Synthetix Quarterly Report: Q3 2022 by Frogs Anonymous

This report provided by the Frogs Anonymous DeFi Research Team

Key Insights

• In spite of market conditions, fee revenue on the Synthetix platform grew over Q3 as recent integrations with high-profile aggregators routed more trades through Synthetix derivatives.
• The introduction of an Optimism bridge accelerated the growth of the Synthetix ecosystem and encouraged the adoption of sUSD as a principal stablecoin on the layer two.
• The protocol steadily implemented governance proposals to not only expand its ecosystem but further embed itself into the basic functioning of decentralized finance.
• These developments have paved the way for the continued expansion of synthetic derivatives into more far-reaching corners of DeFi and laid the groundwork for the coming rollout of Perps v2 and Synthetix v3.
  

Introduction

The exchange of digital assets is the premier use case of decentralized finance, but low liquidity has presented persistent obstacles since its inception.  Users are beholden to the amount of liquidity available for a particular asset, and trading at scale can result in both slippage and high price impact.  One viable solution has been to rely on synthetic derivatives, which reflect the current price of an underlying asset but trade using a general collateral pool as counterparty.  As such, large transactions only remove liquidity from the collateral pool and have no effect on the pricing of any single asset.

Since 2017, Synthetix has been the pioneer of this system of derivatives.  Beginning as a platform for the minting and trading of synthetic assets, its fees have catapulted it to one of the top five crypto projects by revenue, and an ecosystem of interrelated protocols have grown around it to provide synthetics-related services.  The major developments in this ecosystem in 2022 have been the introduction of cross-asset atomic swaps on L1 and the growing adoption of perpetual futures on L2, and both have resulted in a dramatic increase in the protocol’s fee revenue.  Given the outsized impact these events had on the current state of Synthetix, we will briefly describe them before continuing on to Q3.

Q2 Recap

Atomic swaps are an exchange function that allows users to conduct multiple transfers in a single transaction.  For a long time, however, Synthetix was unable to perform these swaps on mainnet due to its system of fee reclamation, which enforced a latency period after each trade.  SIP-120 did away with this system but enabled atomic swaps only between synthetic assets and sUSD.  

In May of this year, SIP-198 removed this restriction and opened the door to all cross-asset atomic swaps on the Synthetix platform. This development had major repercussions for the Synthetix ecosystem, most significantly by expanding the role played by synths on DEXs and aggregators like Curve and 1inch.  

An example: 1inch is a prominent DEX aggregator designed to reduce slippage and fees on user trades by combing through a variety of exchanges and determining which combination of swaps would net the best results.  While a user could swap USDC directly for ETH on Uniswap, they may have better results exchanging the USDC for DAI and proceeding to swap that DAI for ETH.  1inch automates this process by integrating with exchanges around the DeFi system and using them to route trades.

With the enabling of cross-asset atomic swaps, aggregators like 1inch can now route these trades through the Synthetix ecosystem to further reduce slippage. USDC can be swapped for sUSD, for example, then sUSD to sETH and finally to ETH.  In these situations, trading fees are accrued by Synthetix, and revenue has swelled accordingly.  Between the growth of cross-asset swaps on L1 and perpetual futures trading on the Optimism L2 – introduced in Q1 – Synthetix’s revenue has increased threefold year-over-year, ballooning from $7.66M to $22.6M at the time of writing.  The platform’s entry into Q3 can thus be better understood in its proper context: following an explosion of trading activity and an expanding role in the decentralized exchange of assets.

Q3 Data

A variety of data bears this interpretation out.  Synthetix’s market cap rose from $545M in Q2 to $579M in Q3, while many of its competitors languished in the depths of the bear market.  This can be attributed primarily to the new products, integrations, and updates that the platform has shipped over the course of 2022, in line with the adage that bear markets are for building.  

Similarly, Synthetix network usage rose markedly in Q3, with trading volume on Ethereum mainnet rising from $3.06B to $3.48B and the number of trades more than doubling from 3.63K to 7.51K.  Meanwhile, on Optimism, trading volume rose from $1.52B to $2.03B and the number of trades from 73.2K to 77.4K.  

Interestingly, while the number of mainnet trades increased by an impressive 100+%, the number of traders rose from 1.09K to 1.22K, suggesting that the platform’s developments served to galvanize an existing user base rather than attract large numbers of new traders.  This conclusion lends some credence to the idea that the platform’s major value prop is the provision of deep liquidity for traders of size, for whom slippage is more of an issue than the average user.

As a result of this uptick in trading, Synthetix experienced a commensurate rise in fee revenue.  Q3 saw fees on mainnet rise to $8.53M compared to Q2’s $7.77M, while fees on Optimism rose from $5.96M to $7.30M.  By design, all synth trades are filled by the pooled counterparty, and thus liquidity providers are unnecessary.  Because of this, all fee revenue goes directly to Synthetix and its SNX stakers, liquidity tends to remain loyal to the platform, and Synthetix remains one of the more consistently profitable protocols in the crypto space today.  

