Synthetix

A case for SNX

Overview

  1. Synthetix (SNX) is a decentralized protocol to bring financial derivatives to cryptocurrency. A derivative or synthetic asset is a financial contract detailing the terms between the parties. One common example is a derivative that allows the holder to purchase a specific asset at a specific date and price. Such contracts can typically be traded much more easily than the underlying asset. Traditionally derivatives are used especially for trading commodities that are harder to trade physically such as oil but are now also used in many other additional markets.
  2. The derivatives market is one of the largest financial markets worldwide and estimated to be as large as a quadrillion dollars. However, there is a debate that the figure may be greatly overestimated, or that only a fraction of that would be able to be withdrawn before becoming insolvent.
  3. Derivatives on Synthetix are novel as they eliminate individual counterparty risk. Instead, each SNX derivative asset or contract (Synth) is backed by the entire staked supply of SNX tokens. SNX is either unlocked back to or burned by stakers to maintain the target collateral level of their synthetic assets. Current asset prices are monitored by a decentralized system of oracles provided mostly by Chainlink.
  4. Synths are backed by severe over-collateralization ratios. This over-collateralization helps ensure the solvency of all Synth contracts. Each is over-capitalized at 750% of the native token SNX and can be adjusted as needed via the decentralized governance mechanisms. Additional cryptocurrencies may also be allowed as collateral in the future to further mitigate solvency risk.
  5. Synthetix currently supports fiat currencies, commodities, cryptocurrencies, inverse cryptocurrencies, and cryptocurrency indexes. These are tradeable on Synthetix’s exchange Kwenta, as well as on other decentralized exchanges. Trading Synth assets directly with each other on a native exchange like Kwenta allows for ZERO slippage. This allows for the best possible order execution for trading.
  6. Synthetix is working on delivering many new features in 2021. The project is working to launch on layer-2 Ethereum via optimism, which should reduce fees and allow more widespread participation. They are also working on the V3 of their protocol, which is expected to bring futures contracts to cryptocurrency. Finally, they are also working to launch support for equities derivatives as well. This would allow anyone to get synthetic exposure to global equity markets regardless of jurisdiction.
  7. The Synthetics protocol is built on Ethereum and is used by many other projects in DeFi. It is one of the most used protocols on Ethereum with over $2 billion locked in contracts already.
  8. The Synthetix protocol is implementing a robust decentralized governance mechanism to decrease centralized risk. It aims to become more self-sustaining and completely run by its community.

Major Bullish Arguments

  1. The world of traditional finance has already voted the derivative market to be one of the most valuable markets in the world by market cap. Bringing this functionality to the blockchain as a native feature drastically increases the usefulness of cryptocurrency.
  2. Some existing financial assets cannot be easily represented in cryptocurrencies. Synthetic contracts can become an important bridge between the real world and cryptocurrency as the ecosystem continues to mature.
  3. Large-scale investing in short contracts can leave you at the mercy of a few large players in the traditional financial system. Historically, some of the largest brokerage and other institutions have been known to change their short requirements (i.e. increased their margin requirements) just as these investments become profitable. For the brokerage, this makes sense because when shorts are winning big, all their other investors are generally taking major losses. This puts the bottom line of these institutions at risk. Crypto-based investment contracts can’t be altered just because the facilitator’s bottom line is at-risk. Instead, participants are beholden to abide by their agreements even during times that are less profitable for them.

Major Counterarguments

  1. Cryptocurrency is much easier to trade freely than most assets and is becoming even easier all the time. This may decrease the total demand for trading derivatives rather than using the underlying asset directly.
    • While this may have some truth to it when compared to the existing financial system, it does not capture the totality of the investment world. Many investor participants depend on strategies that are more complex than simple buy-and-hold. Synthetic financial contracts allow investors to express more nuanced financial views. These can include views such as price depreciation, short-term movements with leverage, and complex relationships between assets such as one asset appreciating while another depreciates by some specified amount. Investors will always need a place to express these more nuanced views on assets. That said, it may be that a greater portion of crypto is held outright by its owners when compared to, for example, the oil market. One is much more easily traded around the world than the other.
  2. When traders begin to trade more on synthetic assets, especially leveraged synthetic assets, it can destabilize the price action of the underlying asset.
    • While this is true, it is a truth of extremes. When leverage becomes extreme, it can multiply market volatility. However, the ability to open a simple un-leveraged long or short on a market decreases volatility as both sides of the market can simultaneously express their view. The amount of leverage vs the underlying asset is something that needs to be continually monitored by the protocol, Synthetix users, as well as investors in the underlying asset.

Price Potential

  1. As previously stated, the world of traditional finance has already voted the derivative market to be the most valuable single market in the world by market cap. More conservative calculations still place it as one of the major world markets.
  2. A second and easier to measure metric would be that all synthetic crypto-assets should remain proportional to the underlying market cap to the asset they track. Synthetic assets in the existing financial system can be looked to for clues as to what that maximum healthy leverage ratio should be. As long as crypto markets continue to rise, it makes sense that financial contracts based on crypto assets would also rise in value at the system level.

Major Risks

  1. Parts of the Synthetix system are still under centralized control. They are working to replace these aspects with decentralized equivalents over time, but some do not yet have decentralized equivalents. This should improve over time as the industry around DeFi continues to mature.
  2. Participating directly in Synthetics as a staker can lead to a situation where more tokens must be burned than you originally put into the system. Individuals should not attempt to do so without fully understanding the risks they accept by helping to maintain the system.
  3. Too much leverage in a financial system destabilizes the price action of the underlying asset. This may apply more to the assets under Synth contracts than the SNX token itself as other tokens may be comparatively more leveraged. The Synthetix system should be monitored to ensure that leverage does not become excessive on its protocol. This calculation needs to take into account both the supply of SNX tokens and collateral as well as the underlying asset’s current supply available on spot markets.

Additional Resources

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