A little dash of reality
June 20th, 2022

It goes without saying we are living through unprecedented times, at least from a crypto perspective.

But even zooming out for a moment the current macroeconomic situation appears to be deteriorating in a way we haven’t experienced for almost a century following the Bretton Woods agreement which established the USD as the global reserve currency. Given this upheaval, it appears for the moment that the days of loose monetary policy, the backdrop to almost all of crypto history, are over. 

The two exceptions to this pattern were brief periods in 2013 and 2018 when quantitative tightening was tentatively explored by central banks, curious 🤔. This is an interesting coincidence in hindsight given both of those periods coincide fairly closely with the last two crypto bear markets. 

This year inflation-fighting central bankers have created significant volatility in global markets particularly in crypto, we have now seen several projects implode spectacularly over the last few months. If we are being honest it is likely this is just the beginning, when the easy money is switched off, many high-risk behaviours that were richly rewarded in the bull are exposed for the gambling they really were, and the subsequent pain that ensues is epic. We need to be realistic about the fact that many projects that have not managed risk well are likely to come under stress in the coming months. Projects that have been risk-averse and maintained a defensive footing are still going to face stress. Even the most defensive projects are not immune to failure in this environment.

The question each project must ask is how do we deal with this stress, how do we ensure it is discussed within our communities and in the broader crypto ecosystem? It is very tempting to project strength, but this temptation can lead you down a dark path where you are forced to go to greater and greater lengths to hide your growing weaknesses. This strategy inevitably creates opacity and confusion as project leaders try to spin the situation to create the illusion of security. Opacity and obfuscation are antithetical to DeFi. The reality is the only projects that can get away with this kind of behaviour, even for a short time, are centralised entities masquerading as DeFi. A true DeFi project simply cannot hide from the information available on-chain. That said, information on-chain can be hard to interpret and so it is possible, even for DeFi projects, to obfuscate and spin, we must resist this temptation and create a culture of openness and transparency.

When we look at some of the recent incidents where founders attempted to quell fear right up until the moment of collapse, reactions tend to fall into two camps, the first is ‘these people were opportunistic psychopaths gaslighting everyone while extracting maximum value until the last minute’. The other end of the spectrum is, ‘these people were blissfully unaware of the risks they were incurring and were themselves shocked when it all fell apart.’ There is a middle ground between these two positions which is a little more generous to everyone involved in these catastrophes. The world is uncertain, it is extremely hard to predict the future and in the face of imperfect information hoping for the best and faking it until you make it are quite reasonable up to a point. The problem with this is you invariably begin obfuscating the truth and minimising risks. Is it any wonder then, that a person faced with such a situation often chooses self-immolation over coming clean and admitting they were hoping for a better outcome and they took too many risks that eventually caught up with them?

In my view, one of the best things about the Synthetix culture has always been our willingness as a community to confront risk with reasoned arguments and open debate, rather than obfuscation and opacity. Yet I believe the community can still do a better job of communicating risk. The complexity of the staking interfaces has forced most would-be stakers to have a better understanding of the underlying risks than they otherwise might have, but that is not enough. The reality is, staking SNX is high risk and complex, it is one of the most advanced activities you can do in DeFi right now. Come into the discord and watch a prospective staker ask why staking has to be so hard. Then observe as the community patiently explains that staking is high risk and they should ensure they understand their responsibilities before they stake. This has without a doubt limited the uptake of staking! But this is a trade-off the community has embraced fairly well. We can always improve though, there have definitely been times where the inflation-driven high APY from staking has been communicated without clearly calling out all the risks, but in a bull market attention is scarce and it is hard to blame the community for doing whatever it could to attract attention to the protocol and increase awareness given the high noise to signal ratio in bull markets.

That was quite the preamble, but now for the main point. This post will attempt to capture the current state of Synthetix as best as I can, I have solicited input from numerous people within the community as there are many initiatives and aspects of Synthetix that I am simply unable to keep track of at the level of scale and decentralisation Synthetix operates at.

Firstly let’s look at the tech, Synthetix is running on a four-year-old platform architecture, which is kind of insane when you realise the original Havven contracts were deployed on an Ethereum network that was less than three years old at the time. While this legacy codebase is battle-hardened and well audited, we (either internally or via the community) occasionally find bugs that have been introduced over the years. The primary issue with maintaining this much legacy code is that modifying V2x is very high risk, there is a large amount of technical debt and many design decisions were made years ago by engineers who are no longer working on the project. But circumstances have forced us to respond to shifting market dynamics and recently more and more releases have been tacked on to this legacy code. This is unsustainable and it is time we said goodbye to V2x. The deprecation of V2x is close, but so long as the project is running on this code across two separate networks we are seriously constrained in what we can do and how much we can improve the protocol.

Enter Synthetix V3, a completely redesigned version of the protocol running on an ultra-modern architecture that makes deployments and engineering orders of magnitude easier and safer. Unfortunately, while great progress has been made resources have been repeatedly diverted back to V2x to help with much needed releases and fixes that are inevitable as the market oscillates wildly at the end of an epic bull run. V3 is coming but until it is released the risk within the legacy system design must be considered when assessing the returns from staking SNX.

