Synths — Problems, Risks, and the Future.
Currently in DeFi, there are many proposed platforms for synthetic assets; these can vary per chain and all come with their risks and benefits. That said, here we will look to compare the existing options and pinpoint their current issues. We will also review how these protocols retain their stability to other assets, in other words, how they maintain the peg — the most important part of synthetic assets is their ability to maintain their peg to their real world counterparts. It’s pertinent to analyze these mechanisms to find their potential risks and what could cause some form of price spiral.
Below we will break down the biggest projects in the decentralized synthetics space and review the details of their shortcomings.
Currently in DeFi there are many proposed solutions for synthetic assets, these can vary per chain and all come with their risks and benefits. That said, here we will look to compare the existing solutions and pinpoint their current issues. We will be covering:
- Synthetix.io
- Mirror Protocol
- Duet Finance
- Deus Finance
We will also review how these protocols retain their stability to other assets, in other words, how to maintain the peg. The most important part of a synthetic asset is their ability to maintain their peg to their real world counterparts. It is very important to analyze these mechanisms to find their potential risks and what could cause some form of price spiral.
Before we start breaking down the current protocols it is important to first look at the current market size to see how this market has evolved and see if there is a need for these synthetic solutions. We will use a traditional TAM-SAM model.
Total Addressable Market
Currently the best way to get the metric would be to mix not only the current size of the synthetic market accounting for all protocols but also to count DeFi as a whole. Given DeFi is a large market, there are many users that could still be onboarded to the synthetic asset space.
We can begin by looking at the total value locked in DeFi, using DeFi Llama we can see that currently that value has gone down but that is because of a number of specific factors. All in all that total value is still nothing to look down upon totalling 144 Billion in value locked on DeFi protocols.
Now looking at the border market we can take for example some of the most common synthetic assets that are used in the space, for example; Gold, Oil, S&P 500. These assets are very large and encompass so much of the world’s value exchange, however, most users do not have access to trade these assets because of their jurisdictions.
Taking gold as an example we can see the market availability there. Currently gold has a market capitalization of 11 trillion USD. This is almost 10x the current crypto market cap, just capturing two percent of this would encompass the total DeFi value locked, this is not even considering what it would mean in the synthetic asset space, this value capture would be huge.
Furthermore, we can look at total traded volume in some of the largest traded assets in the world. Gold trades around 130 billion USD per day in volume. S&P 500 trades at $240 billion per day in volume. Though these assets are some of the largest in the world, giving the average retail investor access to these markets could mean a lot for those looking to get exposure to assets that historically they did not have exposure to because of their geographical location. This is why synthetic assets have such a large addressable market. It is not only a market for those interested in the crypto space, rather a market for anyone interested in the finance space regardless of jurisdiction.
To sum up the total addressable market it would be foolish to simply conclude “the sky’s the limit” rather take a consevative percent of the total trading volume of the assets as an achievable measure. Two percent of the total trading volume for these assets, for example two percent of 240 billion would be 4.8 billion daily volume transaction, this could be a conservative total market to reach as a synthetic asset given you would be catering to the rest of the world that does not have access to this market.
Next we will look into the current serviceable addressable market as this could paint a clearer picture on how much synthetic assets are currently being used and if this market has demand.
Serviceable Addressable Market
For this breakdown we will focus on the current synthetic asset solutions in the DeFi space and break down their total volumes as well as total users and total value locked. This can give us a clearer picture on their current market adoption as well as sustained demand. First lets begin with the largest protocol in the synthetic asset space, Synthetix. In its history Synthetix has had a total of 12.3 billion in value traded and captured 83.8 million in fees.
This is pretty impressive considering they have only had 56k trades done on the platform by 36k different traders, this is less than two trades per every trader to reach that volume. These are really great numbers for any protocol and they prove that there is a demand and use case for the platform.
Moving on, looking at TVL we can see that they have had a strong decline since their high from 3 billion in total value locked with now only around 500 million in TVL. However, this is also because of the crypto assets losing value in their TVL so this does not exactly represent a loss from attention or user retention. Even during bear markets it can be hard to retain users, so these numbers prove that they have created great user retention.
We can also see that the trading volume on synthetics had its high in 2021, however it has remained consistent ever since the 09–2021 until now. This shows that regardless of market conditions, some users are staying around to use the protocol.
