Originally published for a private newsletter, written by and owned by me
What are Cryptocurrency Derivatives and why are they risky?: Synthetix
Another week’s gone by and DeFi, largely fueled by Compound and Synthetix, continues to drive most of the current growth across the crypto space.
While Compound is fairly intuitive, Synthetix, and the risks it carries with it, continues to be harder to grasp for many cryptocurrency investors.
In case you don’t already know, Synthetix is a protocol and platform for launching what are called synthetic assets on the Ethereum network. Outside of the crypto world, synthetic assets are combined derivatives that track the price of a more tangible underlying asset. Here, by combined derivatives, we mean futures, options, and everything in between. Therefore, it is also possible to think of a synthetic asset as two or more derivatives that are put together into a sort of index for another asset like a stock or commodity.
Inside of the crypto world, these synthetic assets are cryptocurrency tokens whose prices follow the price of a stock, commodity, bond, or even another cryptocurrency(as well as all other asset classes, in theory). Synthetix, the ecosystem mentioned above, best exemplifies this in practice, through how it allows anyone to deposit the SNX token in exchange for what are called “synths.”
What are synths?
Understanding Synthetix requires understanding what synths are, as well as how they are created and bought.
“Synths” are blockchain-based synthetic assets.
Therefore, just like traditional synthetic assets, they can track the prices of any real world asset, including commodities and indexes as well. Consequently, “synths” just might represent crypto’s best chance at putting the rest of the legacy financial system on the blockchain, provided that the Synthetix system holds up.
How are synths issued?
Anyone who holds the Synthetix platform’s native cryptocurrency, SNX, can create or “mint” synths, using the Mintr DApp. This minting refers to depositing SNX in escrow to earn the responsibility of issuing supported synths to the Synthetix Exchange. Currently for every 8 SNXs staked, 1 synth can be sent out.
As of this year, if traders choose to stake Ether instead of SNX, they only have to fulfill a 150% collateralization ratio, which means that they would be able to issue one synth for every 5 Ether.
Even so, Ether stakers receive none of the added benefits that SNX stakers do, which are shares of the Synthetix Exchange’s trading fees and SNX as accrued interest.
Overall, the easiest way to conceptualize the synth minting system is to think of it as the MakerDAO for cryptocurrency derivatives since MakerDAO works in the same fashion.
Therefore, synths that are issued are really just loans.
These loans are currently solely given to the Synthetix exchange, to fund its liquidity but over time, the Synthetix development team hopes that other groups will choose to create new exchanges with its underlying protocol.
How can I buy synths?
Buying synths is far simpler than being a liquidity provider for them.
Why should I trade in synths?
Generally, the Synthetix Exchange and synths allow anyone to establish long and short positions on any supported asset without undergoing any KYC or relinquishing custody of the asset involved at any time.
This is because Synthetix is a decentralized exchange(DEX) or a cryptocurrency exchange that runs only on smart contracts, without the constant interference of an actual business in the middle.
Additionally, now average traders can take all sorts of positions that have historically been reserved for big players like OTC trading desks and hedge funds.
Though Synthetix now primarily supports synths, it also recently launched support for binary options, which are predictions on the future prices of an asset that either pay-off or don’t, and run-of-the-mill futures contracts, indicating that it aims to unseat crypto’s derivatives leaders like BitMex, at least in terms of Ethereum-based derivatives.
What are the risks of “synths?”: The 2008 Crisis and The Threat of Defaults on DeFi
Generally, the risks of synths are identical to the risks of any class of derivative. If we look back to the financial crisis of 2008, we can say that these risks are most easily summed up as “leverage-related.” If you’re not familiar with the term, in this context, leverage refers to borrowing what you don’t have.
Leading up to 2008, derivatives were becoming more and more popular and less and less regulated. The prime example of this was the collateralized debt obligation(CDO), which in this context, was a synthetic asset that usually represented a wide array of mortgages. The key problem with CDOs, leading up to the 2008 global market crash was that they were held up as guaranteed vehicles for passive income.
The reality couldn’t have been further from the truth.
CDOs were predicated on the assumption that the United States real estate market would never stop growing. Powerful banks like Lehman Brothers, AIG, and Bear Stearns took on massive amounts of CDOs on borrowed capital that they were sure they would be able to pay back.
These were loans that in some cases stretched into the billions, because CDOs acted as bonds, offering fixed-interest over the long-term.
As many of us already know, once the US real-estate market tanked and scores of people began to default on their mortgages, CDOs, and the banks that held them did as well.
This resulted in the crash of epic proportions that most of us still remember vividly.
How does the 2008 financial crisis relate to “synths?”
Synths, and all other products that are similar to them like MakerDAO’s CDPs and Compound’s loans carry the same basic risk, though currently, on a much smaller scale.
If we take this year’s BZx exchange attack as our key example, it is easy to see why.
In February, a hacker essentially used one loan on the dYdX exchange to game the DeFi system. In doing so, they began with what is called a flash loan. Generally, a flash loan is the same as a loan via Synthetix or Compound except it requires no collateral and must be repaid after one transaction with it.
Using this feature via dYdX, the hacker took out 10,000 Ether, then proceeded to place several positions across dYdX, Compound, and BZx, which ended in a short of the WBTC stablecoin, an unpaid loan from BZx, and a profit of 1,193 ETH, which they then used to settle their initial loan with dYdX.
All of this was done with complex code that allowed every action to be done as one transaction. Furthermore, the attacker’s profit essentially came from all of the lenders involved, which showed how DEXs like all of those mentioned above are far from perfect.
After just a few days, a new hack occurred that briefly pumped the price of the synth, sUSD. Luckily, however, this attack was stymied by the fact that an insurance fund was already in place to cover all of the losses involved.
Synthetix and all other DeFi related services are still vulnerable to these attacks since they are interconnected by design, and typically require no sign-up procedures to use. If a large enough flash loan attack were carried out, it could render a system like Synthetix insolvent, especially if it targeted SNX.
In the end, Synthetix is easy to use but carries a big risk, due to its loan system. Since it looks poised to become the crypto futures leader on the Ethereum network, it will be interesting to see how its developers plan to address this risk over time.
If you like my content please reach out below or on Twitter here.
Disclaimer: None of this is meant to be financial advice. I’ve researched and worked in crypto since 2016 and I aim to merely educate people on the upsides and downsides of all sorts of projects. Additionally, I’m a student just as all of us are. Therefore, my thoughts on projects evolve naturally over time as I learn more about them.