I’m Worried No One Will Care About Synthetics
Crypto’s Lay of the Land
For a while now the promise of DeFi and Web3 has been the democratization of networks and value systems to ultimately open up financial opportunities to anyone that meaningfully contributes to a community. It’s true that it has provided opportunities for some, however this more often is true for a select few early adopters in the know (and whales) than the majority.
DeFi was supposed to create a new global meritocracy, however so far it’s looking more like a plutocracy than ever before and creating an ever-growing monetary gap. Ethereum for example is primarily used as a settlement layer for other protocols (like Layer-2s) or used by whales — they’re the only ones able to justify the high gas prices. This growing cost opens up possibilities for the wealthy to exploit the rest by front-running — quoting a higher price than a pending transaction, thus creating unfair priority or by voting on and dictating the direction of a protocol.
There needs to be a way to bridge this monetary gap…
The recent boom of NFTs has opened up massive opportunities for the mainstream to interact with the crypto world and has brought with it a lot of positive attention to the space. While some have profited from NFTs over the last 12 months, in their current state, these assets won’t be the main economic drivers and investment vehicles to create long-term sustainable wealth. Why? Their value is trend, seasonal and meme-based, they’re a class of illiquid assets, their utility is questionable and the volatility is easily manipulated (it doesn’t cost much to artificially buy NFTs across two of your wallets to create fake activity and inflate the price!). Many think NFTs are drastically overvalued (and rightly so, look at this single grey pixel that sold for $1.36M USD), it’s a speculative bubble fueled by the idea that there’s always a greater fool to sell to — the NFT bubble has inflated so fast that it may run out of fools faster than anyone thinks.
However, we do acknowledge there are a lot of existing fungible tokens you can apply this to (social tokens?), and it is not to say you cannot generate long-term wealth through illiquid assets, like real estate, but this is the exception rather than the norm. Instead, we view the hallmarks of long-term sustainable economic drivers as having fundamental (objective) value, strong liquidity, active price discoverability and underlying asset utility.
Enter synthetics…
What is a synthetic?
A synthetic asset is a derivative that tracks the price of another asset without needing to hold that asset itself — this could be a basket of other derivative products (loans, options, futures or swaps) backed by an underlying asset or simply tracking the underlying asset itself — cryptocurrencies, forex, traditional stocks / bonds / indexes, commodities (e.g. precious metals), real estate, you name it. You can also tokenize the intangible, take BTCST for instance, anyone can buy into and reap the rewards of bitcoin mining without ever needing to physically own, operate and maintain the machines.
So why should you care about synthetics?
Synthetics gives anyone exposure to a free market for markets — anyone can create their own market from a virtually unlimited set of markets so long as they can provide proof of the underlying asset’s authenticity (this can simply come in the form of a verifiable price feed). Pair this with the open and transparent nature of DeFi + immutability and objective unbiased property of smart contracts and you also remove the necessity for any intermediaries or incumbents, as a result, less room for issues of subjectivity, dishonesty and all that cumbersome bureaucracy. How is this all realized? Imagine an ever-growing financial world with drastically reduced interest rates and fees, flexible ownership models, global accessibility, liquidity through interoperability and more. Now this sounds like financial freedom to us.
Why does DeFi/TradFi need synthetics?
DeFi is still relatively siloed, investors can’t easily trade cross-chain or cross-layer assets without a centralized exchange or a bridge, and we all know how secure these have been. The liquidity silo is a massive trading deterrent and bridges have been the target of many hacks recently, for example, the pNetwork hack was due to a validation flaw that failed to catch impersonated requests created by a malicious contract while the Poly Network hack saw an attacker swapping cross-chain ‘keepers’ for a malicious keeper under their control, allowing them to unlock and withdraw tokens that were supposed to remain locked within the bridge contract (fortunately the hacker says they’re ‘not so interested in money’ or so they say 🤔 but returned the funds). You could argue the same goes for targeting a synthetics’ price oracle, but this is largely mitigated by having a decentralized network of oracle providers and a smart aggregation strategy in the contract to protect against any significant volatility caused by a potentially malicious oracle / inaccurate feed.
TradFi on the other hand brings with it its own set of challenges, take traditional equities like SPY or NDQ as an example. The lack of accessibility outside the US’s jurisdiction excludes many of the emerging economies while the lack of flexible fractional ownership models results in a smaller investor base due to capital and liquidity constraints leaving retail investors and the financially weak (underbanked / unbanked) excluded. This one is pretty obvious but there is also a strong degree of centralization and reliance on middlemen / incumbents, this creates a questionable immutability of records and a lack of transparency. Transactional inefficiency of settlements in the form of legal and operational costs e.g. the risk of disputes and high brokerage fees is also a major deterrent for many traditional investors.
