What You Need to Know About Synthetic Tokens

What are Synthetic Tokens?

The Synthetix platform is wrapping up indexes into a token on the Ethereum protocol that’s just like a stock on a blockchain, to keep it short. A “synth” is the index in question. It’s value is backed by SNX tokens. SNX tokens are minted when a user, called a staker, puts collateral down using Mintr, an application for interacting with SNX contracts. However, when an SNX staker creates a synthetic token, they also create “debt” with it. In order to exit their position, the staker must repay it by burning Synths. So for example if you put 10 USD down as collateral, you have 10 sUSD (Synthetic USD). In order to exit your position, you have to “burn” 10 sUSD in return. As markets fluctuate the debt a staker holds will also fluctuate, up or down depending on market status.

At this time of writing, Synthetix is in a trial with the Ethereum network to allow users to stake their ETH tokens as collateral. This means stakers can borrow SNX tokens based on the amount of ETH tokens they “bet” so to speak. Without having to sell off their ETH tokens. Instead, an ETH staker would create sETH (Synthetic Ethereum). The downside to this, is that sETH stakers do not collect fees or rewards on their sETH but the upside is that they hold no risk. On the flip side, sUSD stakers can participate in what the developers call “pooled debt”, but it comes with the risks of debt of course.

The Stakes of Synthetix

Let’s examine how the minted tokens are utilized. The advantage to synthetic assets, is that it allows holders of asset classes to interact with other assets they otherwise have no access to. Meaning that a holder of oil stakes can trade their oil position into a Bitcoin position for example. Or a holder of Bitcoin can trade their position for Silver.

Synth stakers are incentivized to lay stakes and mint SNX in a few ways. Each trade made with SNX generates a fee. This fee is then added to a pool where stakers claim their portion on a weekly basis. These fees are displayed on all trades so you’re never in the dark about your contribution. In addition, Synthetix has an inflationary money supply. Over the course of 4 years between 2019 and 2023, the supply of SNX will increase from the base 100,000,000 to over 200,000,000, accompanied with a fixed decay rate until September 2023, where that rate will change to a “permanent” 2.5% annual rate. This supply is distributed to stakers so long as they are meeting target collateral ratios.

The Synthetix platform acts as a sort of financial Rosetta Stone, allowing stakers to translate one position into another. The intent of this according to the developers is to solve friction and liquidity issues found on other exchanges. Rates of exchange between assets are determined by an oracle. Oracle based finance calculations come with a set of risks all it’s own. The oracle is not a person in the case of Synthetix, it is an algorithm that determines exchange value. This requires trust in the oracle from the get-go. This algorithm is maintained by Chainlink’s node operators. Synthetix developers have the intent for all oracle data to be maintained by independent node operators as the platform grows.

Pros and Cons

The most glaring con here is trust in the oracle. If you are putting a large amount of capital into this, that is a lot of faith to place on what is essentially the arbiter of market truth. The old proverb “trust but verify” comes to mind. The difference between the Synthetix oracle and traditional ones, is the decentralized nature of it’s maintenance.

Now that the oracle is not centralized, it is possible to manipulate how it works. I don’t believe it to be surprising to find that the community may update or rework the oracle in the event that it’s ability to measure price begins to fail or otherwise becomes a poor system of measurement. An additional problem to this however would be community consensus on it’s alteration. It certainly presents a unique set of challenges.

The pros here however are very interesting and potentially huge. Synthetix is one of the most complex protocols built with Ethereum. DeFi indexes stand to offer stakers an escape and an alternative to traditional exchanges. In my opinion, Synthetix as it currently stands, is a proof of concept that you can indeed run an alternative financial system against the current one dominated by Wall Street cronies. On Wall Street you’re playing somebody else’s game which they have spent a lot of time and money legislating in their favor. But as things currently stand, Synthetix is for everybody.

The Blockchain-ification of Finance

Synthetix is very unique and the closest thing that we currently have to it are asset-backed tokens. PAX gold comes to mind, given that it is a cryptocurrency backed by gold. 1 PAX token is equal to one ounce of fine troy gold. A return to the old school gold standard. While there are paper stocks for gold, you have to acquire these from a middleman which, even if there weren’t fees, is just inconvenient now. Now you could acquire tokens from the comfort of your own smartphone. Currently I think this comes down to preference and trust. Would you rather a machine assist you in finance or a person?

There’s lots of other asset backed tokens out there. Including but not limited to intellectual property, real estate, and commodities. One use case would be for kinds of energy. Which would allow a company who has a need for energy, and say an individual with solar panels on their property to exchange tokens as equals. Asset-backed tokens are promising in their own way, but Synthetix is a bit more unique since it is a “stock” represented in the form of tokens, and the value of that stock is determined by an oracle’s judgement of an index.

There really isn’t that much difference between an asset backed token and a stock, it’s simply cutting out financial middlemen who have been adding additional fees on financial management for generations. Blockchains simply automate this away. In that regard, Synthetix is a step towards the blockchain-ificaton of finance, and not exactly a small one. I don’t think it would be surprising to see more projects like Synthetix rendering the field of finance more efficient and accessible by eliminating the waste fees of human management and it’s gatekeeping power structure in favor of highly accessible, automated ones.