Turning our attention to Mirror Protocol we can see how their volume had remained steady until the recent Terra/Luna crash. This shows that the protocol had been consistent with their growth and user adoption. Especially when looking at their active users we can see how this was in a steady uptrend since their launch in 2021.
Turning our attention to Volume we can see how after their initial launch hype they managed to have constant volume on the protocol up until the Terra/Luna collapse, this shows that their user adoption and retention was functioning correctly given the overall market was decreasing during the time.
To conclude we can say that these protocols are a good gauge for the serviceable addressable market considering their reach and overall history. With the volume they had, any competitor would do very well achieving one billion in total value locked. However, the real metric will be user and TVL retention. Finding steady growth would be the way forward as we can see these protocols suffered from initial hype but then their demand and volume died down after the launch.
The synthetic market is ripe for the taking considering it only accounts for less than 5% of the total DeFi space, however, the addressable market goes far beyond the DeFi native communities. This market is only getting started and this has a big future ahead. The biggest concerns would be from the regulatory side considering these assets are not yet regulated and thus many countries do not allow for them to be traded. Furthermore, the fact they are assimilating other assets adds to the regulatory scrutiny as we saw when Binance attempted to launch their own synthetic asset options but then had to take them down because it was pressured by curtain governments.
Below we will break down the biggest projects in the synthetic asset space at the moment and find their shortcomings.
I. Synthetix.io
Synthetix is one of the oldest synthetic protocols and has gone through a few iterations of their own mechanism, currently their mechanism works by over collateralizing the synthetic assets with their native token $SNX. Synths are currently backed by a 400% collateralization ratio of the $SNX token, users are also able to back synths using $ETH which only requires a 150% collateralization ratio. Some notes on why you might choose to mint with $SNX vs $ETH.
$SNX that is staked captures fees from the system and can be used to mint sAsset,, while the $ETH that is used does not earn system fees rather it just sits as idle collateral.
Potential risks, given that the whole system depends on the value of the $SNX token being relatively stable, if the price of $SNX were to fall quickly it could cause mass liquidations of sAssets on the Synthetics platform. This in turn would cause the price of $SNX to spiral down as more assets are liquidated.
This is partially mitigated by the fact that sAssets are so highly over collateralized to begin with (400%), however, this makes the protocol capital inefficient. Synthetix have also created a mechanism where there is a buffer zone to avoid these liquidation spirals, rather than simply liquidating assets, when collateral is at risk they first they pause any fees the collateral would earn until the ratio is adjusted. Furthermore there is a specific liquidation timeline that is required to happen before any liquidations take place, when an account’s c-ratio drops below 200% the accounts gets flagged and a liquidation timer of 72 hours begins on the account to give a window of opportunity to fix the c-ratio and stop the liquidation countdown. To halt the liquidation timer and remove the flag the staker must reach the target c-ratio (and not just get above 200% again). The time that is given to fix any under collateralization in the system mitigates the potential for the spiral scenarios mentioned above, as liquidations are not immediate and stakers are given time to fix their collateral.
As highlighted in their whitepaper one risk is the debt $SNX holders issue when they stake their $SNX and mint Synths. This debt can be higher if the price of the $SNX token is lower. This means that to exit the system and unlock their staked $SNX, they may need to burn more Synths than they originally minted.
We would end up with a system that only grows its debt; if participants are unable to pay off the debt, then this debt can spiral until it is covered or liquidated. As mentioned earlier, once liquidations occur, they can cause cascades as price falls and more liquidations are triggered. Though the incentive to pay off your debt as synthetic assets price goes down is higher, given you can purchase those assets for less than what you might have originally minted them for.
Security is taken seriously at Synthetix and they have been getting audits on almost all of the changes that are done to the smart contracts of the platform, you can see a full list of all their audits here.
As the protocol has grown, the user base has remained relatively flat or even decreased, this is notable and will define the protocol as they move forward. Though it is important to consider the environment as they had competition from exchanges for some time, but then exchanges were forced to take down their own synthetic assets, then after the return of the protocol to the spotlight the greater environment entered a bear market which tends to take people away from the protocols.
As we can see, even as their user base might not have grown, their trading volume has remained consistent and even had a spike recently in May as many users were shorting ETH with the inverse tokens available on Synthetics.
