Synthetix operates in one of the riskiest markets in finance — crypto derivatives. These are financial instruments that even professionals find difficult to manage and may punish ill-prepared retail investors. In some nations such as the U.K., regulators have prohibited the sale of crypto derivatives to retail investors.
That being said, Synthetix is an Ethereum-based protocol that tokenizes underlying assets ranging from commodities to fiat money. It then issues them as derivative, synthetic assets.
Synthetix bridges the gap between off-chain world and on-chain digital assets, creating a blockchain derivatives market.
The Purpose of Derivatives
Derivatives are financial instruments that let investors protect, or hedge, their portfolios from losses, especially those created by market volatility. Many companies use derivatives to protect their income statements from unforeseen swings in security prices. Airlines, for example, often use derivative contracts to protect themselves from a sudden increase in the price of jet fuel. Agricultural companies do the same with commodity prices.
In crypto, derivatives are often used to make bets on the future swings of token prices.
In 2017, Kain Warwick, an Australian entrepreneur, launched Synthetix and in 2018 he raised $30M through an initial coin offering.
Synthetix relies on Ethereum’s ERC-20 smart contracts to tokenize underlying assets. Simply put, they are the blockchain’s version of traditional derivatives, called synthetic assets or synths. By using synths, investors can trade with commodities, fiat money, indexes, and cryptocurrencies. As such, synths are displayed as derivatives with an “s” prefix.
How Does Synthetix Work?
The key component a protocol like Synthetix must have is a network oracle. They are smart contracts that track the price of an underlying asset in the real world and feed the data to blockchain networks. Otherwise, synths couldn’t track their prices.
Chainlink is the dominant oracle network that Synthetix protocol uses to bridge this gap between off-chain and on-chain data. Thanks to this integration, crypto traders gain exposure to assets that otherwise wouldn’t be available, such as gold or silver.
Nonetheless, synths should not be confused with other digital assets that are backed by real assets. For instance, Pax Gold is an ERC-20 stablecoin backed by gold, on a one-to-one basis where one PAXG is worth one troy ounce of gold, stored in a London’s Brinks Security vault. Because of this relationship, PAXG holders own the underlying asset they can redeem.
This is not the case with a synth like sXAU, representing gold. As a blockchain-based derivative, sXAU is simply a tokenized financial contract offering exposure to gold’s price.
Because they are ERC-20 tokens, synths can be integrated into any Ethereum-compatible network and traded as such. As of August 2022, synths traded to a tune of $5B.
1inch (1INCH) decentralized exchange (DEX) is by far the largest synth trading driver, making up 60% of the total trading volume. The next ones are Kwenta at 33% and Curve at 3.3%. Other decentralized platforms that offer synths are Dhedge, 0x, Yearn, and ibAMM.
On either of those platforms, there are simple steps to follow to start trading Synths:
- Connect MetaMask wallet to the exchange.
- Exchange ETH for sUSD.
- Exchange sUSD for other Synths, such as sBTC or sEUR.
Because synths are tied to underlying assets’ price, there are no custodial issues. Once traders exit market positions with any given synth, they can simply convert it back into non-synth like ETH and transfer it to another exchange to convert it into fiat currency.
SNX Token Staking
Another way to trade with synths is to buy the protocol’s native token SNX, available on major centralized exchanges like Binance or OKX. SNX token holders can then connect their wallets to Synthetix staking and deposit SNX to receive rewards, as either SNX or sUSD, gained from synth exchange rewards.
Moreover, SNX token holders can mint new sUSD Synths, with SNX serving as collateral. But they would have to overcollateralize it to the tune of 650% of the underlying asset (SNX).
For example, if a Synthetix user wants to mint $100 worth of sUSD, they would have to deposit $650 worth of SNX coins. To maintain that percentage, SNX stakers either burn or mint sUSD, which generates weekly rewards as an incentive mechanism.
By un-staking all SNX, traders clear their debt taken with overcollaterization. This dynamic between burning and minting the sUSD Synth creates a safety net for trades on the entire Synthetix protocol, as it ensures liquidity.
Because the collateralization ratio is 650%, Synhtetix effectively has an infinite liquidity pool to facilitate synth trading. If a trader is lucky and SNX significantly increases in price, they could use those extra released funds to mint more sUSD and commit to more trades or simply convert sUSD into fiat.
As of August 2022, Synthetix integrated Ethereum’s Layer 2 scalability solution Optimism, to maximally reduce transfer fees. This means that synth traders can use Synthetix bridge to transfer funds from Layer 1 to Layer 2 and vice versa. This is especially useful for traders who would use Synthetix to borrow synths in order to avoid high gas price (GWEI) on Ethereum.
Who Controls Synthetix?
Originally, the derivatives protocol was governed by the not-for-profit Synthetix Foundation in Australia. This changed in 2020 when the protocol’s governance shifted to three DAOs with SNX token holders in charge of decision-making:
- protocolDAO: in charge of the protocol’s upgrades and smart contract security
- grantsDAO: funds community proposals
- synthetixDAO: funds individuals and organizations that forge partnerships and protocol development
Synthetix is a decentralized derivatives protocol aimed at advanced traders. Because synths rely on the integration with decentralized exchanges, SNX usage is likely to increase if more people prioritize DEXs over CEXs.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.