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Synthetix: Synthetic asset issuance protocol

Matteo Leibowitz

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Experimentation in the decentralized synthetic asset issuance protocol design space continues to advance at a rapid pace. At present MakerDAO leads the pack with its Dai offering, but the emergence of Universal Market Access and Rainbow Network promise to add depth and competition to the synthetic market.

[related id=1]Synthetix is the latest synthetic asset platform to gain attention within the decentralized finance ecosystem. Structured as a multi-tier issuance platform, collateral type, and exchange, Synthetix permits any user to mint synthetic assets, from cryptocurrencies to fiat currencies to derivatives. Similarly to the automated market model employed by Uniswap, synthetics can be seamlessly swapped through the Synthetix Exchange platform without a counterparty.

Despite its increasing popularity, Synthetix has some rather glaring weaknesses in its design, which, if not addressed in the near term, will likely hamper its chances at developing into a long term sustainable venue for synthetic issuance and trading.

Team

Synthetix was born out of Haven. Initially structured as a stablecoin, the team soon realized that the synthetic issuance model could be extended far beyond a stablecoin product. MakerDAO has similar plans on its roadmap, with the CDP structure used in today’s protocol capable of being repurposed to mint any asset with a robust price oracle. 

Synthetix, then operating under the Haven brand, raised a total of $30 million across private and public sales in January and February 2018. Over two-thirds of the 100 million SNX created in the token generation event have vested.

Traction

On the surface, Synthetix has seen impressive growth to date.

The ratio of total locked SNX versus total outstanding SNX supply is 79.28%, indicating active utilization, rather than speculation, among token holders. The fee pool currently contains $9,663 worth of XDR to be claimed, having peaked at $16,529 on May 26. The system’s collateralization ratio sits at an astonishing 813.87%.

Popular DeFi tracking tool, DeFi pulse, ranks Synthetix third based on locked USD value behind relative veterans, Compound and MakerDAO.

Issuance process

The minting process functions as follows:

1. Alice buys SNX, the Synthetix native asset.

2. Alice deposits SNX into the Mintr platform.

3. Alice must maintain a 500% collateralization ratio between the value of her SNX tokens and the synthetic asset that she wishes to mint. 

4. If Alice's collateral is worth $500, she can mint up to 100 Synthetic USD tokens, which trade under the sUSD ticker. By minting sUSD, Alice is effectively taking on debt and going short sUSD.

5. Alice can use these sUSD to purchase another synthetic asset, such as sBTC through the Synthetix Exchange platform.

6. Rather than matching with a counterparty, sUSD is converted into sBTC based on the current exchange rate and duly burnt. The value of circulating synthetic assets remains the same after the conversion.

7. In order for Alice to reclaim her SNX collateral she must pay back her initial sUSD loan. These sUSD are removed from the system via a burn.

8. If the value of Alice’s collateral falls versus the synthetic that she initially minted – sUSD – she can purchase additional sUSD on secondary markets and use that to claim back her initial SNX tokens. sUSD currently trades on KuCoin, Bittrex, and Uniswap.

Incentives

The stability of the Synthetix economy is held together by a series of incentives. The ultimate objective for any synthetic issuance platform is to ensure that the value of collateral is consistently equal to or greater than the value of circulating synthetic assets. If the value of collateral falls below the value of circulating synthetic assets, these synthetics will trade at a discount to the instrument they are tracking as their full value cannot be redeemed for collateral. As a result, they no longer provide utility to those wishing for synthetic exposure.

Users depositing SNX as collateral and minting tokens are rewarded with 0.3% of all trading volume taking place on the Synthetix exchange on a pro rata basis depending on the percentage of outstanding synthetics they have minted. Upon receipt, these fees are automatically converted into the Synthetic Drawing Rights (XRD) token, a reserve asset consisting of a basket of several synthetic currencies. Fees are distributed on a weekly basis and can be claimed for up to six weeks. Unclaimed fees roll into the following fee pool. 

Reward distribution adjusts dynamically depending on the collateral ratio maintained:


No fee reduction is applied in the event that a user adjusts their collateral ratio above 5:1 before rewards are claimed.

