Synthetix Protocol
On-chain Exposure to Real World Assets
This post discusses synthetic assets and the mechanism design behind Synthetix, the most popular decentralized derivative exchange for minting and trading synths.
What is a synth?
Synthetics, or synths, are an asset class that allow a user to gain exposure to a real world asset without actually holding it. They’re not specific to the blockchain. These assets can be currencies, stocks, commodities, indices, or anything with a price feed.
Synths are a valuable tool simply because there are benefits to having exposure without holding the underlying asset. Those benefits vary. Perhaps a trader wants to quickly enter and exit a position, but transacting with the underlying asset is difficult. Or maybe they’d like to hedge their business risk, again avoiding those same difficult transactions. For example, industrial companies often want to hedge their exposure to the price of oil and other energy products. Instead of purchasing barrels of oil, transporting it, and storing it somewhere, they can do so by maintaining synthetic exposure to oil in their portfolio. Another use case is for speculators who want these assets in their portfolio, but have no desire to work with the underlying assets.
Why bring synths to the blockchain?
What I’ve described so far isn’t specific to Ethereum/blockchain based synths – a trader could access these benefits with traditional derivatives on a centralized exchange. In the case of synths on the blockchain, it’s that the user gets all the benefits of holding the underlying asset, plus the advantages of doing so on a decentralized platform.
The crypto ecosystem has the potential to replace parts, if not all, of the traditional financial system. Part of this vision is a future in which one’s entire portfolio – equities, crypto-assets, derivatives, real estate, and more – is stored on the blockchain. This will have a number of benefits including worldwide liquidity and transfers, frictionless movement between assets, trustless ownership, emergent forms of derivatives because of the composability and modularity of DeFi assets, and more.
To realize this vision, we need synths on the blockchain.
A simple example of an on-chain synth is the USD pegged stablecoin, Dai. By using Eth as collateral and minting Dai, or simply purchasing Dai from an exchange, a user receives a token that represents the US Dollar. The user doesn’t actually own any USD, but they gain exposure to it via an on-chain synthetic token. The benefits of Dai are many. It can be used as a better medium of exchange and unit of account than some volatile cryptoassets, so it has enabled Ethereum-based lending, borrowing, and other protocols and services. It can also be kept as part of a balanced portfolio that includes exposure to USD. Side note: you can gain significantly higher yield on your Dai than you would in a “high yield” savings account at a traditional bank. 0.5% APY is a joke, Marcus. The crypto equivalent to a high yield savings account, yearn.finance’s “earn” product, currently offers an order of magnitude greater APY – 8.5% on Dai, and even more on other stablecoins like USDC (12.5%) and USDT (10.2%).
What is Synthetix?
The Synthetix platform is an Ethereum-based derivatives exchange on which anyone can mint and trade synths including various fiat currencies, cryptoassets, commodities, and stocks. It also allows traders to short some of these assets, and its offerings are expanding as the protocol matures. Examples include synthetic BTC and ETH, inverse BTC and ETH, Euros, Dollars, Oil Futures, gold, silver, and many more. Check out the current available synths at synthetix.exchange.
At the time of writing, Synthetix is currently #8 in Total Value Locked on Defi Pulse. There’s approximately $2 Billion locked in the protocol, having grown about 10x over the past year. It has supported almost $4 Billion in historical trading volume through its <2 year history, collecting over $15 million in trading fees. It has become a staple in the DeFi ecosystem, and it’s usage is rapidly increasing.
So how does it work?
Mechanism Design
Synthetix requires users to over-collateralize minted synths with its native token, SNX. Over-collateralization means that users must post an amount of collateral greater than the value of the synth that they create. The ratio of collateral to position value is called the collateralization ratio, or C-ratio. For Synthetix, the C-ratio is 750% which is quite high, due to the volatility of SNX, some of the available synths, and debt pool risk which I’ll describe next. The Synthetix team’s road map includes a few items that will improve capital efficiency. In particular, they are working to include new forms of collateral like ether. Another synth protocol, Mirror, uses stablecoins so their capital efficiency is significantly better, at a C-ratio of 150%. But this comes with its own set of trade offs, and it’s more difficult for Mirror to bootstrap liquidity.
As an example, let’s say Alice wants synthetic exposure to gold on the Ethereum blockchain. She posts 750 SNX tokens, which are worth $10 each. Because the value of her collateral is $7500, she is able to mint 1000 sUSD (synthetic US Dollar). If Alice then wants exposure to gold, she can convert that sUSD directly to sXAU at the current exchange rate.
