Synthetix is a new financial primitive enabling the creation of synthetic assets, offering unique derivatives and exposure to real-world assets on the blockchain.
In this article, we will walk you through the details of what it is, why we need it, and how it works.
What is Synthetix?
Synthetix is a decentralized synthetic asset issuance protocol built on the Ethereum blockchain. Users can mint synthetic assets representing real-world assets as tokens, which track the value of assets one for one. All assets are issued in a completely trustless and decentralized manner. That means you can gain profit from assets without actually owning those.
For example, we have a token called sUSD with the price tracking US dollars, like a stablecoin. However, unlike stablecoin, it’s backed up by collateralized crypto debt, not fiat in a bank account. That “sUSD” is called synth.
Synthetic assets appeared a long time ago, but Synthetix is the first protocol to apply them in the crypto market.
Why do we need Synthetix?
Why don't people buy real assets but synthetic assets?
The reason is for trading purposes. People can easily trade and track the price of each synthetic asset on Synthetix directly, not needing to put their trust in another centralized source. In addition, there are quite a lot of unique features of the Synthetix network available. For example, while selling gold to buy ETH in the real world may be inconvenient sometimes, you can trade these easily via synthetic assets of gold and ETH on the Synthetix Exchange with zero slippage.
How does Synthetix work?
Users can collateralize and lock up the token of Synthetix Network (SNX) into the minting smart contract via the app “Mintr”. That contract will issue these decentralized synthetic assets called synths. Currently, there are five types of synths that can be minted on Synthetix: fiat currency (sEUR, sUSD, etc.), commodities (gold, silver, etc.), cryptocurrencies (sETH, sBTC, etc.), inverse cryptocurrencies (iBTC, iETH, etc.), and cryptocurrencies index (sDEFI, sCEFI, etc.).
For example, since sBTC tracks bitcoin in real life, If the price of bitcoin decreases, the price of sBTC also decreases, but the price of inverse token iBTC will increase. Therefore if you hold iBTC, it is just like shorting the assets.
Minting synth sUSD is the first step to using Synthetic Network:
Users can exchange synths for others easily via Synthetix.Exchange. The price must follow the exchange rate of price feeds received from oracle. The price feeds are currently supplied by both Chainlink’s independent node operators and Synthetix and will soon all be supplied by Chainlink to make the system fully decentralized
In Synthetix, we don't actually trade our synthetic assets for one another. What we do is burn a current asset and mint the same amount of different assets. For example, when we exchange sUSD for sBTC, the Synthetix Exchange will burn sUSD and mint sBTC.
All trades are executed against the contract, known as P2C (peer-to-contract) trading avoiding the need for counterparties. Not like traditional AMM, there is no Liquidity Provider in Synthetix Exchange that provides infinite liquidity up to the total amount of collateral in the system. Unlike an order book exchange, on Synthetix Exchange, we can trade with zero slippage as permissionless on-chain trading and don't need to own SNX tokens.
Synthetic is highly over-collateralized. The network's collateralization ratio (C-ratio) is approximately 750% to ensure a sustainable system. It means there is a significant amount of SNX tokens backing up all the synths and thus provides a large buffer in the case of extreme price movements.
SNX holders are incentivized to stake their tokens and mint Synths in several ways. Since the SNX stakers are the one that creates liquidity, contributes to the protocol, and bears the loss, they deserve the exchange rewards, which are generated whenever someone exchanges one Synth for another (i.e., on Synthetix.exchange). Each trade generates an exchange fee that is sent to a fee pool (0.3%), available for SNX stakers to claim their proportion each week.
The other incentive for SNX holders to stake/mint is SNX staking rewards, which come from the protocol's inflationary monetary policy. SNX tokens are distributed to SNX stakers weekly on a pro-rata basis, ensuring their collateralization ratio does not fall below the target threshold. This mechanism ensures SNX stakers are incentivized to maintain their (C-Ratio) at the optimal rate (currently 750%). In more detail, If it falls below 750%, they won't be able to claim fees. Thus, these stakers need to restore this figure by burning Synths. In addition, they can also decrease the C-ratio by minting Synths.
