Introduction

Traditional financial services are rooted in the usage of centralized intermediaries (banks, custodians, clearinghouses, exchanges, money market, lending) that offer these services to their clients. 

Their “rent-seeking” profitability mechanism creates a long-term fundamental misalignment between their incentives and the incentives of their clients. In addition, their centralized nature makes them more easily corruptible, and more prone to security attacks. 

As with the general trends from 1) products to services; and 2) closed source to open source, a new category of open source services is being created, for the financial services space.  

Also known as Decentralized Finance (DeFi), these open source financial services have been largely created as Layer 2 protocols on top of Ethereum, which offers a solid decentralization basis. 

Over the last three years, Decentralized Finance (DeFi) has emerged as an alternative to traditional financial services. Platforms such as MakerDAO, Compound, DyDx, 0x, Kyber and Synthetix have created open-source, decentralized services for lending, price stability, exchanging crypto assets, margin trading, shorting, and derivatives.

Growth of DeFi and Synthetix

According to open-source DeFi tracker DeFi Pulse, there is over $653M worth of digital assets locked in DeFi contracts, most of the growth taking place over the last 2 years. 

Synthetix is a high-growth project in an already rapidly growing category. Within the last 6 months, Synthetix has become the leader in the DeFi derivatives platform space. 

  • Cumulative trading fees increased from $3,000 to ~$3M
  • The market capitalization of all synths exceeds $24M
  • Daily transaction volume > $5-$15M
  • sETH has become the largest Uniswap pool, which also offers an example of composability of incentives across Layer 2 solutions (5% of weekly SNX staking rewards are offered as an incentive to increase liquidity of sETH pool). The SNX pool is also notable, being the 5th largest one.

What has caused the recent high growth of the project?

  1. The market need for a decentralized derivatives platform. Synthetix offers several benefits over existing status quo solutions, described in the Use Cases section. 
  1. Addition of staking rewards through inflation at a 75% rate for Year 1. More staking → More synths available → Larger trading volumes become possible. 

Use Cases

  1. Ability to trade price exposure — long and short — for a wide variety of assets, commodities, indexes. 

    This use case is similar to that of CFDs, through which platforms such as eToro, offer price exposure to various assets. However, the mechanism to achieve this differs substantially. Compared to existing status quo solutions, Synthetix offers unique differentiators and value propositions: 
    • “Almost infinite” liquidity and instant execution. Since there are no counter-parties and no order book, the execution will be instant, and volume will be bound by the number of Synths already in existence ($24M as of 12/19);
    • Ability to create Synths for everything that has a price feed; and
    • Decentralization.

Below is a summary of the benefits and properties derived from Synthetix’s decentralized nature. 

Anyone can trade Synths. All that is needed is an Ethereum wallet. This makes the solution “permissionless” 
Anyone can become a staker. Unlike a centralized derivatives platform, with Synthetix, anyone can purchase the SNX token and stake it. 
Governance. Protocol development is still centralized, but long term, it is aiming for governance decentralization. Centralized governance at the beginning of a protocol development can lead to faster iteration and development, while offering “safety valves” through which the system can be halted in extreme cases (such an example took place in June 2019)
No centralized custody of assets. Instead, assets enter into custody through the decentralized Ethereum smart contracts and wallets
Censorship resistant. The protocol doesn’t allow censorship of transactions (except for system halting). Censorship resistance is largely inherited from the underlying Ethereum platform
Composability. As we’ve seen with the sETH Uniswap pool integration, the Ethereum ecosystem and protocol design make it easy to connect Synthetix to other DeFi solutions. This is also generally the case with open-source, modular software development. 
Transparency. The protocol mechanics, code and transactions are all publicly available. 
Security. Being built on top of Ethereum, Synthetix benefits from the security properties of the underlying infrastructure. 
  1. Generate fees and staking rewards.
  • There is a 0.5% fee on every trade. The accumulated amount is awarded to SNX stakers weekly. 
  • In addition, new SNX is being minted every week at a decreasing rate targeting 75% inflation by March 2020, and a terminal inflation rate of 2.5% after 2023. (see inflation schedule below)

How it works

  1. Stakers stake their SNX tokens. Through the staking process, the stakers are essentially buying a percentage of the debt pool, as opposed to a fixed USD / sUSD amount. When unstaking, they will need to burn sUSD corresponding to their share of the debt pool.  
    • The amount of debt to be paid back is variable since it’s a percentage of all debt created against the SNX being staked.
    • Stakers can enter positions in order to try to outperform the debt pool average performance, in order to decrease their debt. 
    • Since the SNX debt pool is correlated with the general crypto market, stakers might want to hedge their exposure to the debt pool, which has a long bias at the moment. Show open interest table at the bottom of https://dashboard.synthetix.io/ 
  1. Investors (non-stakers) can enter the Synthetix system by first purchasing sUSD or sETH on Uniswap, Kyber, or other exchanges (most commonly from ETH). Afterwards, they can use synthetix exchange to trade their sUSD or sETH into any other Synths

What keeps the Synthetix platform stable?

