Alex Fatuliaj
February 10, 2024
Economy Spotlight

Economy Spotlight: Synthetix

Our Thoughts

Since Synthetix is a decentralised synthetics protocol, the purpose of the $SNX token is obvious - sovereignty and initial protocol bootstrapping.

Firstly, using another currency as collateral in your protocol bears far too much counter-party risk. Whether it is stablecoins with back doors, Bitcoin with high fees and slow confirmation, or another crypto with its own monetary and fiscal policies, no other currency is suitable than the project’s own to act as collateral for the decentralised exchange.

Secondly, the protocol needed to incentivise the over-collateralisation from the beginning in order to attract the usage it has now, and doing so with an existing currency would have been too expensive; rewarding liquidity providers in the beginning required its own token.

The problem with $SNX is that liquidity providers must keep their c-ratio by burning or minting more Synths so that other users can use the protocol without risk of under-collateralisation. This means that in times when the market turns bearish, and $SNX starts to decrease in price, it will be the liquidity providers that are affected most because they would need to burn their Synths to get back to the right c-ratio. This creates inherent incentive misalignment, whereby the protocol incentivises liquidity during good markets, but disincentivises it during bad markets.

However, the liquidity providers know this risk, and it is unavoidable (or at least thus far it hasn’t been worked out how to avoid it) when creating truly decentralised over-collateral. Giving the ownership of the c-ratio to the liquidity providers decentralises the protocol, which some people will see as a benefit.

The token is necessary, and the decentralised collateral / decentralised B-Book model is a great reason to create a token, but the value accrual has a causal relationship with the usage of the protocol with no additional value injections except speculation, which, as mentioned above, in times of poorer protocol performance will directly lead to poor price performance.

Overall rating: Amber

Protocol Explanation

Synthetix V2 - current

Synthetix Protocol is a backend suite of smart contracts with no direct UI for users - it was created as infrastructure to support DeFi applications with liquidity and synthetic assets. This protocol utilises the liquidity from its own liquidity pool, where users can stake $SNX (which mints them a synthetic asset (Synth)* based on the pool they deposited $SNX to), to provide collateral for the synthetic assets used by dApps. For these stakers, Synthetix does have an interface.

There are two primary synthetic assets: spot, and perpetual futures. Spot Synths track the value of real-world assets, currencies, and commodities, whilst Perps is a decentralised perpetual futures exchange where the $SNX liquidity acts as the counterparty to traders (a decentralised B-Book).

*The reason Synths are minted to stakers is because the liquidity pool needs to be within a specific collateral ratio (c-ratio). It is up to each staker to burn or mint more Synths to get the value of their position back within their given c-ratio, otherwise they cannot claim their rewards.

For example, if $SNX drops in value causing the pool to become under-collateralised, stakers would need to burn Synths (but not unstake $SNX) so that the current ratio between $SNX in the pool and Synths goes back to the required ratio. This means that when people using synthetics go back to claim their $SNX by burning their Synths, there is enough $SNX left to claim after the liquidity providers claim their share by burning their Synths (which now decreased because they had to burn some Synths before (without claiming $SNX) to return to the right c-ratio).

This incentivises the collateralisation of the pool to be within its target.

On the dApp level, Synths (e.g. sETH) can be minted when $SNX, $ETH, $LUSD, and others, get staked as collateral (above I only mentioned $SNX re collateral, but I’m referring to all of these 3 assets). To get the collateral back, dApp users must pay back the debt by burning the synths.

Synthetix V3

Although currently in alpha stage, Synthetix is implementing the ability for people to borrow snxUSD stablecoins, horizontally integrating to expand their DeFi offering.

Their claimed competitive advantage with this is that liquidity pool managers can configure the pools to extend credit to the derivatives market, which is what Synthetix’ core business focuses on. This could create a whole new era of leveraged futures trading.

Economy Flow

$SNX is used as the collateral and to some degree insurance in this decentralised synthetic ecosystem, whereby the synthetic assets that users mint by depositing real assets are also further backed by the $SNX collateral.

It’s a very simple economy, but a necessary one for decentralisation.

1. User 1 - for spot synths - mints synthetic assets.

2. User 2 - for perps - trades against Synthetix.

3. Stakers deposit $SNX (et al.) to act as extra collateral and get Synths in return.

4. Stakers ensure their c-ratio is intact by burning or minting Synths.

5. Users pay fees and stakers get rewarded.

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