Messari: Synthetix Ecosystem Overview

Author: JohnTotalValueLocke

Original Title: 《Synthetix Ecosystem Overview》

Compiled by: Biscuit, Chain Catcher

Introduction

Liquidity is an important factor in assessing whether a crypto asset is of high quality. If we don't want to ask on Twitter "Which cryptocurrency should I buy?", we usually look for answers on exchanges. But what if a crypto asset has no on-chain liquidity or doesn't exist on-chain at all? To meet this demand, Synthetix provides on-chain liquidity solutions for almost all crypto assets by minting and exchanging synthetic assets.

Synthetix synthetic assets are typically represented as 1:1 tokens of assets like USD or ETH. The protocol's token SNX serves as collateral for synthetic assets, staked by liquidity providers, who earn trading fees and staking rewards as incentives.

This integrated model of asset issuance and exchange drives the trading process towards zero slippage. Synthetic assets are not exchanged with counterparties but directly with smart contracts. Swapping between different assets only involves burning and minting asset tokens. Thus, users do not incur slippage fees and are not affected by bid-ask spreads.

This liquidity solution has become a core mechanism for many projects in the cryptocurrency space. Numerous emerging protocols are utilizing this mechanism to build their own tools and use cases for users. Currently, the Synthetix ecosystem includes a decentralized perpetual futures exchange, a decentralized options automated market maker (AMM), and the team has built algorithmic options vaults, prediction markets, and more on top of this. Additionally, Synthetix has integrated many core native DeFi projects.

How Synthetix Works

For example, when users lock ETH or other collateral on MakerDAO, they receive DAI as a loan. Similarly, sUSD is the loan that users receive by collateralizing SNX.

The SNX staking pool is associated with a debt pool formed by synthetic assets. As long as there is reliable price data to support it, Synthetix allows traders to exchange sUSD for synthetic versions of any other asset. In exchange for this flexibility, Synthetix has set a high collateral requirement (currently a 300% collateralization ratio).

When users trade synthetic assets on Synthetix, one form of synthetic debt token is burned, and another equivalent token is minted, with protocol fees deducted in the process. This setup eliminates the need for users to have counterparties, as the protocol simply converts debt types at oracle prices. Therefore, the price users pay/receive is the oracle price, with no spread or price impact.

Trade-offs

The execution price of Synthetix's asset synthesizer comes from oracles. Oracles provide a transparent trading mechanism, which can lead to the risk of front-running. Synthetix has a long history of combating this risk and has sacrificed some UX experience to minimize it.

Fee reclamation is a solution implemented by the Synthetix team to prevent front-running. Trading fees are a factor in the synthetic oracle's TWAP, and fee reclamation can be seen as increasing the settlement time of trades. Thus, the fees users pay will be an average price over a period rather than the real-time price at the moment of execution. Additionally, synthetic assets cannot be traded before fee settlement.

The Ethereum Layer 2 network Optimism helps address this UX issue, as updating oracles on the Layer 2 network incurs much lower fees, allowing for shorter TWAP times to effectively defend against risks.

Since trading fees are linked to the execution price and oracle price, more volatile markets present more opportunities for front-running. In February, Synthetix announced the adoption of dynamic trading fees, which will increase with price volatility. This will reduce the chances for arbitrageurs to front-run in turbulent markets. Theoretically, this solution reduces Synthetix's competitiveness, as trading costs on centralized exchanges also rise in volatile markets.

The decision of whether users utilize this liquidity solution often depends on their trading volume. As trading volume increases, some of these trade-offs diminish, as slippage costs rise.

Since Synthetix trading requires calling many smart contracts, this process incurs higher gas fees. Optimism can alleviate this burden, and costs do not increase with trading volume.

The process of synthetic trading also incurs fees, which may exceed those of some DEXs and could offset Synthetix's low slippage fees. These fees are determined by the DAO and largely depend on the volatility of the underlying assets. For example, forex trading typically faces fees of 5 basis points, while more volatile assets may incur fees of 30 basis points or higher. Importantly, fees do not change with trading volume.

Another factor to consider is that the tradable liquidity within the Synthetix ecosystem is limited by the size of the staking pool, but leverage can be provided through futures products. Wrappers are smart contracts used by Synthetix for 1:1 asset exchanges between ETH/sETH and sUSD/lUSD, while also increasing the protocol's liquidity.

The limited size of the debt pool can create reflexivity within the ecosystem. As the value of collateral rises, users can mint more synthetic assets, which will increase the protocol's trading volume and fees, further enhancing the value of collateral. Conversely, in a downturn, reflexivity will similarly reduce the value of collateral, thereby shrinking liquidity.

The Synthetix ecosystem inherits this reflexivity, including downward spirals and positive growth feedback loops. As new tools increase demand, liquidity pools should grow, allowing for more demand from the ecosystem, and so on. This reflexivity makes Synthetix a viable scalable solution for emerging protocols.

