IntroductionHow Synthetix worksTeam and GovernanceValue accrualValuationHow can Synthetix achieve desired growth?ChallengesConclusion
Thursday, 6 May, 2021
The Digital Investor
Synthetix – a platform to issue and trade synthetic assets
This digital investor explores the Synthetix protocol, its upcoming changes, and how it stacks up against other DeFi protocols in terms of valuation. The article dives into the mechanics of the protocol to understand its challenges and how the protocol can tackle them.
Synthetix is a decentralised platform on Ethereum for issuing and trading synthetic assets or synths that track the value of real-world assets. Born as stablecoin project Havven, Synthetix rebranded and expanded its scope in February 2019. Though Synthetix has its own trading platform, synths can be traded on other venues as well. Synthetix offers a broad range of synths - BTC, ETH, BNB, other digital assets, and their inverse tokens as well (1x short), commodities such as gold, a few equities, and so on. The synth offerings are expected to cover considerable width and depth of asset classes.
How Synthetix works
Synthetix allows holders to mint synths using SNX. While doing so, they have to maintain a 600% C-ratio (Collateral Ratio). When they mint synths, they incur debt. They must actively manage this debt, or they run the risk of liquidation (we describe how debt position changes later). When the C-ratio drops below the desired level, the wallet is flagged, and the synth issuer has one day to act before their position is liquidated. The issuer can either add more SNX as collateral or burn some synths to bring the C-ratio up. If a user mints USD 1000 worth sUSD by staking SNX worth USD 6000. Assuming that this is 10% of the total debt, they have to pay 10% debt back to unlock their collateral. We can now get into the mechanics of how the debt pool and debt positions work.
Debt positions and protocol subsidy
Imagine Alice and Bob, the only SNX stakers, mint 2500 sUSD each by staking SNX worth USD 15,000. Alice converts her sUSD to sETH when ETH is at USD 2500, and Bob keeps sUSD. At this time, both have similar debt and collateral ratio. As the debt of all the SNX stakers is ‘pooled’, the total debt of the system is USD 5,000. This debt is split on a pro-rata basis among the minters. Later, say ETH doubles to USD 5,000. The total debt of the system now increases to USD 7,500, and both Alice and Bob have a debt of USD 3,750 (as each of them minted 50% debt). Alice has gained USD 1,250 (USD 5,000 – USD 3,750) while Bob has lost USD 1,250 (USD 2,500 – USD 3,750). As Bob’s debt was denominated in sUSD, he has an additional burden of USD 1250. Assuming SNX is trading at the same price, his collateral ratio has fallen from 600% to 250%. Now he may provide USD 7,500 worth SNX as more collateral or burn 1250 sUSD to avoid getting liquidated.
Table 1 – Synthetix inflation schedule
Source - Synthetix
Team and Governance
What started as a business to build synthetic stablecoin using a balance sheet has now transformed into a protocol that monetises its balance sheet by facilitating minting and trading synths. The team has shown the ability to pivot when the market presented with an opportunity. Synthetix is also one of the few projects that have managed to decentralise themselves meaningfully as they grew.
When a user wants to stake SNX to earn inflationary rewards and fees from trading, they essentially have to mint some sUSD and contribute to the debt pool. Unlike most of the projects, SNX staking is not just rent-seeking. Users have to take some risks if they wish to earn rewards. The protocol works when users stake SNX and mint something against it, which becomes a part of the debt pool. There is no way to stake and not mint. SNX stakers accrue all the value generated from a trading fee of different synths. As the volume grows, the value accrued by SNX grows in proportion. The value accrual depends on the trading fee, which depends on liquidity, which depends on Synthetix’s balance sheet. SNX market capitalisation poses barriers to total synth liquidity. For example, at USD 1bn market capitalisation, SNX only allows USD 166 mn worth of Synth liquidity to ensure 600% collateralisation. Thus, the SNX token itself acted as a hindrance to value capture.
Adding ETH as collateral
In 2020 Synthetix allowed users to put ETH as collateral to mint sETH. ETH stakers’ debt is not pooled with SNX stakers’ positions. The collateral requirement is 150%, with a minting fee of 50bps and an interest rate of 5% APR.
