Detailed Explanation of Synthetix V3: Protocol-Level Reconstruction of Liquidity

Written by: Babywhale, Foresight News

After the official launch of atomic swaps in 2022, which achieved good results, Synthetix put V3 on the agenda. As one of the "oldest" DeFi protocols, Synthetix was the absolute leader in the synthetic asset space at the beginning of 2021, sparking considerable discussion in the industry regarding synthetic asset protocols.

According to OKX market data, the price of SNX reached an all-time high of about $29 on February 14, 2021, while Bitcoin and Ethereum had not yet reached their historical peaks at that time. However, SNX did not show any remarkable performance afterward. On one hand, this was due to the overly complex mechanism design of Synthetix; on the other hand, users found that trading synthetic assets like sETH and sBTC with such a high collateralization ratio was less appealing than directly trading Bitcoin and Ethereum. The rise of numerous emerging assets further diminished the attractiveness of Synthetix's yields.

However, Synthetix did not decline as a result; instead, it cleverly utilized the zero slippage mechanism between sUSD and sToken to tell a new story of "atomic swaps."

The Past of Synthetix

Synthetix initially appeared on the market purely as a synthetic asset platform and established a very unique "debt pool" mechanism: users borrow sUSD by staking SNX. Unlike MakerDAO, which mints DAI by collateralizing assets, Synthetix also liquidates when the SNX collateralization ratio is insufficient (currently the liquidation line is set at a 160% collateralization ratio), but the underlying logic is fundamentally different.

In Synthetix, all users who stake SNX to mint sUSD share a single "debt pool." This means that when you mint sUSD, the amount of sUSD you mint is proportional to your share of the entire debt pool, and all minted sUSD represents the system's total debt. Since everyone shares a single debt pool, if other users operate in a way that appreciates their assets (for example, using sUSD to buy sBTC, which then rises), it will lead to an increase in the debt of the remaining users.

The reason is that the appreciation of some users' assets means an overall increase in the system's liabilities. If your asset appreciation rate is not higher than the system's average, it means a loss. Conversely, if some users incur losses, then even if you hold sUSD without making any moves, your debt decreases.

It must be said that this design is indeed very novel, keeping the entire system in a dynamic balance. However, novelty does not mean it can be accepted by the majority. When interacting with other DeFi protocols, or when the yields from holding other tokens or NFTs are already high, Synthetix appears less attractive.

In simple terms, you need to over-collateralize SNX to mint sUSD for investment, and the investment targets are somewhat limited. Additionally, the yields generated from investments may be diluted due to other users also generating yields. Although Synthetix provides inflation incentives for stakers and trading fee incentives, in a bull market, users naturally prefer to invest their principal directly compared to tokens that can double in value.

Atomic Swaps

As mentioned earlier, while there are shadows of over-collateralized stablecoin minting similar to MakerDAO, the mechanism is relatively more complex, requiring more strategies to be set up, and the user experience is not very friendly. The narrative of synthetic assets has gradually faded amid the bombardment of new projects in the bull market.

However, Synthetix did not leave empty-handed; the team realized that clinging to the narrative of synthetic assets might ultimately lead to market abandonment. Thus, they cleverly utilized the mechanism of sUSD exchanging for other sTokens, directly using oracles for price feeds to enable zero slippage trading without considering depth, officially starting the narrative of atomic swaps.

The functionality of atomic swaps first appeared in SIP-120 (https://sips.synthetix.io/sips/sip-120/) proposed by Synthetix founder Kain Warwick, Yearn founder Andre Cronje, and two others. This proposal was originally intended as a trading model within the Synthetix ecosystem but was later recognized as an excellent liquidity tool due to the increasing externality of the Synthetix ecosystem.

In August 2022, with the Tiaki version update, the atomic swap function was officially integrated into 1inch, providing zero slippage trading paths for on-chain transactions (mainly focused on large trades).

Thus, the Synthetix team no longer struggled against the wall of the synthetic asset narrative but instead made atomic swaps one of the most important functions of Synthetix. Of course, the deep binding of the Synthetix ecosystem with Optimism and the expansion of ecosystems like options (Lyra) and contracts (Kwenta) are also important parts of Synthetix's strategy.

The Birth of Synthetix V3

For Synthetix, while atomic swaps have indeed improved the liquidity and trading depth of assets like Ethereum and Bitcoin to some extent, it is challenging to further expand its influence. The current c-ratio (which can be understood as the over-collateralization ratio of SNX) that can earn SNX inflation rewards is 400%. Additionally, with a total supply of slightly over 300 million SNX, considering the amount of staked SNX, the proportion of sUSD used to provide liquidity, and the proportion of sUSD traded for other tokens, there are not many assets like sUSD, sETH, and sBTC that can truly provide liquidity in atomic swaps.