Synthetix Ecosystem Data

As of May 2022, Synthetix's average daily trading volume on the Ethereum mainnet was approximately $10 million, down about 60% from an average of $25 million per day in 2021. To date, Synthetix's average daily trading volume on the Optimism network has exceeded $3 million. These figures have been significantly influenced by market conditions and the sharp decline of crypto projects. The surge in trading volume at the end of March was a result of the merging of debt pools between the Ethereum and Optimism chains.

While trading amounts are declining, the number of trades is increasing. On the Ethereum mainnet, Synthetix had over 21,000 trades last year, with 12,000 trades in the first five months of this year. On the Optimism network, the number of trades has shown a steady upward trend. Although some of this data is related to the OP token airdrop, the airdrop is unlikely to be the sole reason.

On the Ethereum mainnet, sUSD was the most traded underlying asset last year. sETH ranked second, while sEUR was third with 10% of the trading volume.

As of June 6, 2022, 150 million SNX were staked on the mainnet, valued at approximately $400 million. About 60 million SNX were staked on Optimism, valued at $160 million. In March, the debt pools merged, making stakers' debt risk independent of the network. The debt pool exposure is primarily sUSD, along with mainstream cryptocurrencies (such as sBTC, sETH) and other crypto assets.

Decentralized Exchange Kwenta

The decentralized exchange Kwenta aims to optimize the user experience of Synthetix's liquidity solutions. Kwenta operates on Ethereum and Optimism, where using Optimism significantly reduces gas fees during trading.

By leveraging the Synthetix debt pool, the user experience provided by Kwenta is similar to that of centralized exchanges, with no trading pair restrictions and no necessary account setup or custody.

Kwenta has added a decentralized perpetual futures exchange to its platform, which is currently in testing.

The exchange employs skewed incentives to balance the risk exposure of the debt pool. The impact on traders depends specifically on their market views. On Synthetix, each trade is against the balance of the debt pool. Therefore, if the market is overly bullish or bearish on a particular asset, the debt pool will incur a significant risk exposure. The decentralized AMM uses this skewed characteristic to incentivize market participants to balance the directional exposure of the debt pool by increasing or decreasing fees.

Operational Data

Kwenta's V2 version launched futures trading features, and although it is still in testing, Synthetix's futures trading volume has exceeded $2 billion since March. As perpetual contracts have become the preferred tool for cryptocurrency leveraged traders, this presents a growth opportunity for Synthetix.

With the launch of the V2 Beta, Kwenta's usage began to increase in March, peaking at 600 users after Optimism announced the airdrop on April 20. Since March 2022, the team has updated the DEX's features almost weekly.

Options Exchange Lyra

Lyra is a native European options AMM on Optimism, providing a decentralized options AMM solution with better pricing and improved liquidity provider (LP) protection.

The main variable for options pricing is implied volatility, which requires the AMM to gather data in a decentralized market. Lyra continuously updates the entire volatility curve using lower gas fees on L2 and a unique process that utilizes a Greeks cache to provide traders with more accurate pricing.

Another limiting factor for options AMMs is the risk to trading pair liquidity providers (LPs). Lyra stakers are also liquidity providers for Lyra. The protocol increases protection for LPs by hedging the main risk exposure of options positions. Lyra uses synthesizers to achieve low-cost hedging of LPs' spot price risks. Adjusting pricing parameters incentivizes traders to balance LPs' volatility risks.

Lyra also uses synthesizers to manage traders' sUSD collateral to align with LP risks. These hedging and incentive designs can provide traders with more liquidity.

Lyra has established a set of core rules around trading. For example, traders cannot close positions within the last 24 hours before options expiration and cannot trade wingy options outside of delta parameters (<15 or >85). Liquidity providers must also lock their liquidity for the entire options cycle (i.e., 28 days). Additionally, options trading incurs no slippage, but there are skewed incentives that can move the market on larger trades.

Lyra recently underwent the Avalon upgrade, which introduced three key new elements to the options AMM. First, liquidity providers can enter/exit at any time, turning LP positions into tradable ERC-20 tokens without locking. Second, Avalon allows liquidity providers to maintain holding periods of up to 12 weeks. Finally, it enables liquidity providers to collateralize a portion of options. While these options positions carry liquidation risks, they yield higher capital efficiency, allowing arbitrageurs to more actively balance the Lyra market.

Operational Data

After slow growth in the first quarter, Lyra's independent daily users nearly doubled in the past two months, reaching 176 on May 15. Since the options pool has a single cycle lock of 28 days, we use a 28-day moving average (MA) to assess its user growth.

As of June 6, 2022, over $11 million in options liquidity was locked on Lyra. Since November 2021, it has facilitated over 25,000 trades, with premiums exceeding $15 million. The total trading volume in May exceeded $500 million. By asset, the highest was ETH options trading pairs, accounting for 72% of trading volume since November 2021. BTC accounted for 18%, while LINK and SOL accounted for 7% and 3%, respectively.

Automated Options Strategy Polynomial

Polynomial was established in April 2022 on top of Lyra, providing users with automated options strategies. Currently, the protocol offers collateralized covered call strategies for sETH and sBTC, as well as cash-secured put strategies. Users can lock funds in the vault for a single cycle (seven days) and then withdraw profits or reinvest automatically.

