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The ultimate guide to decentralized derivatives part 2: Synthetix

We’re proud to share one of the clearest guides to Ethereum’s largest synthetic tokens project to date — Synthetix, as we continue to cover in detail the growing on-chain derivatives landscape

In part 1 we introduced on-chain derivatives and explained why they’re essential, dividing them into 2 ‘tech’ categories: A) synthetic assets and B) on-chain perpetual swaps. Then we reviewed in detail how UMA and Opium (both synthetic assets projects on Ethereum) work and how they’re controlled, and also analyzed how decentralized they really are. Today we’re conquering another mountain top so to speak, by explaining the details of the most well known and oldest Ethereum synthetic asset project, and perhaps the most misunderstood one — Synthetix. Though few resources make its inner working clear, it boasts $2.2 billion worth of on-chain collateral and $30 million in daily trading volume.

Synthetix on-chain volume per-month. Source: DEX metrics DuneAnalytics

So, here’s everything you need to know about Synthetix!

Synthetix

Went live: August 2019

Method: over-collateralized synthetic tokens backed by pooled funds denominated in the $SNX token. (and a small amount of tokens collatralized in ETH and BTC.)

Venues: www.synthetix.io, kwenta.eth.link

Volumes and Collateral: In March 2021 Syntheix’s software backs roughly $327 million worth of synthetic assets, hosting as collateral 112 million SNX tokens, worth at the time of writing $2.2 billion. Daily trading volume interacting with the Synthetix software is roughly $30 million a day or $600 million a month at the time of writing, according to Dune Analytics.

The Synthetix exchange

Synthetix.exchange is a DEX offering 42 trading pairs of synthetic tokens, both regular and ‘inverse’ tokens for short positions on underlying assets such as Etherum, Bitcoin, Euro, BNB and silver. It has an easy to use interface and immediate minting of synthetic tokens. One of the first DeFi projects to offer “liquidity farming” (a reward program that dispenses SNX tokens to accounts that collateralize their assets), it has drawn substantial collateral and speculative interest, with rewards currently of up to 31.65% on $SNX a year to accounts collateralizing their assets.

Synthetix exchange also launched a new binary options section in June 2020 which currently hosts under $50,000 in collateral and is not in the scope of this article. We plan to review it when this series reaches the subject of on-chain options.

How popular is Synthetix?

Synthetix has the 7th largest pool of collateral on Ethereum’s blockchains- $2.4 billion. But this ranking is somewhat misleading — Syntehix’s main collateral, $SNX, has been issued by the project itself, while projects with comparable collateral like SushiSwap, Curve and MakerDAO are collateralized mainly by Ethereum tokens.

Source:DEX metrics, DuneAnaylitics
SushiSwap on-chain volume VS Synthetix

As for the user base, according to the DEX metric dashboard, Synthetix has around 350 weekly unique accounts interacting with its software. In comparison, Synthetix’s ‘neighbors’ in the Ethereum DEX volume ranking, dYdX and Kyber, interact with 1,204 and 1,225 unique weekly addresses. Despite the low number of unique users, Synthetix is one of the leaders in trading volume among the synthetic tokens projects on Ethereum’s network.

The total value of synthetic assets created by the SNX collateral is roughly $327 million, a number reached by dividing the amount of SNX collateral ($2,290,812,556), by the average collateralization ratio (702%).

How Synthetix works

Regular users: The best part of Synthetix is definitely the user experience for those simply seeking to buy or sell synthetic assets on Ethereum. For those familiar with Uniswap and Ethereum wallet software, it just a few simple steps:

1) Buy Synthetix’s gateway assets- sETH or sUSD on an exchange like Uniswap or SushiSwap.

2) Log into Synthetix.Exchange with an Ethereum wallet and buy immediately any of the ‘synths’ — synthetic assets, offered on the exchange. The user pays the market price of the underlying asset and an exchange fee between 0.1% to 0.3% per trade.

sUSD VS USD. Source:CoinGecko

3) The synthetic asset, nicknamed Synths, can be converted when the user wants to return to sUSD or sETH within this system (with a 3 minute waiting period). sETH and sUSD can be withdrawn from Synthetix’s exchange and sold on an external spot exchange.

The basic user’s only concern is their ability to sell sUSD or sETH for the right price. Currently they have quite stable and liquid markets, trading against USDT and ETH.

Collateralizing and staking: This is the tricky part. Let’s explain the rules and incentives behind the backing of these synthetic assets:

1)From now on we’ll refer to $SNX collateral providers/liquidity farmers as stakers. The majority of Synthetix’s Synths are backed by the pool of capital of all SNX stakers.

2) To become a staker in the pool, you are first required to mint sUSD tokens by providing to the software over 400% collateralization — $4 worth SNX for each $1 sUSD minted.

$SNX historical price denominated in USD. Source:CoinGecko

3) After the staker has minted sUSD they have 2 main options: Keep the sUSD (or put it in an external liquidity pool such as the sUSD pool in Curve.fi), or use the sUSD to mint new synthetic assets (e.g. sBTC, sLINK)

4) After the minting of the new sUSD the stakers collateralization requirements change according to the changes in the price of SNX and the changes in price of all the synthetic tokens created by all the various participants who minted Synths in this system.

The ‘debt’ of each backer to the systems is counted in USD value: it starts out as the amount of sUSD they minted and changes according to the changes in the liabilities of the total SNX pool of all stakers.