Finally, Synthetics is only available in ETH and on Optimism, limiting its user base and accessibility. Synthetix has also recently launched a perpetual futures platform Kwenta where $SNX stakers can also benefit from the fees earned there. Though Synthetics might have some downfalls in their operating system, so far it has survived and serves their user base quite well. Next up we will review Mirror protocol.
II. Mirror Protocol
Mirror Protocol is the synthetic asset protocol on what was the Terra blockchain. Mirror has almost no cross chain presence. It also had heavy fees on purchasing or interacting with its synthetic assets, this caused it to have trouble gaining users. The current mechanism of inflationary tokens dilutes their native token as so many of the $MIR tokens are being sent out to the participants as incentive rewards. The token itself has little value from holding it given the inflation is so high compared to its potential earning from protocol fees.
The peg mechanics for Mirror Protocol is dependent on collateral and debt (similar to Synthetics mentioned above) however, with Mirror the collateral types can be the ones seen below. The different multipliers show how much collateral is needed depending on the asset that you choose.
If the user’s collateral value goes below the appropriate ratio then the user will be flagged to be liquidated. This makes for much faster liquidations, and again can have a more aggressive sell side pressure on the collateral assets.
Next, let us look at the $MIR token as this one seems to have had little planning and had essentially become a farm and dump token. As we can see from the below image 45% of the tokens were destined for the mAsset staking rewards, this meant that the tokens could be freely earned but they never had a good reason as to why anyone would choose to hold these tokens.
The token distribution for $MIR was aggressive and thus created a high dilution in the first year of its existence. Furthermore, the plan for emissions post distributions was not laid out.
Distribution Rate (Inflation)
Inflation rate of the $MIR tokens is designed to gradually decrease every year until it reaches 370.575M at the end of year 4. After the end of year 4, no more $MIR tokens will be minted through inflation. This means that when the 4 year timeline is done there has to be enough protocol fees and traffic in the system in order to self-sustain the system without additional minting or additional liquidity incentives.
Up until this point Mirror was paying all the fees it collected to the stakers, however, once the token distribution ended this would have had to change to a format where they would be using a portion of the fees as incentives for the different pools. Given the protocol was never able to reach that point it is not possible to calculate whether or not the protocol would have been sustainable without the high inflation rewards.
Above we can see the expected final distribution of the $MIR token, however, this was expecting that all the LP rewards were simply earned and held, when in reality they were farmed and dumped by participants seeking the high yields. The issue with directing so much of the distribution towards rewards is that it creates little incentive to hold the token since all users know how much will be going towards rewards and inflation.
If we understand how the Terra ecosystem works, we can see the potential of the death spiral on Luna/UST, this in itself can cause a similar spiral in the mAssets on Mirror given that so many of them are collateralized by Luna or UST. This would cause a cascade of liquidations and a subsequent depegging of the mAssets in question.
Next we look at the use of the protocol, given that low risk delta-neutral farmers were incentivized more than high risk singular long / short farmers causing uneven distribution of rewards based on risk taken by the users. With the current reward systems it would benefit users engaging in a delta neutral strategy much more than any participant looking to only long farm or short farm an mAsset. This means that the users who take on the most risk (single sided exposure) receive the least benefits. While users who both long and short the mAssets receive the most benefits given that they have little to no risk on price movements, on-top of the fact that they earn double rewards from the short/long farms. Again, given the high fees for minting and creating mAssets this makes it very unappealing for any users that might want to use the platform for a shorter time frame. Mirror Protocol is set up for long term strategies, thus this makes it so that protocol revenue does not make as much given users are incentivised to participate as little as possible.
As with many synthetic asset protocols creating new assets is a slow and long process. This process is often dependent on governance proposals as well as the user looking to create a new mAsset on Mirror Protocol requires the user to make a full proposal submitting the full information about said asset, followed by the asset being voted on, then the asset getting oracle support. This process can take time, though it worked well enough to add 10+ different assets to the protocol during its first year.
mAssets and their deviation history
It is also important to break down the historical premiums on the mAssets as well as the correlation of price from the mAssets to their in real life counterparts. A protocol’s synthetic assets trust and functionality revolves around them being as close as possible to their real counterparts. Below we will break down some of the examples of the traded assets on Mirror and how they performed. First we will start breaking down mSPY as this is one of the easiest ways to get exposure to the US stock market. Below we can see how in May before the Terra/Luna Crash, there was already a sustained price discrepancy between the Mirror Price and the oracle price. The mAsset appeared to be trading at a negative discount.
