Synthetix : Synthetic Instruments in DeFi
On the emergence of IoU instruments that track price.
Note : I personally have no relation to the team or exposure to Synthetix. This is not investment advice and should not be treated as such. My massive synthetix bag as of writing this is worth $1.50 which was purchased with the intent of taking the Mintr app for a test run.
Synthetic assets allow an individual to gain exposure to an asset without ownership of the underlying asset itself. They can be useful in cases where individuals wish to be able to trade or hedge against price movement of an instrument they cannot quickly get their hands on due to compliance challenges. The DeFi ecosystem's response to the matter has been quite simple. If you have oracles that can feed price, sufficient collateral to cover a position within a price band and pooled liquidity - you could likely issue commodities, currencies and cryptocurrencies without requiring a bank in any of the processes. This article explores Synthetix, the project's incentive mechanisms and growth metrics over the past year.
Synthetic Instruments - The Basics
Synthetic instruments in DeFi today require the following components
A sufficiently decentralised price feed oracle to feed data to the system
Collateral offered in a secondary instrument (e.g., SNX tokens) to back the issuance of a synthetic asset
Price bands within which trade of the asset can occur. (because if the asset is trading beyond a price band, collateral engaged in backing the synthetic asset may not cover the price differential)
For a very dumbed down example - consider a scenario where 1 Bitcoin is collateral and priced at $1000. Ethereum is trading at $100 and the system has a collateral requirement of 500% (i.e. - 5 times the exposure to the asset you seek to have). You could have exposure to ~$200 worth of Ethereum (or 2 ETH) while staking Bitcoin as collateral. In said example, on tying up collateral, you receive 2 synthetic ETH with a liquid market for buying and selling.
For this example, we assume Bitcoin's price is somewhat stable because Satoshi himself is market-making with his giant stash of bitcoins.
In the above example,
If ETH's price crashes to ~75, your "debt" reduces to $150 (from $200). You can receive the entirety of your 1 Bitcoin by repaying a mere $150 (vs $200). In this case, you gain $50 when you sell the synthetic ETH you create when you tie up the Bitcoin as collateral
If ETH's price surged to $150 each, your debt increases to $300 (from $300). You have the option to receive the whole bitcoin and two sETH if you repay $300. In this instance, you lose collateral held ($100 worth of Bitcoin) as your debt is higher.
There is always the caveat that ETH crashes or surges to a point where collateral requirements cannot be met. In these cases, settlements occur at a lower or higher bandwidth.
A look at Synthetix
Synthetix brings the above model to currencies, digital assets (long-short positions) and commodities (gold). Their collateral ratio is 750%. Which means for every $1 sUSD (synthetix USD), there is $7.5 worth of synthetix tied up in a smart contract.* There are two primary participants in the synthetix ecosystem and how they interact is at the crux of what has been driving value to their ecosystem.
Stakers - These are individuals that tie up their SNX (Synthetix token ticker) in exchange for rewards from the ecosystem. Synthetix stakers are rewarded from Synthetix exchange whenever a trade occurs. According to their litepaper, the fee ranges from 0.3% to 1%. The system has given out rewards worth $3.1 million to stakers so far on exchange volume of ~$720 million. Also, the currency has an in-built inflation system that acts similar to a bank deposit. One way to think of stakers is as individuals that are net-long on the underlying instrument (SNX) while betting against the dollar. If the dollar appreciates against the underlying asset (ie - SNX price trends downwards) an increase in collateral would be required.
The important fact to note here is that tokens received as rewards are vested over the course of a year, removing immediate sell pressure from the market and keeping stakers aligned on the longer run with the project.
Traders - These are individuals or users that are merely looking to gain exposure to instruments like Btc, foreign currencies or commodities without engaging with a centralised exchange ecosystem. While arguments can be made against how many of them may be simply trying to evade compliance requirements - the fact remains that I could go from holding ETh to gold exposure (and vice versa) in a matter of minutes on a dex with synthetix.**
Stakers stand to benefit when SNX as an instrument appreciate. Traders stand to benefit when what they have traded against (eg: BTC, gold etc) appreciate in price. This means, if the price of SNX itself decreases, someone staking stands to lose as they will need to spend more to avoid liquidation of their holdings as SNX requires a collateral of 750%. Similarly, if SNX's price appreciates against a synthetic asset (like sETH), the individual stands to profit due to lower synthetix amount being required to repay the debt.
