat Synths - sUSD, sKRW, sEUR 2. Cryptocurrency Synths - sBTC, sETH 3. Inverse Cryptocurrency Synths - iBTC, iETH (short exposure to cryptocurrencies where one makes money when the underlying falls in value and loses money when the underlying rises in value) 4. Commodity Synths - Gold (sXAU), Silver (sXAG) 5. Index Synths - sDEFI (basket of DeFi tokens), sCEX (basket of Centralized exchanges)
How does Synthetix work?
To understand what is unique about Synthetix, we need to compare it to other exchange models:
CEX- Centralized exchanges are the exchanges that we all are most familiar with. They maintain an Order Book. Those who want to buy, enter their bids, those who want to sell, enter their offers and the exchange matches the bids and offers.
DEX- Decentralized exchanges like Uniswap depend on Liquidity Pools. Liquidity Providers create Liquidity Pools by contributing an equal value of 2 assets. Traders can then buy from and sell to these pools. An algorithm maintains the exchange rate between the 2 assets.
Synthetix does not maintain any Order Book or Liquidity Pool. When you buy, you don’t buy from anyone or any pool, and when you sell, you don’t sell to anyone or to any pool. Instead, you mint/create Synth by depositing collateral.
So you’re literally creating Synths out of thin air? How is the peg maintained? What is the sanctity of the price?
The price at which you mint the Synth is fed by an oracle. For example, if you’re minting sBTC, oracles will find the price at which BTC is trading at several Centralized and Decentralized exchanges and use the average as the minting price.
The newly created Synths are backed 750% by SNX (Synthetix Native Token) which you must deposit/stake as collateral to mint the Synth. If the price of the Synth falls vs SNX, then you’re effectively over-collateralized. Your SNX will therefore be released and you can mint more Synths. If the price of the Synth rises vs SNX, then you’re effectively under-collateralized and you will need to either burn (repay) the asset or deposit more SNX as collateral. The collateral serves the dual purpose of providing liquidity and stability to the system. The high collateralization ratio serves as a buffer against volatile market movements.
Is Synthetix like MakerDao?
For those familiar with MakerDao, you might notice some similarity. In MakerDao, the price of Dai (Maker’s USD pegged stablecoin) is backed by other cryptocurrencies. There are a few major differences: * MakerDao only mints 1 synthetic asset - Dai, while Synthetix facilitates minting of several types of Synths * Dai can be backed by one of several cryptocurrencies, while Synths can only be backed by SNX.
* MakerDao's collateralization ratio is only 150% vs Synthetix's 750%. * If the collateral value falls below a certain level at MakerDao, the assets are automatically liquidated i.e. the collateral is sold and Dai is burnt. In Synthetix there is no liquidation mechanism.
Synthetix sounds way too capital inefficient. For every $100 of a new asset, you have to deposit $750 of SNX? In Traditional Finance, Synthetic Assets usually offer capital efficiency where you get exposure with less capital, not more.
Lack of a liquidation mechanism is one of the reasons that such a high collateralization ratio is maintained. Other reasons being that the system is untested and SNX is highly volatile. Given the high cost, minting of Synths is incentivized by providing SNX stakers 2 types of rewards:
1. Transaction fees - Any trade in the Synthetix Exchange incurs a 0.3% fee. This fee accrues to SNX stakers.
2. Inflation - SNX launched in 2018 with a supply of 100 million tokens and is going to increase to about 250 million tokens by 2023. The current supply is at roughly 150 million tokens. The new SNX is allocated to those who stake SNX. Currently, this inflation is at roughly 30% and forms the bulk of the staking returns.
=> Net-net, if you mint Synth by staking 100 SNX, all things remaining the same, by the end of the year, you will benefit not only from the upside of minted Synth but also will have earned 130+ SNX as staking rewards.
Note that a staker can claim inflation rewards and transaction fees only if the required collateralization ratio is maintained. If the ratio falls below the required level, the fees do not accrue. This incentivizes minters to always meet the required collateralization ratio despite no liquidation mechanism.
