Synthetix Ecosystem Overview

Introduction

To get exposure to an asset in crypto, you must find liquidity for that asset. Assuming we don’t want to use a Twitter poll asking “who has X I can buy?”, we typically turn to exchanges. But what if there is no on-chain supply for the asset you want or if the asset doesn’t exist on-chain at all? To meet this need, Synthetix mints and exchanges synthetic assets to provide a liquidity solution for almost any asset.

These synthetic assets are typically 1:1 token representations of an asset like the USD or ETH. The protocol's token SNX is deposited (staked) by liquidity providers and serves as the backing collateral for the synthetic assets. In exchange, stakers get trading fees and staking rewards.

This synthetic model of asset issuance and exchange facilitates zero-slippage trading. Instead of exchanging assets with a counterparty, synths are exchanged with smart contracts. Swapping between one synthetic and another only involves burning one token and minting another. As a result, there is no bid-offer spread to be paid or impacted.

This liquidity solution has become a core building block for many other use cases in crypto. New protocols are using it to build their own tools and use cases for users. The ecosystem today boasts a decentralized exchange with perpetual futures, a decentralized options automated market maker (AMM), on top of which an algorithmic options vault has been built, a Prediction Market, and more. Synthetix also has integrations with many of DeFi’s core primitives.

How It Works

To give an analogy, DAI is a loan you receive for locking ETH or other collateral on MakerDAO. Similarly, sUSD is a loan you receive for staking your SNX. The analogy ends there.

The staked SNX is a collective collateral pool, and the synths issued against it make a collective debt pool. Synthetix allows traders to swap sUSD for a synthetic version of any other asset as long as there is a reliable price feed. In exchange for this flexibility, Synthetix requires a larger collateral requirement (currently 300% collateralization).

When you exchange synths on Synthetix, one form of synthetic debt token is burned and another of equal value is minted, minus the fees. This setup removes the need for a counterparty as the protocol simply converts the debt type at the oracle price. So the price you pay/receive is the oracle price, with no spread or price impact.

Trade-Offs

The execution prices for synths are from oracles. In crypto, oracle updates are transactions that are transparent and therefore create the risk of front-running. Synthetix has a long history fighting this risk, and has made some UX sacrifices to minimize it.

Fee reclamation is one solution the team has implemented to stop frontrunning. It can be thought of as increasing settlement time for trades. The transaction fee becomes a factor of a TWAP of the synth oracles. So your fee will be a percentage of the average price over some time period instead of the moment of execution. The synths transacted also cannot be traded until the transaction settles.

Optimism helps this UX problem because the fees to update oracles is much lower, so the TWAP can be much shorter still with effective defense.

More volatile markets increase the opportunity for frontrunning as well, since the price movement between trade execution and oracle update is larger. In February, Synthetix announced a dynamic exchange fee that will increase with volatility. This will reduce the opportunity to front-run in volatile markets. In theory, it should not reduce competitiveness since the cost of trading in volatile markets goes up on all exchanges.

The decision whether or not to use this liquidity solution often comes down to the size of the trade. Some of these trade-offs diminish as the trade size grows, because slippage savings would increase.

Due to the number of contracts called, trading on Synthetix comes with higher gas fees. Trading on Optimism certainly reduces this burden. This cost would not increase with trade size.

There is also a fee on synth transactions, which can be higher than some DEXs and could outweigh the slippage savings. The fee is determined by the DAO and is largely dependent on the volatility of the underlier. For example, forex trades typically face a 5 bp fee while more volatile assets can be 30 bps or higher. Importantly, the fee does not change with trade size.

Another consideration is that the liquidity tradeable in the Synthetix ecosystem is limited by the size of the collateral pool. Futures help here, because of the leverage they provide. Wrappers, which are smart contracts that facilitate the 1:1 exchange for assets, for ETH/sETH and sUSD/lUSD also increase protocol liquidity.

The limited size of the debt pool can create reflexivity in the ecosystem. As collateral values rise, more synths can be minted, which should increase trading volumes and thus fees and therefore the value of collateral, and so on. On the way down, the reflexivity similarly shrinks the value of collateral and thus liquidity and so on.

The Synthetix ecosystem inherits this reflexivity, both downside convexity as well as positive growth feedback loop. As new tools increase demand, the liquidity pool should increase, allowing for more demand from the ecosystem and so on. This reflexivity makes Synthetix a viable scaling solution for new protocols.

Usage

Synthetix is averaging roughly $10 million in daily volumes on Ethereum Mainnet through May of 2022, down roughly 60% from a $25 million daily average in 2021. On Optimism, daily average volume is over $3 million so far this year. Much of this is thanks to market conditions and dollar values being down substantially. The spike at the end of March is a result of the merging of debt pools between the Ethereum and Optimism chains.