Now let’s take a look at the economic health of the network. A naive observer would look at the entire history of Synthetix going back to March 2018 through early 2020 and say that based on price alone something seems to be going well. $2 SNX and a market cap of $500m+ looks great on paper. There is an issue though, between the time SNX last traded at $2 in June of 2020 through to today it experienced a 1,500% price appreciation and subsequent decline. With a network like Synthetix, while the incentives are structured to be able to absorb these kinds of cycles, unfortunately even the best incentives are not perfectly symmetrical and so the network is under far more pressure at $2 today than it was back before the start of DeFi summer. It is impossible to predict where the market might bottom from here. We are operating with a macro backdrop that has no equal except possibly the start of Covid, and even that looks like fun compared to what the next six months might bring to financial markets.

Given we can’t know where the bottom might be, let’s look at two key psychological levels for SNX, $1 and 50c. There is currently around $150m in debt backed by SNX in the network, at $1 SNX, in order to maintain a network ratio over 200% (the target is 300%, but during high volatility, we must expect that some of that buffer will be eroded) we need stakers to continue to pay down their debt even as they absorb liquidations to the tune of around $50m. Thankfully the CC’s were able to implement SIP-148 in time for the move from $5 down to $2, these socialised liquidations have already added significant confidence to the network.

This is critical to understand, Synthetix is an over-collateralised crypto-backed suite of stablecoins, it CAN implode. It hasn’t yet and this is a testament to the responsiveness of the community to difficult circumstances and a willingness to experiment with novel mechanisms to provide stability. But if BTC nukes to $3k tonight (an albeit unlikely scenario, but like what in the fuck is even happening right now, so who knows) it is extremely likely Synthetix and many other DeFi protocols would struggle to absorb this volatility. Leading to cascading liquidations and chaos. It is certainly possible the Synthetix network and other DeFi projects could recover, but what that would look like is an exercise for another time. The good news is anyone can inspect the health of the network and all of DeFi, of course, you still need to make some assumptions about the responses to incentives of individual participants but all of the data is at least available. 

It is worth discussing governance for a second, I’m planning a much more comprehensive post on what passes for “governance” across much of crypto these days, but that post is still in draft. What we can say is that there is no opaque centralised body the Synthetix network relies on to “guard” the Synthetix protocol. It is incentives all the way down. We have a group of elected Councils that all work together to manage the risk of the network on behalf of token holders, and while these governance bodies have discretion they are ultimately responsible to token holders. So how likely is it that this $50m figure is available to pay down the debt as the collateral value declines? Looking at the major wallets in the ecosystem there is significantly more than $50m in stables at least in principle, available to address debt.

Between $1 and 50c it is likely a further 50m in debt needs to be absorbed, these numbers are approximations for a number of reasons. The primary one is that it depends on the percentage of the network that is liquidated on the way down, as well as what the price of ETH and BTC do, because the debt pool is skewed long, stakers profit when ETH declines which reduces the debt. This provides some cushion in a falling market. The largest holder of SNX and debt, the treasury council, is committed to servicing its debt which takes a lot of stress off smaller holders. The fact that none of the top twenty wallets have been liquidated even as the price of SNX has declined by 80% also inspires confidence in the commitment of large stakers to the network. But it is critical to understand there are risks here, any protocol or platform that tries to claim it is risk-free is absolutely bullshitting you, as we have all painfully experienced lately. 

Whether the rest of the stakers continue to pay down debt will be based on how confident they are the network will remain solvent. At the current SNX/ETH ratio 50c SNX would require ETH below $400, at those levels there will be major stress throughout crypto so predicting the behaviour of individual actors becomes more challenging. But fundamentally, provided there are sufficient well capitalised stakers in the network there is no reason to believe that the debt will not continue to be burned even if the SNX price continues to fall.

There is some good news though, the recent volatility has led to a significant increase in trading volumes, which means even ignoring inflation, if SNX falls below $1 and exchange volume remains constant, staking yields from sUSD fees generated by the protocol will be well over 20% APY. This should help provide confidence for the stakers who remain and continue to pay down debt as these fees can be put directly to servicing debt each week. The growth has been so profound that less than a week ago I predicted on twitter that Synthetix would flip BTC on daily fees generated, as of a few days ago that came to pass.

This is now out of date!
This is now out of date!

The other aspect of the project that continues to inspire confidence and honestly gets way too little awareness outside the community is that Synthetix is one of the few protocols that has fully decentralised governance yet is able to maintain a rapid pace of iteration and experimentation. This is simply not even close to being priced in by the market. But as things slow down it will become increasingly clear that the investment in community governance made by Synthetix has created incredible value. This will only accelerate as V3GM launches and other protocols begin to adopt the Synthetix governance framework.

As the dust settles over the next few months, it will become clear which projects have employed good governance to manage risk and which were picking up pennies in front of steamrollers. Personally, I have made my decision as to how that will play out.

While it is impossible to have certainty in this environment, one can still maintain conviction. Without conviction, you are dead in the water in crypto. Times like these will test even those of us with the highest conviction, it is worth remembering that it is ok to have doubts and you should always question your assumptions. That is how we move the space forward. 

I would like to thank the Synthetix community, Spartan Council members and the core contributors for the dedication, engagement and perseverance they have demonstrated during these challenging times. WMMI.

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