Synthetix: A Financial Tunnel Bridging the On-chain and the Off-chain
0xed11
September 22nd, 2022

Author: @!0xWang1| @RealResearchDAO

Foreword

As an individual investor, it is not easy to experience various types of transactions in the financial market to a certain extent, especially when trading assets across national borders. Most of the entry barriers, such as deposits and withdrawals, regulatory policies, KYC, etc., will shut out most traders. At the same time, traders who want to exchange their type of assets for another one are also faced with many inconveniences. Costs such as time consumption and transaction fees stop most traders from using their assets flexibly. As a simulation of priced assets, synthetic assets solve the problem of insufficient flexibility. At the same time, combined with smart contracts, synthetic assets can also provide users with transactions of different types of assets without supervision.

Synthetix, as an Ethereum-based synthetic asset issuance protocol, is also an OG of the DeFi ecosystem. It provides traditional financial market users with flexible asset portfolio solutions, as well as more asset choices to help out on-chain users by combining their cryptocurrency with real-world assets, thereby creating a more mature financial market.

What is Synthetix?

Synthetix is an Ethereum-based synthetic asset protocol that allows users to issue and trade synthetic assets (Synth). Synth tracks the price of the underlying asset, and users can purchase Synths to enjoy the price rise (or fall) of the underlying assets tracked by Synths, without having to be the actual owner of the asset. Synthetix was originally a stablecoin project called Havven. Before becoming Synthetix, Havven received a total investment of 30 million US dollars. However, the original stablecoin project did not develop smoothly. The team adjusted the strategy in time and started the business of synthetic assets. Havven then upgraded from a stablecoin project to Synthetix, a protocol platform for synthetic assets.

What do synthetic assets do?

Synthetic assets are a kind of financial derivatives, which can be simply understood as an asset that can represent real-world assets for users to trade. Many users suffer from restrictions on transaction barriers and complicated procedures, and they cannot participate in transactions at will for various assets. As a simulation of real-world assets, synthetic assets provide users with the experience of trading different assets in a special trading platform, which is equivalent to a brand-new platform of trading for all users. Trading with synthetic assets will not be affected by various conditions. At the same time, synthetic assets can also carry out operations such as packaging and combination, individual splitting, and other operations on the assets in the display to meet the different needs of users.

What does Synth include?

Synth includes almost all assets with reliable price sources, such as cryptocurrencies like Bitcoin or Ethereum, commodities such as gold and silver, and fiat currencies such as the US dollar. There are even reverse Synths that track the underlying assets in reverse, making it easy for traders to gain short exposure or hedge their current holdings and liquidity mining positions.

The core idea is that by using Synthetix, traders can gain exposure to certain assets that do not exist on-chain. Synthetix also supports the freedom to create various indexes, such as DeFi indexes that track DeFi asset portfolios.

Why Synthetix?

As a synthetic asset issuance protocol, Synthetix not only provides services for synthetic asset issuance but also provides a platform for synthetic asset trading. For most users, trading is the main function of Synthetix: users can use their cryptocurrencies to buy gold, silver, and other commodities by over-collateralizing, and can also trade crypto assets such as BTC and ETH. 

Why is there a demand for Synthetix even though there are well-developed centralized exchanges?

Wider asset exposure

First of all, when a user trades a synthetic asset, it does not require the user to actually hold the underlying asset. For example, when a user buys gold on Synthetix, he essentially buys a derivative product of gold, not the actual gold. However, the derivative product reflects the market price of gold which users will be able to profit from trading it. Such a transaction method reduces the friction when exchanging assets and allows users to quickly exchange different types of assets. After all, in traditional finance, it takes quite some steps to convert gold into Bitcoin. Synthetic assets can help users to move funds more flexibly and gain access to more types of assets.

An arbitrage opportunity based on the platform’s mechanics

Secondly, users can arbitrage based on Synthetix's collateral mechanics. sUSD is a stablecoin issued by Synthetix and pegged to 1 USD. However, sUSD has relatively large volatility while being tradable, and may depeg (the price of 1sUSD is lower than 1USD). At this time, users who stake SNX as collateral, while issuing synthetic assets (such as sUSD), also bear the corresponding debt settled in sUSD. After selling their synthetic assets, users can choose to buy more sUSD that are worth higher than the total debt at a price lower than 1USD to gain arbitrage. And on Synthetix, the synthetic assets generated by staking SNX are not limited to just sUSD, which is the main difference between Synthetix and MakerDAO.

Smart Contract Transactions and Oracle Price Feeding

Finally, and most importantly. Transactions on Synthetix are completely decentralized, and the advantage of Synthetix is that users do not need to worry about their counterparties, asset liquidity, frictions, and slippages when trading. The transactions on Synthetix are all managed by smart contracts. When users trade different underlying synthetic assets, they are automatically ensured by smart contracts, which is different from the traditional order book transactions. The price of synthetic assets on Synthetix are all fed by Chainlink’s oracle, providing accurate price exchange rates for synthetic assets.