Introduction of the sUSD Bridge

For a number of reasons, Synthetix sought early on to expand its ecosystem onto a layer 2 solution, choosing to deploy on Optimism in July of last year.  Synthetix users were drawn to layer 2 for the same reasons that any are, namely for the faster transactions and lower fees.  In this case, however, the platform had its own incentive.  Relying as it does on oracle price feeds to determine the rates of exchange for synth trades, the faster transactions enabled Synthetix to reduce oracle latency, while lower fees made more frequent updates possible.  This allowed the platform to do away with its fee reclamation system on Optimism long before the Ethereum mainnet.  

While the move had its benefits, the issue of cross-chain liquidity naturally arose.  As stablecoin pegs depend in all situations on a balance between supply and demand, fragmenting liquidity exacerbates the risk of a depeg, particularly on the chain with lower supply.  Synthetix’s solution was to build an sUSD bridge directly into its staking UI by integrating with the Socket infrastructure already in place.  Q3 marked the launch of this new and convenient bridging solution, and users can now bridge any synthetic asset between Ethereum and Optimism directly from the Synthetix dashboard.  

The availability of a reliable sUSD bridge clearly had an effect on usage, and the circulating supply on Optimism rose from 53.33M to a peak of 86.32M on August 9th before closing the quarter at 66.2M.  This represents a 24.1% increase in supply, though the effect was more pronounced when looking at chain dominance.

When measured against the Ethereum mainnet, Optimism commanded 37.18% of the sUSD supply at the beginning of the quarter and ended it at 49.78%.  This represented a 33.9% increase in the percentage of sUSD hosted on the layer 2.  Even now, sUSD is split about evenly between the mainnet and Optimism, suggesting that layer 2 protocols in the Synthetix ecosystem have benefited considerably from the easier access to liquidity.

This is precisely what we see when we examine the TVL of Lyra, the major options exchange of the Synthetix ecosystem.  Looking at the total value locked on Optimism, we see that the bridge resulted in a considerable uptick in user activity.  Beginning the quarter at $3.5M, it ended Q3 with $21.19M, representing a 605% increase in TVL.  Given that this growth in TVL began on July 19th – conspicuously, the exact day the sUSD bridge was launched – it’s safe to conclude that introducing the bridge has had a profound effect on the protocols hosted on Optimism and will only continue to facilitate the flow of liquidity towards the platform’s layer 2 ecosystem.  

The Synthetix Ecosystem

As Synthetix continued to grow, the greater ecosystem of protocols within its sphere of influence did as well.  Some of these employ Synthetix liquidity and thus generate fees for the platform (e.g. Kwenta, Lyra, 1inch), while others simply grew out of the Synthetix community (e.g. Aelin, Thales).  Over the last quarter, the integration of 0x and Polynomial improved platform revenue and facilitated the ecosystem’s growth on Optimism.  Meanwhile, governance proposals advanced the composability of the Synthetix platform, encouraging new ecosystem partners to not only integrate with Synthetix, but to build on one another.

Kwenta: Kwenta is the primary decentralized exchange upon which synths are traded, using a peer-to-contract model to facilitate both swaps and perp trades.  Its trading volume increased dramatically in Q3, rising from $591M last quarter to $2.05B on mainnet.  Kwenta also commanded a trading volume of $41.7M on Optimism.

Lyra: Lyra is a protocol built on Optimism to offer options on Synthetix derivatives.

Thanks in part to an earlier  initiative to bribe veCRV holders to vote liquidity towards the sUSD pool, Lyra generated $51.7M in trading volume in Q3.  

Polynomial: Polynomial is an options vault protocol built on top of Lyra that enables users to automate their covered call or cash secured put strategies.  Launched in Q3, it generated $32.7K in trading volume on Optimism.

dHedge: dHedge is a socialized hedge fund built on top of the Synthetix platform.  Users can create dHedge pools to manage as they see fit, and others can add liquidity to benefit from their success in trading Synthetix derivatives.  Q3 saw $1.88M in trading volume, with volume on Optimism rising to $1.14M.  

1inch: 1inch is a DEX aggregator that scans decentralized exchanges for the best trade routings based on cost, fees, and slippage.  Synthetic’s system of cross-asset atomic swaps was integrated into the protocol in Q2, resulting in a significant boom in Synthetix trading volume.  Q3 volume was $1.11B on mainnet and $8.87M on Optimism.

Curve: Curve is a decentralized exchange that specializes in providing deep liquidity for high volume trading pairs (BTC, ETC, stablecoins).  Utilizing Synthetix’s cross-asset atomic swaps, Curve’s Q3 trading volume was $88.2M.  

0x: 0x is a decentralized exchange that specializes in ERC-20 tokens.  Since incorporating cross-asset atomic swaps, it facilitated $277K of trading volume on mainnet and $58.9K on Optimism.

SIPs Passed in Q3

258 – Trade Directionality in Pricing of Atomic Swaps

As described above, atomic swaps were made possible by SIP-120, which prevented the frontrunning of trades by stakers who may have exploited oracle latency.  After the pricing function was modified to choose the lower of the two prices provided by Chainlink and Uniswap oracles, frontrunners could no longer force a trader into a bad fill that they would have to pay for in fee reclamation.  SIP-258 developed this concept further by modifying the pricing function to incorporate the directionality of sETH and sBTC trades – by filling them not at the lower price, but at the price considered “worse”, given the direction of the trade.  