As we can see, over the last 30 days that the asset was trading there was a -5.93% price spread between the Mirror pools vs the oracle price of the asset. 5% is a pretty large spread, especially considering this asset often only has small price movements.
Next we will look into other mAssets. mETH was one of the mAssets with the most history on the protocol, looking at its price performance below we can see how the mAsset price was trading at a premium since 08–21. This discrepancy was exacerbated towards the last months the protocol was active. As we can see from the below price chart we can see that the premium was almost $400 worth. This is a very large price discrepancy considering the size of the asset in question. That said, arbitraging the asset back to a peg was not possible with the current Mirror mechanisms. With almost an 11% price deviation from the oracle price this is a big spread to deal with when considering using a Synthetic asset.
As we look at the top 10 assets on mirror we can see the Oracle Price Deviation (%) could range from 1% to 25%, this shows that there was a very high difference in the prices. For any user looking to participate with the Mirror protocol there would need to be enough incentives in order to justify these high spreads as they could not take advantage of the spreads themselves.
Moving on from the mAssets it is also important to look at the security that the protocol provides. Mirror protocol is audited by Cyber Unit as well as Cryptonics, these are respected code auditing firms that are recognized in the industry, there is also a modest bug bounty program that pays rewards for anyone that finds a bug that can be of concern for the protocol’s safety.
Finally looking at TVL we can see how overall the appeal for the Mirror Protocol has been dropping since the launch. Even before the fall of the Terra ecosystem the TVL on Mirror was below one billion in total value locked, this shows the lack of appeal from users given it did not have the best fees for easy everyday use.
Next we will talk about Duet Protocol, a newer synthetic protocol that looks to change the way these previous mentioned protocols function.
III. Duet Protocol
Duet Protocol (Duet) is a synthetic asset protocol, their main selling point is that they unleash liquidity for DeFi protocols. Duet allows for both single assets such as BTC/USDT/DAI as well as receipt tokens such as WBNB-BUSD — LP tokens, as collateral. Users gain access to that liquidity in the form of synthetic stablecoin dUSD and other synthetic assets.
Duet aims to solve the capital inefficiencies that exist in the market by bringing liquidity to what normally are idle funds. These can often be in the form of LP tokens. This is unique because not only can you be earning from your LP tokens, but you can also be using those LP tokens as collateral to unlock new liquidity for your funds.
Duet does all this through their synthetic collateralized stablecoin called dUSD as well as with other synthetic assets that can be traded and used on their platform. A simple way of understanding their mechanism is comparing it to Abracadabra, where users can mint MIM using interest bearing assets. However, unlike Abracadabra, with Duet users can mint dUSD or other synthetics not only using interest bearing assets but also using LP tokens.
Below we can see a structure of how this mechanism works on synthetics and how the creation of dUSD or the other synthetics can function.
Users that wish to participate with Duet need to deposit collateral into the protocol, then the protocol turns this capital into interest earning collateral by deploying it into different strategies –this is supposed to be with their direct partners, however, they have not announced any official partnerships– Next, the users proceed to mint dUSD which can be used however the participant prefers. This USD is backed by collateral that is yield bearing.
Currently there are only three assets available on the Duet protocol platform, these are dUSD, dWTI (OIL) & dXAU (gold). This limits what users can do on the platform, and thus is reflected in their TVL, as we can see below, TVL is very low. One million is not enough for many bigger participants to come in and use the protocol as there is simply not enough liquidity to participate in these markets.
That said, this is still a very new protocol, and thus has not had time to gain attention from users given that they have launched in May of 2022. They launched with around 2.5 million in TVL but have since lost half of that. Retaining users and gaining more liquidity will be the most important factor for this newer protocol to see if it can truly work as a new solution to synthetic assets.
We also need to talk about liquidations on the Duet platform. These liquidations come with a percent commission that is charged by the protocol in an event of liquidation. As we can see from the image below there are very high premium for liquidations of their own native assets, this does not incentivise holders of $DUET & $dUSD to use them as collateral given that their LDR is 85% — LDR = Liquidation Discount Ratio, LDR represents the expected cost of liquidation.
