Understanding the Synthetix Defi protocol.

Brief intro to Ethereum and Smart Contracts.

Many people confuse the term Ethereum to be a cryptocurrency just like bitcoin. For years even I believed the same until recently when I started reading and learning about Ethereum.

Ethereum, just like bitcoin, allows you to use digital money without payment providers or banks. But Ethereum is programmable 😎. It introduces transaction protocols called Smart Contracts which allows the engineers to write programs that can send and receive money.

This gives birth to a whole new sector called Decentralized Finance or Defi which is to traditional finance what the internet was to paper-based media. Defi refers to financial services using smart contracts which are automated enforceable agreements that don’t need intermediaries like a bank or lawyer and use online blockchain technology instead.

There are 100s of Defi protocols that are built to solve some of the problems faced in traditional finance. One such protocol is the Synthetix protocol.

In the simplest words, Synthetix is an Ethereum-based protocol for the issuance of synthetic assets.

But to understand this, we first need to understand the financial term called Synthetic Assets.

Synthetic Assets

This term is not specific to cryptocurrencies or decentralized finance. Instead, it has been there in traditional finance for a long time.

As per definition, a synthetic asset is a financial instrument that derives its value from another asset.

For example, synthetic GOLD (sGOLD) derives its value from the real-world asset that is GOLD. Here, synthetic GOLD is nothing but an imitation, a simulation of the real-world asset.

To understand it better, let us take the Dream11 game as an example. In Dream11, you choose your playing 11 and depending on the player's performance on the field, you earn points/money. But your playing 11 is just a simulation of those real players.

Similarly, sGOLD is just an imitation of GOLD. And depending on GOLD's performance, the value of sGOLD changes. In the image above, various other synths are shown pegged to their respective real-world assets (fiats, commodities and cryptocurrencies). sBTC -> BTC, sETH -> ETH, etc.

Synthetic assets allow traders to take a position in an asset without actually needing to spend the capital to directly buy or sell that asset. Though this gives the traders exposure to real-world assets, it won't really give them the dividend that the actual stockholders get. Synthetic assets remove any limitations that regulatory bodies place on an individual to start trading the real-world assets. It also allows traders to switch from commodity like sXAU (synthetic Gold) to cryptocurrency like sETH which is not possible in the case of real-world assets.

Synthetix Protocol and SNX tokens

Now that we know what synthetic assets are, let us get back to the 1-line definition of the Sythetix Protocol.

Synthetix is an Ethereum-based protocol for the issuance of synthetic assets. It is a trading platform to buy or sell synthetic assets.

All the Synths are backed by Synthetix's native token called SNX (Synthetix Network Token). SNX is used as collateral to mint Synths and is currently backed by 800%¹ collateralization ratio.

In other words, to buy synths, users will have to back the amount with an 800% collateralization ratio. For example, to mint 100 USDT, you will have to deposit the equivalent of 800 USDT.

1 USDT = $1

So, to mint 100 USDT, you will have to deposit $800. The high collateral ratio ensures there is enough collateral to absorb large price shocks in the case of big market price wings.

Synths are minted using Mintr which is a decentralized application for interacting with the Synthetix contracts.

The price of the Synth's is tracked in real-time using Chainlink oracle data feeds which allows the investors to buy and sell all the assets like real assets, only without a central body. In this way, Synths provide exposure to assets that are normally inaccessible to the average crypto investor — gold and silver, for example — and lets you trade them quickly and efficiently.

How is the Synth peg maintained?

Since the Synths are pegged to the real-world assets, they have to make sure the value remains stable and the ratio is maintained for the well functioning system.

There are 3 methods to maintain Synth pegs.

1. Arbitrage

SNX stakers incur debt when they mint Synths. When the peg collapses, they can profit by buying sUSD back at a lower price and burning it to reducing their debt, as the Synthetix system always values 1 sUSD as $1 USD.

2. sETH liquidity pool on Uniswap

When traders stakes/mints their SNX, an exchange fee is generated which is sent to the liquidity pool available for SNX stakers to claim their proportion each week. This allows the traders to purchase Synths to start trading or sell Synths to take profits.

3. SNX auction

Synthetix is currently trialling a new mechanism with the dFusion protocol (from Gnosis) in which discounted SNX is sold at auction for ETH, which is then used to purchase Synths below the peg.

Synthetix is one of the top movers in the rapidly growing Defi space and is one of the most complex and useful protocols built on Ethereum to date. While learning about the protocol I had to refer to various articles and youtube videos and so many financial terms to the already complex protocol made it difficult for a beginner to understand. So I decided to write a high-level explanation of the protocol in simple words to help the beginners understand. This article was written under the guidance of my mentor, Arth Patel, at Ethereum India Fellowship, organized by Devfolio.

Notes

¹ C-Ratio is 800% at the time of writing this blog. (as per Synthetix Litepaper, V1.4, March 2020). Although this may be raised or lowered in the future through community governance mechanisms.

References