Synthetic asset issuers solely looking to collect fees rather than going net long/short can hedge their exposure into a market neutral position. For example, if Alice mints sUSD and buys ETH, she is short sUSD – she wants the value of sUSD to decline, or, put differently, the price of ETH to appreciate, so that she can pay back her debt at a discount. However, she can neutralize this short exposure by shorting ETH, either on the Synthetix exchange itself through the inverse ETH product (iETH) or by borrowing ETH and selling it for USD via a secondary lending platform like Compound or dYdX.   

It is these rewards, or dividends, that drive SNX's value and permit it to collateralize the system. A reflexive cycle, the higher the value of SNX, the more synthetics can be issued. The more synthetics issued, the more trading volume. The more trading volume, the more SNX value appreciates.  

This reflexive relationship flow is bi-directional. If trading volume on Synthetix drops then so should the value of SNX. In an efficient market, this leads to a cascading effect, with the collateralization ratio of outstanding assets in the Synthetix ecosystem falling.

In order to further incentivize the issuance of synthetic assets, the protocol employs an aggressive issuance schedule, with newly issued SNX deposited on a pro rata basis to those with SNX staked as collateral on the platform.


In order to ensure that these inflationary rewards are not market sold on receipt, SNX earned through staking will not be transferrable within the first year of being issued.

Liquidation, or lack of

Synthetix chooses to employ a ‘carrot’ incentive system rather than the hybrid ‘carrot’ and ‘stick’ model used by competing synthetic asset platforms like MakerDAO and UMA. There is no liquidation process and/or penalty when collateral falls below a certain threshold – instead, synthetic issuers are supposed to be motivated to maintain their margin requirements through the cost of missing out on platform trading fees.

Without a liquidation process, and with a highly illiquid token as collateral, the system is uniquely exposed to scenarios where the price of SNX collapses and the value of outstanding debt exceeds that of collateral. If SNX issuers have already sold their sUSD for some alternative crypto asset, like ETH, via Uniswap or Bittrex, then they have no incentive to re-collateralize the system.

Consider the following scenario:

1. Alice locks 1,000 SNX, worth $500, and mints $100 worth of sUSD.

2. Alice then uses sUSD to buy $100 of ETH on Uniswap.

3. The price of SNX falls by 80% — Alice’s SNX collateral is now worth just $100.

4. In order to reclaim her $100 of SNX collateral, Alice must pay back $100 worth of sUSD.

In the above example, Alice is left with two choices. She can either hold on to her $100 ETH or she can sell her $100 ETH in order to claim back $100 worth of SNX. This is somewhat equivalent to the 'free option' problem present in state channels. Alice will opt to hold on to her $100 of ETH due to the relative liquidity of ETH versus that of SNX, meaning that the system will remain below its target collateralization ratio. In the event that the price of SNX recovers and is now worth considerably more than $100 worth of ETH, Alice can pay back her debt and reclaim her collateral. Of course, by failing to top up her collateral, Alice is losing out on trading fee revenues, but it is difficult to accurately predict how much these will be worth and under the assumption that the system as a whole is undercollateralized it seems likely that there will be little appetite for trading in the first place.  

Because exchange fees are paid out on a weekly basis, can be claimed up to every six weeks, and incur no penalties under the condition that the collateralization ratio is maintained at the time of claiming fees, the system is incentive incompatible. The system could viably be severely undercollateralized for weeks at a time, with issuers simply topping up their collateral on a periodic basis.     

Without a liquidation process, it is rather difficult to understand what role SNX plays within the system. MakerDAO employs an 'emergency shutdown' feature, whereby, in the scenario where the system falls below a certain collateralization ratio, all collateral is liquidated and those holding Dai receive the equivalent of $1 in ETH. Synthetix, by contrast, does not have those same redemption guarantees: only those with SNX locked will ever be able to redeem their synthetics. 

The introduction of both a preliminary liquidation process and an 'emergency settlement' feature would drastically strengthen the Synthetix model. With a liquidation process, third parties could burn sUSD in return for SNX at a discount in circumstances where the collateralization ratio falls below a certain threshold. Alice would be incentivized to ensure that her collateralization ratio is above the required threshold as the value she has to lose in collateral will always be greater than the value of her debt. In a black swan event where the value of SNX collapses, an 'emergency settlement' process would ensure that holders of synthetics can be made whole. 