The question arises, against whom is Alice trading? If the value of her position increases, who pays her that increase in value when she exits her position? Synthetix addresses this by creating a shared debt pool across all stakers. When Alice mints her 1000 sUSD, she incurs a debt which is calculated as a percentage of the total debt pool. To exit her position, Alice must pay back her debt proportional to her ownership of the debt pool. If the total debt pool is currently worth 1000 sUSD, and she adds her own 1000 sUSD, her position is 50% of the pool. She can then convert and trade her synths at the going rate to gain exposure to the assets of her choice. As the value of her synths increase, the size of the total debt pool increases – but her percentage ownership of the pool remains the same.
So Alice minted 1000 sUSD and converted it to sXAU (synthetic gold). She is responsible for 50% of the debt pool, because there was already 1000 sUSD in the pool when she minted hers. Let’s say gold doubles in price and Alice’s position is worth 2000 sUSD. The size of the total debt pool is now worth 3000 sUSD. Alice is still responsible for 50% of the pool, so she must pay back 1500 sUSD to exit her position. Her sXAU position is worth 2000 sUSD, so she makes a profit of $500. Great!
But what about the other traders in the pool? Let’s say Bob had also minted 1000 sUSD and was responsible for the other 50% of the debt pool. Bob had converted his synths to sTSLA (synthetic TSLA stock), which didn’t change in price at all (entertain me, please). Bob’s sTSLA is still worth 1000 sUSD, but the size of the debt pool had increased to 3000 sUSD because of Alice’s gold position. Now, Bob owes 1500 sUSD to the protocol, so he’s down $500. He’ll need to mint or purchase more sUSD on an exchange if he wants to exit his position.
Here is another illustration of these concepts from the Synthetix litepaper, which I recommend reading through.
While Bob’s TSLA exposure didn’t change in value at all, he lost money. How could this happen? Well, it turns out that each staker actually has their positions valued against other positions in the pool.
The result of this system is that stakers must take on debt pool risk – the risk that their debt increases due to exchange rate changes. While clearly a risk for stakers, this is an important feature of the Synthetix system and it’s necessary to create a counterparty against which positions are valued. It also means that a trader can convert their synths to other synths at the current exchange rate without the need for an explicit counterparty. Additionally, when the debt pool is small like in our examples above, the debt pool risk is high because the portfolio lacks diversification. As the portfolio grows and the platform offers a wide variety of uncorrelated assets, debt pool risk becomes more and more balanced. The risk taken by stakers approaches the risk of just owning the synth, which is really the end goal of any synth platform. Currently, the debt pool is long-skewed, so including a variety of long and short instruments will help balance this in the future.
SNX stakers are rewarded for taking this debt pool risk. First, whenever someone exchanges one synth to another, trading fees are collected by the protocol and disbursed to SNX stakers proportionally. Additionally, stakers receive direct staking rewards based on synthetix’s inflationary monetary policy which distributes SNX tokens to SNX stakers weekly.
Stakers vs. Traders
I’ve thrown around the terms “staker” and “trader” pretty loosely here. But there’s an important distiction. Stakers are the ones who are taking on debt pool risk, because they’re the ones who have minted synths and own part of the protocol debt.
The role of a trader is different. A trader doesn’t actually mint any synths, but they can purchase sUSD on an exchange and convert their sUSD to any other synth on the Synthetix platform. A trader does not take any debt pool risk, and they can swap and sell their synths at the going exchange rates. They gain synthetic exposure to real world assets without any distortion in returns from the debt pool.
Feedback Loops
Debt pool risk is higher when the platforms portfolio is small and undiversified. But the protocol can experience feedback loops that are beneficial for traders and stakers alike. As the protocol grows and the debt pool consists of more uncorrelated synths, traders are attracted to the platform because they can gain exposure to a wider variety of assets. This induces higher trading volume on the platform, resulting in higher trading fees collected by stakers. With higher trading fees comes greater demand for SNX, which drives up the price of SNX and enables the minting of more synths. More synths means higher trading volume… you get the point. As this positive feedback loop iterates on itself, debt pool risk decreases because of the greater diversification across the portfolio.
However, the feedback loops can go in the negative direction as well. For the Synthetix protocol to be successful, it must spend as much time as possible in the positive loop. It’s on the right track so far.
Conclusion
Synthetix has become the most popular decentralized derivatives platform. It enables on-chain exposure to a variety of real world assets, a critical function in DeFi. It uses very clever mechanism design to achieve this functionality, rewarding stakers for taking on debt pool risk and enabling the synthetic exposure for which traders use the platform. As it stands, Synthetix has grown explosively over the past year, engaging in the positive feedback loop that can make the protocol successful.
More broadly, Synthetix is just cracking the surface of what is possible with synthetic assets. I’m looking forward to more derivatives, more asset classes, and entirely new forms of assets that are uniquely enabled by synths on the blockchain. I’m excited for the next few years as Synthetix and other projects continue to build this future.
Thanks to Austin King for reading drafts of this post.