Covered call options are a common options strategy, where users own the underlying asset (sBTC) and then sell equivalent call options. In dollar terms, the user's risk in this trade equals the value of the underlying asset (i.e., the value of the sBTC held). If the underlying closes above the call option's strike price, the user will receive the option's premium plus the profit between the underlying and the strike price. Ultimately, the user may end up with less sBTC and more dollars. The only way to incur a loss in dollar terms is if sBTC declines (the same would apply if the user simply held sBTC without a covered call option).

Cash-secured put options operate slightly differently. By selling put options, users can buy the underlying asset when the closing price is below a certain price. Since these options are European-style, settlement is in dollars rather than in the underlying asset. Therefore, if the underlying asset remains above the target price, the user can earn the premium. If the underlying closes below the strike price, the vault must purchase the asset at the strike price and then sell it at a lower price. If that difference exceeds the premium received, the vault will incur a loss.
Polynomial offers out-of-the-money options with a one-week expiration and a delta of less than 20. Currently, execution is triggered by licensed managers, and the execution process is automated.

Operational Data

Given the liquidity of the market, Polynomial has set a cap on its vault. The cap for BTC put options is $500,000, while the cap for ETH put options strategies is $1.5 million. The cap for the BTC collateralized covered call strategy is 13 BTC, and for the ETH collateralized covered call strategy, it is 450 ETH. The ETH covered call and put options strategies have been nearly fully subscribed since their launch, while the purchase rate for the Bitcoin vault has consistently remained above 50%. Polynomial's TVL currently exceeds $2.4 million.

During the bearish period for cryptocurrencies, the vault has remained open to all users, as reflected in the data. The covered call options strategy has performed very well (with annualized APYs of 30% for Bitcoin and 21% for Ethereum). The put options strategy has been affected (with annualized APYs dropping by about 60%). Nevertheless, the retention rate for the put options strategy remains quite high, exceeding 60%, and the Bitcoin cash-collateralized put options strategy is still nearly fully subscribed.

Polynomial chose to build on Optimism to reduce transaction fees, thereby attracting more user participation. Currently, Polynomial has steadily grown to over 3,800 independent users, with the majority of deposits below $1,000.

Prediction Market Thales

Thales is a unique protocol initially built to serve as a binary options market for Synthetix, but the team has since shifted its focus to a prediction market. The binary options market allows participants to bet on certain future outcomes, such as "Will ETH be above $2,000 at expiration?" This binary options market is similar to a horse racing market, where odds change based on people's bets on certain horses.

The team has updated the concept of the binary options market to create a continuous betting market called Thales Royale. This means that results are considered correct unless someone deposits a bond and disputes them. For certain events, such as game outcomes, the market will use oracles to provide odds and results.

In addition to using SNX and sUSD, the project does not rely on the Synthetix protocol. However, it offers additional rewards for SNX stakers and uses SNX for incentives.

In the past six months, Thales has seen trading volume exceed $2 million across nearly 4,000 trades. Their so-called "AMM" binary options market includes options products for BTC, ETH, LINK, SNX, SOL, and more. The team focuses on expanding from the binary options market to the prediction market.

Integration

In November 2021, Synthetix approved a proposal allowing users to perform atomic swaps of synthesizers without enabling front-end oracle operations. This proposal led to a significant increase in trading volume and integrations with DEXs like Curve and 1inch.

The TVL of synthetic assets (i.e., sEUR, sJPY, etc.) on Curve is a great example. Fixed Forex, launched by Andre Cronje in July 2021, aims to create a blockchain entry point for traditional stablecoin assets. By allowing atomic trading of forex assets, Synthetix has added much-needed liquidity to these forex assets. Users can exchange traditional assets for crypto synthetic assets through synthesizers on Curve and then trade any other assets on Kwenta. Currently, the fixed forex pools on Curve and Sushi have over $30 million in liquidity.

Yield aggregator Popcorn Finance is leveraging this new synthetic mechanism to allow single yield farmers to allocate part of their income to charities. Users can reduce friction losses when transferring assets from fixed forex to Synthetix through Popcorn's aggregator and yield farms.

Synthetix has also integrated its stablecoin sUSD into Curve liquidity pools. Year-to-date, the sUSD pool consisting of sUSD, DAI, USDC, and USDT on Curve has completed over $2.1 billion in trading volume, currently holding about $100 million in liquidity.

At the beginning of 2022, Synthetix's improvement proposal was passed. This proposal lifted the restriction on including sUSD in trades to use Chainlink prices for trading (instead of relying on uniV3 oracles). This change was brought about by Synthetix's integration with DEX aggregator 1inch. Now, 1inch can provide users with better liquidity and the ability to mint synthetic assets through slippage-free atomic trades.

Conclusion

Synthetix serves as a unique DeFi Lego block module, providing on-chain liquidity solutions for various crypto assets. Developers are building on this protocol to expand DeFi-native financial products. As the Synthetix ecosystem evolves, the protocol may see more integrations with other DeFi protocols. Given the reflexivity in its design, new projects in the ecosystem should drive more trading volume, benefiting holders. As funds flow in, it will bring more liquidity, thereby enhancing the overall experience for users in the Synthetix ecosystem.