Hello everyone, today we will talk about Synthetix.
"The mystery of 'synthesis'"
Synthetix positions itself as a decentralized liquidity supply protocol, with two key terms: decentralized and liquidity supply. Decentralization is easy to understand; we will elaborate on liquidity supply.
In the DeFi world, mainstream liquidity provision comes from exchanges, which can be centralized exchanges, such as the leading centralized exchange Binance, using an order book to match user trades; or decentralized exchanges like Uniswap, using AMM (Automated Market Maker) to provide liquidity for traders.
However, in providing liquidity, neither of these two methods is a perfect solution. For centralized exchanges, the listed assets are limited, and some long-tail assets cannot be traded if they are not listed; for DEX, although the liquidity of long-tail assets is relatively better, they also face the problem of trading slippage, as limited liquidity forces traders to trade at prices worse than expected, incurring higher costs.
Synthetix's goal is to solve the problem of no counterparty or slippage in trading.
It is realized through price oracles and synthetic assets, which we will discuss separately.
Synthetic assets (synthetic assets abbreviated as synths) are the essence of achieving almost unlimited liquidity in the entire mechanism.
In simple terms, synthetic assets are 'synthetic' assets that are pegged 1:1 in real-time to the price of real assets, usually marked with the prefix 's-' in the protocol. For instance, sBTC is a synthetic asset that realizes a real-time peg to the price of BTC through price oracles, and aside from its price being the same as BTC, it has no other correlation; holding sBTC does not mean holding BTC.
Why can synthetic assets achieve smooth trading and generate nearly infinite liquidity? Because all trading assets are 'synthetic', meaning a trader’s buying or selling does not rely on counterparties, there doesn't need to be someone on the other side trading with real money; the counterparty is the Synthetix protocol, which can theoretically 'synthesize' assets infinitely. In theory, if you hold sUSD, you can buy or sell sBTC or sETH at market prices in real-time, and it also supports futures trading.
Since 'synthesis' is needed, the price at which it is synthesized becomes very important, so oracles are a crucial element in this mechanism.
Simply put, a price oracle is a mechanism for obtaining the corresponding price of a product; it’s called 'oracle' but has no actual predictive ability. The oracle continuously quotes prices, allowing synthetic assets to be synthesized at market prices, providing unlimited liquidity for the protocol.
Competing with frontrunners.
Due to the time required for Ethereum to generate blocks, the prices on the oracles are not actually 'real-time', which brings arbitrage opportunities.
Let’s take an example to illustrate how this arbitrage occurs: you know the current price of BTC, but generating a new block on Ethereum takes 15 seconds. So due to the time lag, the current price oracle has not yet updated the latest price. This means you have about 10 seconds of prophetic ability, allowing you to buy early if you know the price is going up or sell if you know the price is going down. More importantly, this process does not involve prediction at all, so there is no risk for frontrunners.
Frontrunners gain risk-free profits but cause the price of synthetic assets to deviate from the actual market price, resulting in losses for the synthetic asset pool. Moreover, this is unfair to other traders on the trading platform; honest traders are at a disadvantage due to delayed price updates, and due to the price fluctuations before and after frontrunning, ordinary users face greater losses.
For the platform, maintaining user trust is essential for the project's long-term operation.
Can the issue of front-running be solved? The Synthetix protocol has been working hard to reduce the impact of frontrunners. There are mainly five ways; let’s take a look at them one by one.
1. Restrict everyone’s trading speed; the premise for frontrunning is paying more gas fees to miners, creating a queue-jumping effect. To prevent anyone from frontrunning, a cap is placed on everyone’s gas fees, making it impossible to trade quickly. However, this comes at a cost of poor user experience; if you pay less gas, everyone trades slowly.
2. Faster block speed, since there is a time lag in on-chain transactions, if it’s fast enough, there will be no arbitrage time. The main Ethereum chain is slow, while L2 is faster, so Synthetix has also deployed the protocol on the Optimism Layer 2 network to accelerate oracle price updates and leave no time for arbitrageurs.
3. Smoothing price fluctuations; if prices do not fluctuate significantly, there will be no arbitrage opportunities. Based on price oracles, a time-weighted average price is applied, meaning calculating the average price over a period to smooth price changes, reducing sudden price fluctuations and thus reducing arbitrage space.
4. Additional trading fees; if arbitrage occurs, you need to pay more, which might eliminate the hassle. The general logic is that when market volatility is high, dynamic fees are charged, and when market volatility decreases, dynamic trading fees revert to 0, effectively compressing arbitrage profits to 0.
5. Atomic trading, a feature of front-running trading is stepwise arbitrage, while atomic trading’s feature is either fully executed or not executed at all, with no stepwise arbitrage, using 'worse price execution', meaning using multiple oracles and then choosing the price that is least favorable to the trader, further compressing the arbitrage space.
Efforts to compress arbitrage space for frontrunners provide a fair trading environment for normal users, and with nearly unlimited liquidity in the protocol, such a perfect environment is not a trading paradise?
Heaven is far from it; what Synthetix really wants to tell you is: there is no free lunch in the world.
Outperforming the opponent is winning.
So what is the cost? The cost is that you must outperform the average in trading here.
Let's elaborate on that.
Synthetic assets are essentially borrowed; if the price of the underlying asset fluctuates significantly, the corresponding value of synthetic assets will also fluctuate violently. Once the value of the borrowed asset exceeds that of the collateral, it faces liquidation, and the entire protocol's credit bankruptcy will lead to a death spiral.