Synthetix has successfully combined internal stability mechanisms with external ones, in aiming to keep the sUSD and sETH pegs stable (1 USD and 1 ETH respectively). There are three main mechanisms that contribute to this: 

  1. If peg < 1, SNX can be staked and ‘more’ sUSD will be generated, compared to par 
  1. eETH liquidity pool on uniswap. Every week, 5% of SNX staking rewards are given to sETH liquidity pool members. 
  1. SNX arbitrage contract. If peg < 1, the ETH that is sent to the contract is exchanged into SNX at 1:1 ETH-sETH value, through the Uniswap pool (footnote: https://blog.synthetix.io/our-new-seth-snx-arb-contract-is-now-live/)

Risks & Problems

It is important to highlight some of the existing risks and potential problems with Synthetix. 

  1. Underlying ETH platform speed can be a limiting factor to reaching volumes 10-100x larger
  1. Wide variety of uncorrelated instruments (commodities, fixed income, equities, indexes), long and short, would help balance the debt pool risk, which is currently long-skewed.
  1. Oracles. Since Synths prices are being fed through oracles, their reliability and security are essential for the system.

    Synthetix has suffered an oracle attack in June 2019, through its KRW price feed. The Synthetix team was able to disable transfers within the system and reach an agreement with the attacker, resulting in no funds lost. The specific vulnerability has been addressed, but overall oracle risk still remains important.
  1. What will be the effect of the reduced staking reward inflation rate (75% to 25% in March 2020) on the SNX staking rate, the price of SNX, and implicitly the market capitalization of Synths?

    Without proper growth of the trading volumes (which is currently the case), stakers might find it less appealing to stake SNX at a much lower rate. 

    Two protocol improvements — SIP 23 and 24 — published on December 6th — change the inflation schedule to a gradual weekly decrease, and add a terminal inflation of 2.5% starting in 2023. This would normally diminish the risks around the March 2020 date, when a 75% to 25% change was expected.
  1. Collateral quality. SNX is likely not as good of a collateral than other crypto assets, such as ETH. However, the high over-collateralization requirements (750%) aim to mitigate this risk. In addition, the Synthetix team has talked about adding ETH as collateral to the system in the future. While adding ETH would help increase the debt pool, it might also reduce the demand for SNX — since there’s an alternative to creating synths without having to stake SNX)
  1. Positive-positive and negative-negative feedback loops
  • Higher trading volume → Higher trading fees → Higher demand for SNX → Higher SNX price → more Synths minted → higher trading volume
  • SNX price drops → SNX stakers fall below 750% collateralization ratio.  
    • → Burn Synths to re-establish 750% ration → Synths market cap decreases → Trading fees decrease → Smaller incentive to stake (price decline continues)
    • → Buy SNX in the market → SNX price increases
  1. The sUSD and sETH pegging and volume are important to maintaining strong, liquid connection points to the outside-Synthetix world. Increased liquidity in these connection points and the future addition of others, will help maintain system stability.

The Opportunity Ahead of Synthetix

Synthetix has become the DeFi leader in the decentralized derivatives platform vertical in just a few months post-launch, highlighting the demand for DeFi derivatives. 

In traditional finance, derivatives market size is estimated to be roughly 10x the world GDP Assuming DeFi market size is roughly the size of the assets being staked in it ($650M), the market size for DeFi derivatives at the moment would be in the order of billions — roughly $6.5B. 

Given the recent high growth and a large addressable market, Synthetix seems well-positioned to dominate the DeFi derivatives space. 

Disclosure: This report is not investment advice, it is strictly informational. Do not trade or invest in any tokens, companies or entities based solely upon this information. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on topics discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision. Albaron Ventures abides by a No Trade Policy for the assets listed in this report for 3 days following its public release. At the time of publication, Albaron Ventures owns SNX tokens.