But even Chainlink's oracle may not be able to accurately capture prices in a short period of time when dealing with volatile assets (such as U.S. stocks).

To solve this problem, the synthetic assets of some stocks will have a two-minute protection period. During these two minutes, the assets will be temporarily frozen. If it is determined that there is no huge fluctuation, it will be unfrozen, which ensures that the synthetic assets on-chain will be generated. The quantity is stable and will not cause a huge price difference.

*Quoted from "The Lego Bridge Linking Capital Markets - Synthetix" by @Vic TALK

How Synthetix Works

Not only can you theoretically trade all types of assets, but you can also enjoy a smooth and zero-slippage trading experience. So, how does Synthetix work?

Users are assigned roles

Users can use Synthetix as two roles: Staker and Trader.

Staker

Just like other asset issuance protocols, users also need to collateralize assets on Synthetix before issuing synthetic assets. For example, to issue DAI in MakerDAO, ETH needs to be collateralized. Synthetix follows a similar logic, but instead it is collateralized by its native token, SNX. Users can issue synthetic assets by over-collateralizing SNX in the smart contract. According to the latest SIP-148 proposal, the current coverage ratio on Synthetix is 400%, that is, users who stake $400 worth of SNX can mint $100 in sUSD.

The platform's staking reward for Staker is divided into two parts: the platform’s transaction fee income (divided according to proportions). The transaction fee is usually 0.3%, and the user's reward is paid in sUSD on a weekly basis. At the same time, staking SNX itself has an annual yield, but requires users to lock up their SNX for one year. It is equivalent to staking SNX as single-asset staking, and the reward is paid in SNX to users.

Staker is essentially a liquidity provider. Under the mechanism of the dynamic debt pool (detailed later), a large amount of SNX staked by the Staker provides Trader with almost unlimited liquidity.

Trader

A Trader is a user who trades synthetic assets (Synth) on Synthetix's own exchange, Kwenta, after issuing sUSD with staked SNX or directly purchasing sUSD on a DEX. The essence of the exchange of sUSD for synthetic assets is to burn sUSD and mint the corresponding Synths.

After the transaction is completed, users can exchange their Synths for sUSD. Similar to sUSD -> Synths, the essence of Synths -> sUSD is to burn Synths and mint corresponding sUSD at the same time. The user can get back their staked SNX by returning the sUSD. At the same time, due to the special mechanism of the dynamic debt pool, the sUSD owned by the users may not be able to exchange for all the staked SNX. 

You are in the game! Entering the dynamic debt pool.

The dynamic debt pool mechanism is the core and the most critical part of the entire Synthetix system. The dynamic debt pool supports Synthetix's core trading advantages of zero slippage and smooth transactions.

At the beginning of using Synthetix, when users over-collateralized SNX to issue sUSD, the corresponding “debt” will be created. When the user terminates the trading activities of synthetic assets (Synth) and wants to withdraw from the platform, the “debt” should also be first paid off.

But under the dynamic debt pool mechanism, the user's debt changes in real-time according to the rise or fall of the price of Synth when the user conducts Synth trading activities, and the debt is jointly borne by all users who stake SNX in the system.

For example, when all synthetic assets in the system are sBTC, if the price of BTC is halved, then the total debt in the system will also be halved, and the debt of each Staker will also be halved. Similarly, if the price of BTC rises double, the total debt of the system will also double, and the debt of each Staker will also double.

Therefore, even if the user just stakes SNX to obtain sUSD and does nothing, he will become a member of the entire game and cannot enjoy the stable income brought by staking collaterals.

An Example

Assuming that there are a total of 2 users, Bob (in Blue) and Alice (in Red), in the current system. They each minted 1,000 sUSD, that is, they each assumed debt of 1,000 sUSD. At this time, Bob will exchange all sUSD to sBTC, and Alice will hold sUSD unchanged.

As can be seen from the table, the dynamic debt pool will allocate all the debts in the system to the users according to the smart contract. At this time, the sBTC assets of Bob’s are worth 2000 sUSD. At this time, Bob sells sBTC to get 2000 sUSD. He now only needs 1500 sUSD to withdraw the staked SNX, while Alice needs to buy an additional 500 sUSD to withdraw the staked SNX.

The impact of all dynamic debt pools on users is that when users act as Stakers, the sUSD obtained is a fixed amount, but the sUSD-based liabilities are calculated according to a fixed ratio. At the moment when SNX is staked to issue sUSD, the amount of sUSD minted is equal to the amount of the user’s debt. However, as the dynamic debt pool continuously allocates debt according to the value of Synth in the system, the amount of sUSD of Staker's and the amount of debt are often not equal.

Although users have no counterparties when trading Synths, Staker and Trader are counterparties in a dynamic zero-sum game in the debt pool: when the total value of traded Synths in the system falls, Staker is profitable; when the total value of Synths rises, Stakers holding sUSD will face losses due to the rising debt. For Staker, the act of holding sUSD without trading is essentially longing the investment ability of the users or other participants. Also, users will face the risk of losing money at any time due to the strong investment ability of others. So even if you do nothing, Staker users are already "in the game" at the moment of entering Synthetix.