Hypothetical Example (again!)
1. Eth's price is at $100. You have $750 worth at SNX at $1 each
2. You make 1 ETH from the Mintr app, tying up $750 worth of SNX (750 SNX tokens).
3. Your debt in the system is worth $100. Assuming you took the sETH and sold it in the market for $100 when the price was still high, you have a profit of $20 when you buy 1 ETH at $80 from the market to repay the sETH and recoup your 750 SNX.
4. Assuming the price of ETH stays at $100, and SNX's price crashes to $0.5 from $1, you will need to tie up an additional 750 SNX to avoid having your SNX locked in their smart contract. This is the risk of synthetic currency issuance
In order to reward individuals for taking said risk, those staking are paid exchange fees and inflation induced rewards from time to time.
Edit : As of now, Mintr lets you make only sUSD.
To account for a balance in the network, Synthetix considers a "network debt" approach. It has been simplified in the following infographic in their litepaper
Synthetix does not require traders to engage with staking in any form. You can go from holding Eth to synthetic gold in 5 minutes using Uniswap and Exchange.synthetix.io at an almost 1:1 ratio. This means, as a trader, you will not be required to have 750% collateral requirement. It is only those that are staking (and thereby taking 'debt" in the form of sUSD) that have to handle the collateral requirement. The liquidation process does not currently occur on SNX (unlike MakerDAO). Instead, tokens are simply held in the contract until the c-ratio (collateral ratio) is back above 750%.
Synthetix In Numbers
Note : I have only used sUSD figures for these. Actual numbers are likely higher given the number of assets (sBTC, sDeFI etc) on Synthetix. There are a few data science teams doing contract analysis on those figures. When it is published, I'll have them added as a hyper link.
sUSD today has ~1/50th of the active user-base Tether has and 1/3rd of its closest competitor (MakerDAO) from a decentralisation pov. However, having ~700 users on a synthetic USD issuance platform is no small feat given how competitive the DeFi space is today and the number of large players that exist. At these numbers, SNX does meaningfully beat a more "traditional" incumbent like GUSD (Gemini exchange's DeFi project)
In terms of transactional volume, synthetix is still likely in its early stages. A fair valuation on basis of valuation and active user-base may not be applicable here given that the system is used as a synthetic asset issuance platform. Where synthetix did prove me wrong (so far) was on my assumption that a network can't be used for DeFi without the underlying asset itself having value from functions other than issuing a synthetic currency. That is, Ethereum had value in functions other than MakerDAOs before it was used for DAI. My assumption was that a new network cannot replicate that. So far, synthetix has proved me wrong on that front. The question that remains for me is how much can this scale without the price of synthetix itself ballooning massively.
Why Does Any Of This Matter
Synthetic instruments will lay the basis for the future of DeFi and its large-scale adoption. As it stands today, stable-tokens are one use-case that has found product market fit but in order to rival traditional banks (or unbank the banked) - the ecosystem will need to be able to produce considerably more sophisticated financial products. Those would involve foreign currencies, equity instruments, put/call options, futures and ideally, even insurance. Synthetic instruments are laying the foundations for increased complexity in the DeFi ecosystem today. My previous post exploring how a bank for the gig economy could accept deposits and receive interest on them. Introducing synthetic instruments to the product mix makes it possible to allow individuals to have exposure to a commodity like Gold or going long/short on an equity like Tesla. Can any of this rival with what traditional fintech offers? Likely not. But making that comparison is akin to comparing Netflix running on 256 kbps modems with HBO on cable networks in the early 2000s. We know how that story has panned out over the last 20 years.
Note : As of writing this, SNX is traded primarily on decentralised exchanges and liquidity for large-sums remain centralised with a handful of OTC desks. This does pose a risk if I am to analyse how "decentralised" the project is. That said - it is impressive that a project could bootstrap a network, avoid centralised exchanges and boot-strap the most liquid token on Uniswap. An interesting indication of the future of exchanges as adoption increases. We will explore what peer to contract transactions and crowd-sourced liquidity pools are soon'ish