SNX

Using SNX as collateral is a suboptimal design choice, although the Synthetix team did recently announce that they will be allowing SNX holders to stake up to 200% of their position in ETH. 

Using SNX as collateral contains three risks.

First, SNX markets are highly illiquid and subject to large degrees of price slippage. The Uniswap SNX/ETH pair is currently the most liquid venue for SNX traders. Taking ETH price at $245.00, there is currently over $575,000 in the SNX liquidity pool. The constant product structure produces the following table:

Even with a robust liquidation system, thin SNX market liquidity suggests that recouping value in the case of undercollateralization would be difficult. A 1,000,000 SNX market sell on Uniswap, 1% of total supply, would be enough to wipe 6o% off the network value and immediately lead to undercollateralization of the Synthetix system: it is likely that a far smaller order could do equivalent damage on standard order book exchanges. Thin market liquidity can go both ways. As illustrated by the recent CLAM debacle on Poloniex, SNX price can be artificially manipulated, used to mint a large volume of sUSD, which can then be exchanged for a more liquid coin like ETH. Meanwhile, when accounting for real collateral value, these sUSD should actually trade at a heavy discount to the dollar. 

The second deficiency of using the illiquid SNX as collateral is that collateral requirements must be set at unprecedented levels. MakerDAO uses a 150% collateralization ratio, which has perhaps proven to be over-conservative: by early February, the median collateralization of CDPs at time of liquidation was 149.5%. A 500% collateralization ratio comes with significant opportunity cost in the context of high lending rates being offered across lending protocols as well as inventory risk: it remains questionable as to whether the value of exchange fees can outperform Dai's risk-free rate, which currently sits at 7.86%.

The third shortcoming in using SNX as collateral is that the value of synthetics issued and the system’s ability to scale is inherently inhibited by SNX market cap. With a ~$30 million network value, the system can currently handle a maximum $6 million of synthetic issuance. As discussed, there is a reflexive relationship between SNX’s fundamental value and synthetic trading volume: in order for SNX to be valuable and continue to accrue value there has to be a continuously growing trading volume. This is difficult to achieve in such a capital inefficient system. 

Oracles

The Synthetix oracle design has further cause for concern. While the proprietary Synthetix Exchange will honour exchange rates at par there is no mechanism to keep synthetic assets trading at their target pegs on secondary markets. At present sUSD is trading at $0.97 vs. Dai on Uniswap, having traded as low as $0.89 last week.

MakerDAO leverages interest rates to effect CDP holder behaviour: in instances where Dai is trading below its target peg interest rates are hiked, with the increased cost of debt incentivizing the destruction of Dai and the contraction of outstanding supply. Conversely, when Dai is trading below $1, interest rates decline: cheaper debt encourages the creation of new Dai, the increase of outstanding supply, and the depreciation of Dai price. Without these interest rate mechanisms, the Synthetix system has no way to return supply and demand for synthetic assets to their equilibrium. Considering the various risks associated with the protocol’s design, one would imagine that synthetics issued via Synthetix will trade at discounts in perpetuity.

Maintaining resilient price oracles is a must for any synthetic issuance platform – the system must be permanently aware of the value of both the issued assets and the supporting collateral. At present the Synthetix team controls all oracles, with a plan to migrate to a Chainlink product in the near future. The SNX price oracle seemingly does not account for liquidity, instead taking the last traded price on Uniswap. As illustrated by the previous table, this is problematic when considering the price slippage associated with sizable orders.

The future of Synthetix

At this time the allure of Synthetix is clear: the various platforms are well designed and, relative to many Decentralized Finance products, easy to use. SNX is one of the few tokens on the market with an explicit yield tied to the growth of the core product and the cryptocurrency ecosystem is beginning to understand the enormous potential of censorship resistant synthetic products. 

However, the decision to both avoid incorporating a liquidation process and to create a proprietary token to use as collateral is suboptimal. The former – the non-existence of a liquidation process – is especially confounding: the latter is likely the result of needing to placate ICO investors.

If Synthetix is to succeed in the coming years, the integration of a liquidation process, more liquid collateral types, and some kind of monetary policy tools are a must. This may prove to be unpalatable to existing SNX holders, who will be exposed to liquidation risk, but without these redemption guarantees demand for synthetic products, and trading volume on the Synthetix Exchange, will likely flounder.