Though volume is down, transactions are up. On mainnet, Synthetix saw over 21,000 trades last year, and in the first five months of this year, there have already been 12,000. On Optimism, the trend has been steadily increasing. Although some of this is related to the OP token airdrop, it is unlikely the only catalyst.

On Mainnet, sUSD is the most transacted underlier over the last year. sETH is the second most common, and sEUR is third at 10% of transactions.

There is 150 million SNX staked on mainnet, worth roughly $400 million as of June 6th, 2022. On Optimism there is roughly 60 million SNX staked, worth $160 million. In March, the debt pools were merged, so the debt exposure for stakers is not network-agnostic. The debt pool exposure is predominantly sUSD, along with blue chips and forex.

Kwenta

The decentralized exchange Kwenta was created to optimize the user experience of the Synthetix liquidity solution. Kwenta operates on Ethereum as well as Optimism, where the use of the Layer-2 solution reduces gas fees while trading synths.

By leveraging the Synthetix debt pool, Kwenta can be a decentralized exchange that offers a similar experience to a centralized exchange. There are no trading pair restrictions, and there is no account setup or custody necessary.

Currently in beta, Kwenta has added a decentralized perpetual futures exchange to its platform.

The exchange implements a skew incentive/disincentive to balance the exposure of the debt pool. This can work for or against traders, depending on their market view. On Synthetix, each trade is against the debt pool. So if the market becomes too heavily long or short against an asset, the debt pool gains a very large exposure. The decentralized AMM uses this skew characteristic to incentivize market participants to balance the debt pool’s directional exposure by increasing or reducing fees.

Usage

Kwenta is continuing to roll out new products. V2 brings futures trading, and though it is still in beta, futures trade volumes on Synthetix are over $2 billion since March. Because perpetual futures have become the preferred tool for leveraged traders in crypto, this an opportunity for growth.

Usage began increasing in March with the launch of V2 beta and then peaked at 600 users on April 20 after Optimism announced their airdrop. The team has been releasing products for the DEX almost every week since March 2022.

Lyra

Built natively on Optimism, Lyra is an AMM for trading European options. Lyra addresses two problems for decentralized option AMMs: better pricing and better liquidity provider (LP) protection.

The primary variable to options pricing is implied volatility, which a decentralized AMM gleans from the market. Lower gas fees on L2 and a unique process to update volatility prices (greeks cache) allow Lyra to consistently update the entire volatility curve, giving more accurate pricing for traders.

Another limiting factor for option AMMs is the risk to liquidity providers on the other side of these trades. Lyra stakers are the liquidity providers for Lyra. The protocol increases protection for LPs by hedging the main risk exposures of the options positions. Lyra uses synths to cheaply hedge LP’s spot-price risk. A pricing adjustment parameter incentivizes traders to balance LP’s volatility risk.

Lyra also uses synths to manage trader collateral, which is in sUSD, to align it with the risks to LPs. These new hedging and incentive designs should enable more liquidity for traders.

The trade-off for the above advantages is that the AMM has to create rules around trading. For example, traders cannot close out a position in the final 24 hours before expiry, and wingy options outside of delta parameters (<15 or >85 delta) cannot be traded. Liquidity providers also must lock their liquidity for the entirety of a round, which is 28 days. Further, there is no slippage, but there is a skew incentive that moves the market on larger trades.

Lyra recently implemented its Avalon upgrade, though it is still rolling out the UI for it. Avalon introduces three key new elements to the options AMM. First, anytime entry/exit for liquidity providers. This will turn LP positions into ERC-20 tokens that can be traded and do not need to be locked up. Second, Avalon allows for longer maturities up to 12 weeks. Finally, it allows for partially collateralized options. These positions have a risk of liquidation, but they also allow for more capital efficiency, which should empower arbitrageurs to more actively balance the Lyra market.

Usage

After slower adoption in the first quarter, the 28-day moving average of unique daily users almost doubled in the last two months to 176 on May 15. We use the 28-day moving average (MA) because the options pools are locked into a 28-day cycle.

As of June 6th, 2022, there is over $11 million in liquidity locked on Lyra. It has facilitated over 25,000 trades exchanging over $15 million of premium since November of 2021. The total notional traded surpassed $500 million in May. By asset, ETH is the highest notional traded, making up 72% of notional volume since November 2021. BTC was 18%, while LINK and SOL were 7% and 3%, respectively.

Polynomial

Built on top of Lyra in April 2022, Polynomial offers users automated options strategies. Currently, the protocol offers covered-call strategies and cash-secured put strategies for sETH and sBTC. Users lock capital in the vault for a cycle (one week) and can then either withdraw from the vault or let it compound.

Covered calls is an option strategy where you own the underlier (sBTC) and you sell a call of equal notional against it. In USD terms, your risk in this trade is equal to the value of the underlier (the amount of sBTC you hold). If the underlier closes above the strike price of the call, you receive the premium from the option as well as the gains between where you bought the underlier and the strike. However, you are left with less of the underlier. So you can end up with less sBTC but more USD. The only way to lose in USD terms is if sBTC falls (the same would be true if you simply held sBTC with no covered call).