For example, as a simplification: If 100% of the Synths in the Synthetix system are sBTC and if the price of BTC doubles and the price of SNX stays the same, all stakers must double the amount of SNX in their staking account or ‘burn’ half of their sUSD tokens, in order to maintain the same level of collateral. In the same scenario of 100% minting of sBTCs, if the price of BTC stays the same but the price of SNX goes down by 50% against the dollar, the stakers also must double their ratio of collateral to sUSD to keep up with target levels.

3) These collateralization requirements are incentivized by the $SNX staking reward program, a type of ‘liquidity farming’. Each week $SNX tokens are distributed according to the amount of funds stakers have deposited, backing the Synths. If a staker’s collateralization level is close to the current target level of 500%, they will receive the weekly staking rewards (currently 37% annualized). The staker’s reward is a share of newly minted SNX tokens, according to their contribution to the total pool of funds, plus a percentage of trading fees from the exchange platform. If the staker’s collateralization level is too high or too low they will not receive the weekly award. If the level of collateral in the stakers account drops to 200%, the funds in their account are locked until more SNX is provided, ensuring the synthetic assets are fully backed.

Screenshot of a empty Synthetix stakers Mintr dashboard

Detailed of $SNX to sUSD collateralization requirements (“c-ratios”) and their incentives:

506% or higher: Do not receive rewards and fees, and should mint sUSD or withdraw SNX to lower their collateralization level.

Close to 500% (506% — 494%): Receives weekly SNX rewards each Wednesday.

494% — 200%: Need to top off the account with more $SNX or burn sUSD in order to claim rewards and fees once again.

200% or lower: SNX collateral is frozen. The staker has to deposit more $SNX or his account will be liquidated within 72 hours.

Synthetix also allows collateralized synthetic assets in ETH. Synths backed by ETH are collateralized by 150% and do not participate in the ‘pool debt’ of the system. They also do not receive fees or rewards. Currently there are 12,000 (priced at $18 million at the time of writing) Ethereum tokens deposited in this section.

Monetary policy and tokenomics

From March 2019 to August 2023, the total SNX supply will have increased by 260%. But from September 2023 the annual inflation will be only 2.5%, according to the current plans, and stakers will be incentivized mostly by the trading fees. Will that be sustainable?

Amount of different Synths backed by Synthetix according to stats.synthetix.io. Screenshot March 1st 2021

Today stakers are not only betting on the price of SNX plus a few percentage in rewards a month, but also on the fluctuations in price of all the assets they are backing while having little to no control over the content of this basket of assets.

In other words, without hedging, the stakers have no control over the type of risk they are taking. That is why Synthetix’s manual advises that stakers hedge their position in an external exchange. For example, if the synths pool is today 50% sBTC and 50% sLINK, they should long BTC with a position size equal to half of the sUSD they have minted, and ChainLink with the other half, so that if BTC or ChainLink goes up, they can transfer their profit into Synthetix’s system to maintain their collereal ratio. In reality the basket of assets is divided between a variety of assets and if they’re interested in protecting the value of their accounts, they must update their defensive positions frequently, according to changes in the synths pool. In addition, if they want to be protected from a drop in $SNX, they must short $SNX on an external exchange such as FTX or Binance.

Future plans

There is a current proposed SIP to phase out the weekly snapshot model in favor of time-based rewards in order to stop manipulation of the weekly snapshot of collateral that determines the staking rewards. Synthetix is testing the off-chain protocol Optimistic Ethereum, aiming to move to this layer 2 Ethereum protocol in order to reduce fees and latency. On February 14th 2021 Coindesk reported Coinbase Ventures and Paradigm invested $12 million dollars in SNX tokens and plan to support upgrading the platphorm.

Points of failure quiz

Contracts: Since July 2020 Synthetix’s code and protocol are controlled by 4/8 multisig keys held by the project’s developing team. The developers can modify and update the protocols containing the funds in real time. Signers can also pause contracts and individual Synths in case of an emergency, but SNX token holders can vote to override signers’ decision.

Price Oracle: The price oracles in Synthix are currently maintained and controlled centrally by the developers team, with plans to use ChainLink oracles in the future.

The UFO test (KYC): Using Synthetix does not require KYC. A UFO can enjoy the use of synthetix’s assets. But in order to hedge a staking account he may need to use a KYC’d exchange.

Conclusion

While Synthetix offers one of the easiest to use and most liquid venues for trading synthetic assets on Ethereum in early 2021, this simplicity and liquidity is a result of a large trade-off on the back end, demanding an unusual level of investment and risk from the backer of the system. The risks and changing collateral demand are often not fully understood by independent staker. Synthetix’s incentives and collateral system have been beneficial in bootstrapping it but are likely to be unsustainable in the long run due to the dropping off of the liquidity mining planned for 2023 combined with the high risks and demands from independent stakers. Stakers have unlimited exposure to both the price of $SNX and the price of the pool of Synths which changes according to the whims of the market, making it a poor choice for those who are not insiders of the project or highly confident in its future.

We hope we have contributed in this post to clarifying Synthetix’s product, risks and issues, with our aim to increase the clarity and transparency in the DeFi space. In the next post we will wrap up Ethereum synthetic asset section of our Ultimate Guide with Mirror Protocol.

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Efficient Frontier

Efficient Frontier

Leading research & algorithmic trading firm for the cryptocurrency markets efrontier.io