Similar to other tokens, Synths can be traded on the open market, and their price can fall below the assets they track. In this case, they ensure minimal deviations from the peg by providing incentives. For example, each week, a portion of the SNX added to the total supply through the inflationary monetary policy is distributed as a reward to users providing liquidity for synths on the outside swaps. In addition, Synthetix is currently trialing 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.
The mechanism above incentivizes SNX holders to stake SNX because they can claim more profits than just holding the token. The high C-ratio (~750%) leads to a significant demand to buy SNX tokens. By owning SNX tokens, users can participate in the protocol's governance and vote for future system changes.
Normally, users minting synths by staking SNX tokens will join the 'pooled debt,' and the price of each synth in this global pool will cause a decrease or increase in their debt. If the price of assets you are holding increases, you can burn part of them to withdraw all the original SNX tokens and gain profit from the price gap and vice versa. The scenario below shows the effect of other synths' prices on every trader on Synthetix:
Synthetix is also currently trialing Ether as an alternative form of collateral. That means traders can borrow Synths against their ETH and begin trading immediately without selling their ETH. However, staking ETH requires a collateral ratio of 150% and creates a debt denominated in ETH. Thus, ETH stakers mint sETH rather than sUSD and do not participate in the system's 'pooled debt.' In this model, these stakers don't receive fees or rewards as they take no risk for the debt pool. Similarly, only SNX stakers minting synths, but not normal traders buying synths on the network, can earn rewards and bear the risk of liquidation.
Every time SNX stakers mint or burn tokens, the smart contract will check the debt pool and the debt of each staker by updating the Cumulative Debt Delta Ratio on the Debt Register. This data can be used to calculate the debt of each remaining stakers. Debt Register also saves data about the latest minting/burning action. For example, when minting:
The cumulative Debt Delta Ratio is the product of “User debt percentage” and relative time(index), which can be used to calculate the debt of any staker.
The Advantages of Synthetix
While Synthetix helps traders approach outside assets in crypto and reduces the risk of buying the actual assets, they can still gain profit from those.
Synthetix works in partnership with a decentralized oracle network of ChainLink rather than a centralized counterparty. That allows Synthetix to provide more reliable price feeds for the user.
With Synthetix Exchange, users can trade with zero slippage with infinite liquidity. Kwenta uses the P2C protocol of Synthetic to make zero slippage exchange.
In addition, since they also publish on Layer 2 Optimism, the gas fee reduces 50 times which makes it able to compete directly with most of AMMs currently. That means people can trade any synth representing real-world assets they want at a very low gas fee and ~0 slippage in Kwenta.
Synthetix is also integrated with dHedge (assets management platform on Ethereum), Lyra (decentralized options protocol), and Thale (binary options protocol), which makes their ecosystem more powerful.
The Drawbacks of Synthetix
Because of the fluctuation of debt inside the system, sometimes users must pay more synth than the amount they mint to withdraw SNX.
Synthetix uses many proxy contracts for future updates and thus is partially centralized. That means users must put their trust in the Synthetix team.
There are limited functionalities in synthetic assets compared to the real-life assets they tracked.
However, the Synthetix team introduced SIP's (Synthetix Improvement Proposals), allowing users to propose their ideas to improve Synthetix protocol and mitigate the risk for users.
With the credible price feeds from ChainLink’s oracle, Synthetix has the potential to bring every single asset on blockchain and synthesize them with the equivalent value. It is undeniable that Synthetix is one of the most innovative protocols in DeFi.
As the first-mover in the synthetic assets space, Synthetix has established a reputation as a reliable protocol for decentralizing derivating trading. However, in the landscape of numerous solutions for reducing slippage and gas fees from other competitors, Synthetix has to continue innovating and improving.
 Synthetix System Documentation, docs.synthetix.io, accessed 12th November 2022.
 What is Synthetix (SNX)? Everything you need to know SNZ, coin98.net, accessed 12th November 2022.