Therefore, it is very important to hedge against price volatility risks. Synthetix uses two methods to solve this: the first is over-collateralization, and the second is the debt pool.
First of all, the premise of providing lending without a credit system and being able to operate continuously is over-collateralization, ensuring there are enough assets to repay the loan. Synthetix has a very high over-collateralization ratio, which was initially 800%, meaning that one needs to collateralize 800 USD worth of SNX to borrow an equivalent synthetic asset of 100 USD. Currently, the protocol stipulates an over-collateralization ratio of 500%, which is still a very high ratio. It uses asset redundancy to combat high volatility. (The collateralization ratio is adjusted dynamically; you can refer to this https://dune.com/synthetix_community/parameters)
The debt pool is also one of the ways to share risk against the high volatility of digital currencies. When staking SNX (Synthetix's token) and minting sUSD, this sUSD is essentially a loan from the staker to the protocol.
And the debt is not calculated using absolute values but as proportions.
For example, there are two people A and B on the platform, both of whom minted 100 sUSD, making the total value of the debt pool 200 sUSD, with each person holding 50%.
When A exchanges sUSD for sBTC, and after a period of time, the price of BTC doubles, A’s synthetic asset value becomes 200 sUSD while B remains unchanged, holding 100 USD worth of assets, making the total value of the debt pool 300 USD. Since each person holds 50% of the total debt, A needs to repay 300 * 50% = 150 USD of debt, and B also needs to repay 150 USD of debt.
For stakers and borrowers, this means that as long as your trading ability is worse than others, you will have to repay more debt; the content of the trading is essentially the trading ability of the counterparty.
What are the benefits of this mechanism for Synthetix? My understanding is that it better diversifies risk; all stakers share the risk of asset volatility, which reduces the pressure on a single individual, making systemic risk less likely.
Under such a mechanism design, even if staking SNX can earn transaction fee income, I think about it and still dare not invest money. This is a zero-sum game, and every penny you earn is a loss for the counterparty. This mechanism design determines that this is a platform aimed at professional investors or investment institutions, and is more suitable as backend capabilities embedded behind complex transactions.
Regulatory whistleblowing forces a slowdown.
In fact, the Synthetix you see now is quite different from the Synthetix of two years ago. At that time, synthetic assets were far from just being able to synthesize crypto assets.
Stock indices, fiat currencies, and gold can all be tracked based on price. In his blog, the founder also detailed the considerations of designing synthetic assets that track stocks: considering trading hours, unlike the 24/7 trading of crypto assets, stock markets are closed during nights, weekends, and holidays, so trading of corresponding synthetic assets must also be paused during stock market closures. Considering traders' trading habits and quoting currencies, the FTSE index is usually quoted in pounds, while the Nikkei index is quoted in yen, but Synthetix tracks assets in USD; whether to force a USD quote in design, thereby eliminating the need for traders to consider foreign exchange fluctuations, is an unavoidable issue.
Although there are various small problems in product design, the combination of synthetic assets and oracles has already proven that trading real-world assets on-chain is technically feasible.
This gives the crypto world infinite imagination and liquidity, allowing any asset combination, trading 24/7, a huge decentralized derivatives trading market unfolding gradually.
But this huge blueprint has not yet fully unfolded before it closes again.
Due to regulatory pressure, commodity and foreign exchange-related assets can no longer be found in the current trading list of synthetic assets, with only two empty lists showing they once existed.
Starting from stablecoins, returning to the background.
At the starting point of Synthetix, its destination was not to become a prominent derivative. Initially, it was meant to be a stablecoin player.
Synthetix's predecessor was Havven, originally named Haven. In 2017, the crypto world experienced a bull market, with Bitcoin surging and creating waves, but the cost of trading amidst the giant waves was the risk of being flipped into the sea at any moment, necessitating supplies and trading to come to 'Haven'. Perhaps the founder, Kain Warwick, initially aimed to serve investors.
He once said in his blog that he really liked this saying: entrepreneurship is like jumping off a cliff while building a plane to avoid crashing.
However, starting a business in the crypto world is even more perilous, as there are no blueprints for the planes, and one must invent them.
From the 2017 ICO fundraising to the official renaming of Havven to Synthetix at the end of 2018, in just one year, Havven completed the stablecoin experiment.
Havven's stablecoin attempt can be understood as the on-chain asset tracking of the US dollar; since the anchoring of the US dollar has been successful, can other fiat currencies, precious metals, indices, and other cryptocurrencies also be anchored?
In the process of constant falling, whether pushed forward by existing experiences or echoing the market's ambitions, from the paper plane of stablecoins to the glider of derivatives, it is both opportunity and inevitability.
Stablecoins move to the left, anchoring more assets; after the door to synthetic derivatives is closed, this not yet fully assembled plane turns right.
To the right is smoother exchange and trading, becoming a 'liquidity supply protocol'.
Looking at it from the present, this seems like a smooth path to becoming a service provider behind the trading, offering professional services to institutional traders. ToB trading is far less lively than ToC trading, and the project is not as lively as the constant influx of hot topics.
But fortunately, the cliff he jumped from is deep enough, giving enough time for aircraft development while watching and testing.
We stand at the bottom of the cliff, waiting for the wind.