In the case where Staker and Trader are counterparties to each other, Staker seems to have assumed the risk of all the debts in the system, which will also motivate users to actively participate in Synth transactions.

The risks borne by Stakers provide Trader with almost unlimited liquidity in the dynamic debt pool, and it is also a guarantee for the continuation of the Synthetix trading system. At the same time, in order to compensate for the risks faced by Stakers, the system will divide the transaction fees to Stakers as staking rewards.

Thus, the path is as follows: Not willing to lose passively -> Be involved in Synth transactions -> Large transaction volume and high transaction fees bring more income to staking SNX and attract more Staker -> Users enter the game.

A buffer against liquidation

Unlike the immediate liquidation mechanism of many lending platforms, in order to avoid systemic risks, Synthetix has a 72-hour buffer period for liquidation, that is, when the user's debt-to-collateral ratio is insufficient and faces liquidation, they can collateralize more of his native token within 72 hours. For the operation of supplementary collaterals, as long as the overall coverage rate is higher than 400%, liquidation can be avoided, giving users enough time to buy SNX to make up their positions. On one hand, this mechanism ensures that the protocol will not face systemic risks in the face of a plummeting market. On the other hand, the SNX price will also recover.

Take a breather in a bear market

As a market sector that gathers a large amount of liquidity, DeFi first experiences the cruelty of a bear market. In a falling market, the funds deposited in the DeFi ecosystem escape and face subsequent liquidations. Many once-glorious projects are gradually heading for a death spiral. As an OG member of the DeFi industry, Synthetix naturally cannot avoid a plummeting token price and subsequent liquidations. But after experiencing the trauma of dropping by 90%, Synthetix's native token SNX rose again by a lot. Is it because of the will of the market or SNX’s confidence in retaining value? What happened to Synthetix between those ups and downs?

Solving the problems for the whales

Previously, Curve and Synthetix jointly launched a cross-asset Swap.

The idea is to achieve large-volume transactions with low slippage by combining Curve and Synthetix. For example, to exchange $1m USDC for ETH, the exchange path for the cross-asset Swap is:

USDC - (sUSD - sETH) - ETH

Curve: USDC - sUSD

Synthetix: sUSD - sETH

Curve: sETH - ETH

It can be seen above that the exchange between tokens of the same type is completed by Curve, and the exchange between different types of tokens is handed over to Synthetix, using the 0-slippage transaction between Synths as a bridge to achieve 0-slippage exchange.

This is the perfect solution for the big whales, but why isn't it being used? The reason is that it takes about 6 minutes to complete a cross-asset Swap, and the time consumption is obviously not appealing.

SIP-120

In June, the Synthetix community passed the SIP-120 proposal (i.e Synthetix Improvement Proposal 120) which improved the performance of Synthetix. This proposal has caused the price of SNX to nearly double.

Synthetix's synthetic assets have theoretically unlimited liquidity, and Traders don't have to worry about liquidity depth being affected. But all this depends on the price feed of the oracle, which also causes users to wait a long time for the oracle to work. SIP-120 introduces the pricing of Uniswap, comparing the prices of Uniswap with Chainlink’s oracle, which ensures the accuracy of the price and improves the transaction speed. At the same time, Synthetix integrated 1Inch to improve execution efficiency. Orders from Curve+Synthetix were processed by 1Inch, and the fees and transaction volume generated by the Synthetix protocol soared. Most of the trading volume originates from 1Inch, a decentralized aggregator. 1Inch dominates all projects that facilitate Synth transactions. The SIP-120 proposal is key to the protocol's recent momentum. The new instant transaction feature is called "Atomic Swap".

*The transaction volume of Synthetix soared after the introduction of Atomic Swap in SIP-120 Source: token terminal_
*The transaction volume of Synthetix soared after the introduction of Atomic Swap in SIP-120 Source: token terminal_

Conclusion

Synthetic assets provide users with more flexible ways of using funds and broader trading space. Synthetix is ​​also an absolute leader in the synthetic asset industry. But combined with the market conditions, Synthetix still faces some problems.

When executing a transaction on Synthetix L1, the smooth experience comes from the high gas fee. At the same time, due to the complex smart contract of the Synthetix ecosystem, each transaction of the user's operation is slightly complicated, which is undoubtedly a very high barrier for most users.

At the same time, Synthetix's only collateral is SNX, which also brings in certain systemic risks. When the token’s price plummets, the entire system will face serious liquidation risks. If Synthetix wants to expand further, it should introduce more stablecoins into its collateral system, allowing more users to easily participate and also splits the risks brought by single collateral.

As a bridge connecting traditional finance to crypto, Synthetix is ​​also very likely to be affected by regulations. When faced with regulatory issues, it is important to maintain the operation in compliance with regulations to avoid potential strikes. Not only Synthetix, but every crypto project should also consider regulatory issues more carefully.

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