Trading synthetics in a crypto environment essentially breaks all of these open, it offers anyone a powerful investment vehicle with lower interest rates and fees, utility and liquidity through interoperability with DeFi protocols adopting their own unique ownership models and more.
Synthetics’ Lay of the Land
Synthetic asset protocols like Synthetix and UMA are some of the oldest in DeFi, however despite their tenure they remain among the most underutilized protocols. So why aren’t they more popular? This can be boiled down to the following:
Lack of genuine utility
Shallow utility, there is very little to no active utility for these synthetics. They’re mostly created for the purposes of tracking Forex currencies and used as collateral in another protocol e.g. Synthetix’s sUSD is mostly minted and deposited into protocols like Curve. There have been attempts to create individual secondary markets for synthetics, but liquidity and volume remains extremely low especially on spot markets. For example, Synthetix (excl. Forex) only has an all-time volume of top traded commodities at $196M and for top traded equities at $20M. For reference, DAI’s uniswap 24H volume (as of 13th of Dec 2021) is at $252M, now extrapolate that all-time and you can clearly see how underutilised synthetics are. On the other hand, investors aren’t able to transfer or hedge risk against price fluctuations of the underlying asset as derivative trading options for synthetics are very limited.
Poor UX
UX on platforms like Mirror, UMA and even Synthetix isn’t straight forward for the average user. These days you’re expected to be financially literate, be well-versed in the jargon of the space and understand DeFi primitives. This alienates a lot of people and makes it hard for mainstream users to onboard into synthetics and crypto more broadly. Not only is it extremely capital inefficient (which we’ll get to below) but it requires constant manual intervention from the user to ensure every position is sufficiently collateralized. This is often referred to as maintaining the peg or c-ratio. In crypto where assets and markets are extremely volatile, monitoring all of this can be a full-time job. Furthermore, blockchain-based trading experiences are slow and expensive, two massive deterrents when tossing up between a centralised and decentralized solution.
Capital inefficient
To mint a synthetic on Synthetix, you’ll need to maintain a 750% c-ratio. This means for every $250 synthetic asset you mint, you’ll have to deposit $1875 worth of the underlying collateral. If this doesn’t shout capital inefficient, then we don’t know what will. Other protocols like Mirror have attempted to lower the c-ratio and apply a multiplier, however this brings with itself its own set of risks i.e. the constant fear of a margin call / liquidation. This is largely due to the choice and usage of the underlying collateral, they’re either backed purely by DeFi 1.0 liquidity mining schemes or they’re far too volatile relative to the underlying asset, this further limits its usage as collateral i.e. deploying it to any other protocol (to earn yield etc.) is far too risky.
As a result, there is widespread lack of incentives to provide these synthetic assets to other secondary markets, this creates a negative feedback loop, weak liquidity and as a result, inactive and inaccurate price discoverability, adding yet another deterrent to trading synthetics.
Uncertain regulatory environment
The jury is still out as to whether these synthetics are considered securities or not, and as such there is some apprehension as to whether or not to use them. Due to this, many projects that once interacted with synthetics are now rethinking their positioning to avoid regulatory attention.
As you can probably tell by now, synthetics as we know it are fundamentally incomplete.
Introducing Synthetic 2.0
DeFi 2.0 + Synthetic = Synthetic 2.0 (real original, we know it)
By swapping the liquidity and value ownership model on its head, DeFi 2.0 breaks the chains that are currently holding synthetic assets back. Having a stable source of protocol-owned value backing the collateral asset opens up a world of opportunities for anyone minting new synthetics. Think of a world where you can worry less about constantly maintaining your position and can freely trade (or invest) your synthetics on markets offering a variety of investment vehicles all centred around synthetics. A true market for markets. DeFi 2.0 also enables a new form of governance that fully leverages protocol controlled liquidity by allowing the community to take ownership over the distribution of value not only within but also interoperably with other protocols. If this excites you as much as it does for us, then hold on for a little while longer ;).
Wrapping up
By no means are we saying everyone should abandon the current innovations in DeFi, but rather the diversification is going to be very important for the long-term sustainability and growth in the user base of the general public. Synthetics are complementary to DeFi and will be the second of three major pillars (read this for the first) in the advent of DeFi 2.0 with Serity again playing a key role in this movement.
The next article will be big, we’ll be introducing Serity!
Stay tuned once more.