Synthetix is among the most complicated protocols I’ve looked at. Let’s look at a few examples of what returns would look like for a staker in different conditions
When you mint Synths, you incur a debt. When you’re looking to close your position and get your collateral back, you have to repay the debt by burning the tokens. The number of tokens that you have to burn may be higher or lower than the tokens you initially minted.
A- Let’s start with the most basic situation where there are 2 minters- Anna and George. Each mint $50k of sBTC. If BTC goes up 50%, then the value of the total debt pool and their sBTC will also go up 50%. To close the position, they’ll need to burn their sBTC which would leave them in a no-profit, no-loss position.
B- If Anna mints $50k of sBTC and George mints $50k of sUSD and BTC climbs 50%, then the total debt pool will climb 25% and both Anna and George will be equally liable for the increased value of the debt pool although Anna’s Synths will have gone up in value while George’s will have remained flat. This will lead to Anna making a profit and George suffering a loss of $12.5k.
C- If Anna mints $50k of sBTC and George mints $50k of sUSD and BTC falls 50%, then the total debt pool will fall 25% and both Anna and George will be equally liable for the decreased value of the debt pool although Anna’s Synths will have dropped in value while George’s will have remained flat. This will lead to Anna suffering a loss and George making a profit of $12.5k.
D- If Anna mints $50k of sBTC and George mints $50k of iBTC and BTC falls 50%, then the total debt pool will remain flat. Anna’s Synths will have dropped in value while George’s will have climbed. This will lead to Anna suffering a loss and George making a profit of $25k.
=> In addition to the above profit or loss situation, Anna and George would both have earned inflation rewards and transaction fees during the period of their staking.
What are the advantages of this system?
* No liquidity issues- One of the biggest advantages of this system is that your trade does not impact price and you can mint as many tokens as your collateral will permit. In a traditional exchange, high demand leads to prices rising, and increased selling leads to prices falling. In a decentralized exchange, large trades will make the liquidity pools lopsided. In the case of Synthetix, the order size will not impact price as price is derived from other exchanges which are not seeing your volumes.
* Expansion of assets available on-chain- Every type of real-world or crypto asset with a price data feed can be brought to the world of DeFi and be traded in a totally trust-less manner.
* Shorting - Shorting is made possible with iAssets.
* Exposure to Indexes- The DeFi index makes it possible to get exposure to multiple DeFi tokens with 1 trade.
Future Growth
Synthetix will see future growth from new products such as:
* Synths tracking real-world stocks aka sAAPL or sTSLA likely to be launched
* More products like leveraged trading, decentralized futures, etc in the works
* Introduction of more advanced trading strategies like VWAP, TWAP, limit orders, stop loss, etc
The biggest risk with Synthetix
* Regulation- Synthetix allows issuance of assets including stocks without the approval of regulators like the SEC. If and when Synthetix launches sSecurities like sTSLA and sAAPL, the SEC may claim that Synthetix is operating illegally.
* No price discovery - Synths allow one to buy assets without impacting price. I suspect I’m being excessively conservative but if demand and supply do not impact price then how does price discovery happen?
* Tokenomics: The following reasons make SNX tokenomics less attractive over-time
(i) Inflation - Inflation is subsidizing the platform as of now. A person will post 750% collateral as long as they get high inflation rewards. However, inflation rewards will fall from the current 30% to 2.5% by 2023. When that happens, posting 750% collateral will no longer be viable unless transaction volumes climb substantially and transaction fees make up for the drop in inflation. By 2023, the total supply of SNX will be 250 million. If we assume that at that time 50% SNX is staked and SNX is trading at $20 each (almost flat from the current price), the annual transaction fee pool will have to be $750 million to make up for the drop in inflation rewards. To put this in perspective, the total transaction fees earned by the platform in 2020 was roughly $12 million. If SNX price rises then the expected transaction fee pool will need to be even higher.
(ii) Accept more cryptocurrencies as collateral - Synthetix is beginning to accept ETH as collateral. This is good news for users of the protocol but that does reduce the utility of SNX.
(iii) A drop in collateralization ratio - As the protocol becomes more stable, the collateralization ratio may be reduced from the current 750%. This would make staking more capital efficient but it would also increase total supply as tokens get unstaked.
Final Words
I am not dismissing this protocol but I need to get more comfortable with the workings of its algorithms before I invest in it.