These high liquidation premiums can make it very expensive to use the protocol in case of liquidation, given the high volatility in the market already it is a high risk. When a vault is under default, any user can claim the underlying collaterals by repaying the outstanding amount of synthetic assets. This is what is stated on their Whitepaper, however, there does not seem to be any interface for users to participate in the liquidation mechanism.
There does not appear to be any audits on the Duet protocol, and no information on whether the contracts are under audit, furthermore, there are no bug bounties. This can be concerning for anyone considering depositing funds onto the protocol as it is a higher risk given the lack of security associated with the protocol. This would be one of the reasons that they don’t have much in terms of TVL, simply because of the risk associated with using a platform that is not audited.
Next we will talk about Deus Finance, and how they are approaching the synthetic asset space slightly differently.
IV. Deus Finance
Deus finance is a protocol that is focused around their stablecoin $DEI. Through $DEI they also have other synthetic assets that can be created. The main focus of the Deus Finance protocol is their fractionally algorithmic stablecoin. Fractionally algorithmic means that the stablecoin can be partially or fully backed yet the pegging mechanism depends on the algorithmic part. When it comes to redemptions, that is when the backing comes into play in order to cover the lack of demand from the system and pay for the redemptions required.
Currently Deus Finance is active on 4 different networks, however, most of their liquidity lies in Fantom, as we can see from the below chart, out of the total 20.69 million locked on the platform 19.9 is on the Fantom network. This shows that there is very little interest from users on other chains to participate with the Deus Finance protocol.
Below we can see a flow chart of how the Deus system functions, they have an elaborate system that manages their peg as well as their redemptions in case of users cashing out.
This system appears to be a next step in the algorithmic stablecoin saga, however, it does not account for the correlation of the exogenous collateral that can be used. That means, when the value of one of the collaterals drops, it is highly likely that all of the collateral value is dropping as well (except for the stablecoin collateral).
The issue that remains goes back to scalability, if $DEI is to grow then more collateral is to enter the protocol. This comes with its risks, the most important of them being a hack exploit. Currently Deus Finance has no audits, like Duet protocol which was mentioned earlier, if they wish to grow their TVL the most important focus should be on security. Given the amount of DeFi hacks that have already happened in 2022, a protocol that does not prioritize security is high risk for any interested party looking to engage with that protocol.
Another big issue with the protocol is their lack of information regarding liquidations, currently it is unclear what happens when $DEI becomes undercollateralized and a user does not manage that position. The lack of clarity on these possible liquidations could be an issue for any participant looking for answers, or if they were to be liquidated, it is unclear what the parameters for the liquidations are.
Finally we talk about their synthetic assets (or lack thereof), currently on the Deus dApp you can only interact with GME, EUR and the RUB apart from the $DEI stablecoin, this leaves a limited use case as the lack of assets do not support more usage of the protocol. As we had mentioned the focus of this article was synthetic assets, however, stablecoins take a big part of the synthetic asset space as they are one of the most used assets in the crypto ecosystem overall.
There are issues mentioned above that would be red flags for any bigger investors out there, this is probably one of the reasons for which the TVL of the project has remained relatively low. Going forward it is important that protocols focus more on security before shipping, as well as mitigating all of the potential death spiral risks from price fluctuations or from potential bank runs on their stablecoins.
Conclusion
Currently the state of synthetic assets in the crypto and DeFi space is still very limited, not only that but the fact you need to over-collateralize these assets makes for inefficient markets. Having assets that are dependent on collateral also opens the door for liquidations and with that liquidation cascades that can wipe out your user base in a black swan event. Furthermore, most, if not all of the collateral is crypto. Crypto collateral is always tied in price so if the market pulls back almost all of your collateral value will also be dropping with the market, this of course is with the exception of stablecoins.
Finally, we must talk about the use of Stablecoins; most of these synthetic asset platforms have their own version of a stablecoin. Given they all have created their own type of stablecoin, it adds another layer of risk — the risk of de-peg. The biggest issue with stablecoins is that unless they are over-collateralized, and always carry a bank run risk which could destabilize the whole protocol. But when you over collateralize a stablecoin, you create a lot of flat, unused capital that is only sitting there until it is needed, once again making for capitally inefficient markets.
Synthr will plug in these gaps in the DeFi synthetics market in order to reach its fullest potential; watch this space to find out how.
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