Cash secured puts operate slightly differently. By selling puts, you agree to buy the underlier if it closes below a certain price. Because these options are European style, the settlement is in USD terms, not the underlier. So if the underlier stays above strike, you simply receive the premium. If the underlier closes below the strike price, the vault must buy the asset at the strike price and then sell it at the lower price. If that difference is greater than the premium received, then the vault loses money.

Polynomial sells out-of-the-money options with a 1-week expiry and less than a 20-delta. Currently, strikes are selected by a permissioned manager, but this process will be automated.

Usage

Given liquidity in the market, Polynomial restricts their vault sizes. The BTC put selling vault is capped at $500,000, while the ETH put selling strategy has $1.5 million of capacity. The Bitcoin covered call strategy caps out at 13 BTC, and the ETH covered call strategy is full at 450 ETH. The ETH call and put strategies have been nearly fully subscribed since launch, with Bitcoin vaults staying consistently over 50%. Polynomial’s TVL currently sits above $2.4 million.

The vaults have been open during bearish times for crypto, and their performance reflects it. The covered call strategies have done really well (annualizing 30% and 21% APYs for Bitcoin and Ethereum, respectively). The put selling strategies have suffered (both down around 60%). Still, retention is fairly high over 60%, and the Bitcoin cash-secured-put strategy remains nearly fully subscribed.

Building on Optimism allows for reduced fees, which can attract more retail participation. Polynomial has steadily grown to over 3,800 unique users, and the deposit sizes have been mostly under $100, with a vast majority below $1,000.

Thales

Thales is a unique protocol that began with binary options markets leveraging Synthetix and has since turned more of its focus to parimutuel markets. Binary markets allow participants to place yes or no bets for certain outcomes, such as “Will ETH be above $2,000 by expiration?” Parimutuel markets are mostly used in prediction markets — think of how odds on horse races move based on how much people bet on certain horses.

The team has iterated on the idea of parimutuel markets to create Thales Royale, a sequential betting market. The exotics markets are optimistically curated, meaning the outcome is assumed correct unless someone deposits a bond and poses a dispute. For some events, like game outcomes, the markets use an oracle feed for both odds and outcomes.

Beyond using SNX and sUSD, the project is not heavily reliant on the Synthetix protocol. However, it does offer extra rewards to SNX stakers and uses SNX for incentives.

Thales has seen over $2 million in volumes across almost 4,000 trades over the last 6 months. Their binary options markets called “AMM” include BTC, ETH, LINK, SNX, SOL, and more. The team is focused on scaling the parimutuel prediction markets alongside the binary options.

Integrations

In November 2021, Synthetix approved a proposal for users to do atomic exchanges of synths without enabling front-running oracles. The proposal has led to increased volumes and integrations from DEXs like Curve and 1inch.

A good example is the TVL of forex synths (i.e., sEUR, sJPY, etc.) on Curve. Fixed Forex was launched in July 2021 by Andre Cronje to create an on-ramp for forex to get on the blockchain. By allowing atomic exchanges on forex, Synthetix has added much-needed liquidity to these forex currencies. One can onboard foreign stables through Fixed Forex, swap them to synths on Curve, and then can trade on Kwenta for any other asset. Currently, there is over $30 million of liquidity on Curve and Sushi from Fixed Forex.

The yield aggregator Popcorn Finance is taking advantage of this new integration. Popcorn empowers yield farmers to allocate some portion of earnings to charities. Popcorn can now include forex yield farms on its aggregator because of the decreased friction moving assets from Fixed Forex to Synthetix.

Synthetix is also integrated with Curve through its stablecoin. Year-to-date, the sUSD pool on Curve which is made up of sUSD, DAI, USDC, and USDT has done over $2.1 billion in volume and currently hosts ~$100 million of liquidity.

In early 2022, a Synthetix Improvement Proposal passed. It removed a restriction that required sUSD to be included in a trade in order to trade at the pure Chainlink price (instead of needing a uniV3 oracle). This is a gamechanger for an integration with 1inch, a DEX aggregator. Now 1inch can offer better liquidity for users by atomically transferring assets for synths, trading the synths with no slippage, and then transferring back.

Conclusion

Synthetix has created a unique building block which provides DeFi with scalable access to liquidity for a nearly infinite variety of assets. Builders are taking advantage by creating products on top of the protocol to expand the financial products native to DeFi. As the Synthetix ecosystem grows, more integrations with other protocols will likely add to the community. Given the reflexivity in the design, more use cases in the ecosystem should drive more volumes and thus earnings for holders. When the flywheel kicks in, it will lead to more liquidity and thus a better experience for users across the ecosystem.

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