Integration with Curve
Curve is arguably the best venue for trading pairs that track the same price (sBTC and WBTC, USDT and DAI, and so on). Due to its peculiar AMM function, unlike Uniswap, Curve does not have pools with assets that track different prices. Curve partnered with Synthetix to facilitate cross-asset swaps. Say trader wants to convert WBTC to DAI using Curve, it works as follows –
The second step occurs at ~0 slippage, as Synthetix works on a price oracle instead of an AMM curve like many DEXes. To see the impact Synthetix has on this, we tried to see the effect of selling 100 WBTC for DAI across three different DEXes – Sushiswap, Uniswap, and Curve. When we attempted this trade (May 1, 2021), the impact seen on Curve was the least. While bitcoin was trading around USD 56,700 on centralised exchanges, the offer on Curve for selling 100 WBTC was USD 55,928 versus USD 53,870 on Sushiswap and USD 50,910 on Uniswap. The price offered on Curve is only possible because of Synthetix. Since its launch in January 2021, Curve cross-asset swaps already suggest Curve cross-asset swaps already suggest link1that high volume swaps already go through synthetix. The biggest single trade was a USD 20mn swap so far.
Figure 2: Price impact of selling 100 BTC on different DEXes
Source: Synthetix Dashboard, SEBA Bank
Sources of trading fee
Apart from Curve, the other sources of the trading fee are Synthetix Exchange, Kwenta, dHedge, 1inch, etc. We expect Synthetix will expand its integrations further and onboard more traders to drive the volume.
Fig 3 – Breakdown of the total synth volume by trading venues
Source: Synthetix Dashboard, SEBA Bank
There is little to compare Synthetix with other protocols as it has a much broader scope and total addressable market compared to the rest of the decentralised exchanges.
Fig 4 – Market Cap to annualised revenue of major DeFi protocols
Source - The block research, SEBA Bank
It is not to say that Synthetix does justice to its current valuation multiple. However, we must look beyond numbers here. The fact is Synthetix is one of the primary building blocks of DeFi on Ethereum. If an investor thinks DeFi on Ethereum is here to stay, they can be optimistic that Synthetix will be used as a facilitator by other projects, just as Curve does, in ways we probably cannot imagine today. We think this is because DeFi will likely expand to other assets (outside of digital assets), and any asset with a constant price feed via an oracle can be issued and traded using Synthetix. The team spent a lot of time getting the debt management system right before going for user/trader onboarding. Synthetix has one of the most robust communities in DeFi, and we cannot underestimate the importance of a strong community.
Fig 5 – 7D average synth volume and trading fee
Source - SEBA Bank, SNX.tools
At the current market cap of USD 2.7 bn, if Synthetix has to have a Market cap / Protocol revenue of 10, assuming 30bps average fee per trade, synths have to do an annual volume worth USD 90 bn. Based on the 7D volume of Uniswap and Sushiswap, their annualised volumes are USD 452 bn and USD 120 bn, respectively. Given that Synthetix offers the best rates for high volume trades and the foundation has now been laid for such high-volume trades, the market is signalling that USD 90 bn volume for Synthetix is not too farfetched.
How can Synthetix achieve desired growth?
Synthetix launched on Optimistic Ethereum in Dec 2020. It will help in reducing gas costs and add more throughput, which will allow Synthetix to reduce oracle latency. Reduced oracle latency will allow deploying leveraged futures contracts on Synthetix exchange. The team estimates Synthetix will offer a minimum of 10x leverage on futures.
The first challenge is Synthetix uses its governance token to build its balance sheet. As long as the price is in an uptrend, everything works fine. However, a downtrend may cause damage to the protocol’s balance sheet and has the potential to be reflexive. As SNX price drops, debt positions have to be burnt, reducing the balance sheet, further damaging the sentiment. Synthetix has recently added ETH as collateral to address this issue.
Currently, Synthetix looks overvalued compared to other DeFi protocols. However, it is a crucial piece of infrastructure within the DeFi ecosystem. It offers a strong foundation for other protocols to build on top of. Many impending upgrades will improve the user experience of Synthetix. We think that puzzle pieces are aligning for Synthetix, and the project has the potential to justify and surpass expectations.
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