According to Dune data, at the time of writing, the total supply of SNX is about 314 million, with a staking rate of approximately 67.37% across L1 and L2. The amounts of sUSD, sETH, and sBTC providing liquidity and available for atomic swaps on Curve (including L1 and L2) are approximately 36.9 million, 19,180, and 576.7, respectively. Based on the prices of SNX, Bitcoin, and Ethereum at the time of writing, the total value of these liquidity-providing sTokens is about $83.4 million, while the total value of staked SNX is about $558.9 million, meaning the total value of sTokens available for atomic swaps is less than 15% of the total value of staked SNX.

Therefore, for Synthetix, to provide better trading depth and higher fee yields, it can only increase the number of sTokens like sUSD, which cannot be achieved solely through SNX. Thus, Synthetix V3 was born, significantly optimizing the atomic swap narrative while retaining futures, contracts, and other markets.

The optimizations related to V3 that have already been voted through include:

SIP-255

SIP-255 adjusted the distribution path of fees generated from atomic swaps that were originally intended to reward SNX stakers, so that these fees are automatically burned to repay the stakers' debts, thereby reducing debt and potential liquidation risks. It can also be understood that users receive sUSD from atomic swap rewards, and then this portion of sUSD, which would originally need to be manually claimed by users, is automatically burned to reduce the stakers' liabilities. Stakers can choose to re-stake the redeemed SNX to earn this portion of the rewards.

From the project's perspective, this measure can help stakers, especially those who often forget to claim rewards, maintain a long-term healthy debt ratio and reduce liquidation risks. Additionally, this plan can increase the utilization of SNX and sUSD, and reduce stakers' sensitivity to collateralization ratios, thereby encouraging more staking, effectively reducing the overall debt of the protocol, and minting more sTokens.

SIP-301

SIP-301 aims to create ERC-721 format account token NFTs for users, allowing them to transfer their SNX staking positions between different wallet addresses. This proposal decouples the absolute binding of "account" and "address." Furthermore, the ERC-721 standard maximizes the composability of smart contracts and existing user interfaces. It also allows for the creation of a secondary market for account tokens.

Additionally, by adding more robust delegation features, operational security has also improved. For example, a hardware wallet may have an account that is authorized to claim rewards delegated to a software wallet. If the software wallet is compromised, the attacker will only be able to claim the unpaid rewards of the account (for instance, they cannot withdraw all collateral from the staking account).

SIP-302, 303, 304, 305

These four SIPs include the mechanism designs for pools, markets, liquidations, and rewards in the V3 version. In simple terms, when minting sUSD using other collateral assets approved by voting (which may include Ethereum), each market can set custom parameters based on asset attributes. This means that the new markets in V3 will no longer follow the debt pool model but will adopt a CDP model similar to MakerDAO, with the difference being that the minted sUSD can enhance on-chain trading depth through the special features of atomic swaps.

Moreover, V3 has also made experiential improvements in supporting the establishment of permissionless current futures markets, as well as liquidations and rewards.

From the existing approved SIPs, Synthetix V3 has the potential to meet market expectations:

Support for collateralization of assets other than SNX. As analyzed above, using only SNX as collateral to mint sUSD will limit the actual circulation of sUSD due to the project's own mechanism. The new version addresses this limitation by supporting multiple collateral types for minting sUSD, increasing the channels for producing sUSD and further unleashing the project's imagination.

This imagination, on one hand, is that the new markets are not constrained by a unified debt pool, adopting a more popular CDP model, which may position assets like sUSD that support atomic swaps as important hubs for future on-chain trading. With just a 0.35% fee (current data, which may change in the future), transactions can be executed directly based on oracle prices, significantly increasing trading depth and further becoming the preferred path for transactions through aggregators.

On the other hand, the increase in the number of sUSD allows for richer upper-level architectural designs around sUSD, in addition to its unique atomic swap features (such as the permissionless current futures market mentioned above). As a result, Synthetix's fee income will further improve compared to the current situation. With the current fee-burning mechanism, SNX stakers can focus more on generating yields using sUSD.

More importantly, in addition to sUSD, the synthetic asset nature of Synthetix allows it to encompass assets like sETH, sBTC, etc. The expected launch time for Synthetix V3 is at the end of the first quarter or the beginning of the second quarter. At that time, Synthetix will transform from a pure synthetic asset market aiming to become a "decentralized brokerage" into a comprehensive DeFi protocol driven by both synthetic asset sTokens and atomic swaps, focusing on liquidity. For Synthetix, this can be considered a relatively successful transformation, and for the DeFi market, it provides another good option beyond using mathematically intensive formulas that consume a lot of gas to enhance liquidity and trading depth.