230 – Universal Circuit Breaker

The prices of certain assets are not included in the default exchange rates provided by Chainlink, and thus gaps existed in the validation of oracle price feeds for certain synths.  By updating the ExchangeCircuitBreaker contract to support oracles outside of the regular price system, the circuit breaker system now provides for the validation of arbitrary oracles previously excluded.

257 – Debt Ratio Futures Market

Synthetix created a futures market for the debt ratio of SNX stakers.  The Synthetix platform revolves around the staking of SNX and the minting of sUSD against it, and a number of variables affect changes in the amount of this debt.  By creating a futures market for the debt ratio – which tracks the amount of inflation or deflation relative to the original debt load, rather than the total amount of debt – the platform has introduced a product for stakers to safely and internally hedge the risks of debt inflation.  

249 – BNB Perp

Synthetix created a perpetual futures market for $BNB, the native token of the BNB chain.  $BNB is the third largest non-stable cryptocurrency by market cap and consistently ranks among the highest tokens by 24-hour trading volume.  Perpetual futures markets are added to Synthetix largely to benefit Kwenta, its flagship futures platform, and additions are chosen based on user demand for new markets.

262 – XMR and Doge Perps

Synthetix created perpetual futures markets for $XMR and $DOGE. Monero is the crypto space’s most well-known privacy coin, and Dogecoin its most notorious meme coin.  Due to legal restrictions in many jurisdictions, $XMR can be difficult to purchase on centralized exchanges, and no alternative markets exist on decentralized futures exchanges. Similarly, $DOGE futures are unavailable on competing exchanges in spite of Dogecoin’s enduring, if unexpected popularity.  

269 – OP Perp

Synthetix created a perpetual futures market for $OP, the native token of the Optimism layer 2 solution.  Due to the number of large $OP holders – both users who received airdrops and protocols who received grants – the demand exists for futures products as a hedging solution.  Particularly in light of Synthetix’s presence on Optimism, many users of Kwenta may also hold $OP and make use of a futures market.

Q4 and Beyond

A successful third quarter has set the platform up for an active Q4, and a number of major updates sit on the horizon.  The most important of these are perps v2, debt migration, and Synthetix v3.  

Perps v2

Later in Q4, Synthetix has plans to upgrade its system of perpetual futures, enacting lower fees and more predictable funding rates.  The goal of perps v2 is to expand liquidity on the perpetual futures platforms in the Synthetix ecosystem.  Thus, while fees will be lower, improved UI – as well as higher limits on open interest and the addition of new futures markets – will serve to attract new users, ultimately increasing revenue.  

Debt Migration

As more and more ecosystem activity takes place on Optimism, it becomes more important for user liquidity to transition over to layer 2.  While the sUSD bridge has accelerated this process, migration is still hindered by the amount of sUSD minted against SNX collateral on the mainnet.  A mechanism is in place for users to migrate staked SNX from Ethereum to Optimism, but all mainnet debt must be burned before they can do so.  Plans are underway for the implementation of SIP-237, which will introduce a new mechanism to migrate sUSD debt positions to Optimism, paving the way for the introduction of Synthetix v3.  

Synthetix v3

A strong case can be made that the cold start liquidity issue is the central problem of DeFi.  New protocols are required to put considerable time and resources into incentivizing liquidity provision for their tokens, and oftentimes those with superior products lose out to those with superior game theory.  This problem is exacerbated by a system in which liquidity is fragmented on different chains, creating additional roadblocks to its flow into new assets.

Synthetix v3 is an ambitious attempt to solve this problem, with benefits for both protocols and liquidity providers. First, it will introduce a differentiated debt pool, which will make it possible for SNX stakers to choose which asset pools their SNX will supply collateral for – in essence, which trades they will be counterparty to. This will allow stakers to implement their own LP strategies, choosing which pools to collateralize based on staking incentives and desired exposure.  

Second - and more revolutionary - it will enable protocols to permissionlessly create their own synthetic derivatives.  When combined with the introduction of a differentiated debt pool, this means that builders can not only create their own assets on Synthetix, but source and incentivize liquidity for them.  This will essentially convert the entire Synthetix collateral pool to a unified source of liquidity that can be directed towards any financial derivative on the platform, without governance or council intervention.  The upgrade will mark a massive step forward for Synthetix as a platform in its quest to provide liquidity-as-a-service, and is slated to occur in Q4 of this year.

Conclusion

The picture today is of a protocol steadily working towards its stated, long-term goal: to transform from a derivatives platform used by traders into a platform upon which any project can permissionlessly create its own derivatives and source its liquidity.  By doing so, the protocol aims to transition into providing liquidity as a service and to solve the original problem of decentralized finance.  Synthetix has accomplished a great deal in 2022, which is borne out in the numbers we’ve seen over Q3.  Beyond the positive data, however, a more significant conclusion can be drawn: that these developments not only improve the platform’s performance, but bring it incrementally closer to actualizing its long term vision.