Balance sheet as a business model; a framework for understanding synthetic asset platforms
The business model of both Synthetix and Maker is simple: monetizing a balance sheet.
Maker allows users to post ETH collateral to a balance sheet and to mint a synthetic stablecoin (Dai) at a specified collateralization ratio. In return, users pay a fee which is distributed to MKR/DAI stakeholders via a buy/burn schema and the DSR.
Synthetix builds a balance sheet in its native token through staking incentives, allows users to mint a broad spectrum of synthetic assets (sBTC, sETH, iMKR, etc.), and charges users fees to create and trade debt. These fees, along with protocol inflation, are passed back to Synthetix stakers, incentivizing them to keep their collateral posted.
The business model of a synthetic asset platform, with a few tweaks, is largely that of a bank; build a balance sheets of user deposits, lend out capital for a rate of return, and distribute the proceeds back to stakeholders.
The two meaningful differences between dominant synthetic asset platforms
1. The spectrum of assets a network prices debt in determines the market size
Maker is relatively simple, risk-averse and bank-like in this regard - it mints and prices debt in Dai, which tracks the USD. When a user opens a CDP, the user posts ETH collateral, and promises to repay the Dai that was borrowed. Because all protocol debt is issued in Dai and Maker has a robust liquidation process for CDPs, a user can be reasonably certain that the network won’t become undercollateralized.
Synthetix is more complex, risk-on, and has a potential path to a different and much larger market than Maker. Currently, a user can mint or trade (reprice) debt with one of 24 different assets when staking the SNX token or utilizing Synthetix.Exchange. When a user mints $1 of sUSD (a USD stablecoin), the SNX-denominated collateral pool is responsible for backing $1 of sUSD. However, when a user trades (reprices) sUSD for a synth like sBTC, the network’s debt fluctuates as the price of sBTC changes. Network debt can fluctuate heavily, and as a result a greater degree of over-collateralization (+750%) is required to operate the network safely. Eventually, this ratio will drop as SNX gets more liquid, a liquidation process is implemented, and the network generally matures.
Being able to mint different types of synthetic debt drastically increases the addressable fee market for a synthetic asset protocol, yet also increases the extent to which it can become undercollateralized due to users repricing debt profitably. To solve for this, Synthetix will need to move towards having a balanced book of synthetic assets, by integrating different collateral types and utilizing open-interest based APR.
2. Value accrual differences between liquidity vs. governance tokens
The differences between Maker and Synthetix token economics will lead to divergent outcomes for the two respective platforms.
Maker currently builds its balance sheet with ETH, charges users fees to mint and maintain a Dai position, and distributes fees to MKR/Dai holders. The MKR token is used for governance of the network and as the lender of last resort if the network becomes undercollateralized. The value for MKR tokens accrues based on the amount of outstanding debt, and therefore stability fees, which determines the amount of MKR to be purchased and burned. To cover existing accrued stability fees, about 0.8% of MKR would need to be burned; 0.5% has been burned already. At a high level, MKR holders risk dilutive events as the lender of last resort and act as the governor of risk in the system. If MKR can scale its stablecoin protocol across multiple collateral types, it becomes a digital central bank.
Synthetix’s balance sheet is built by incentivizing holders to stake the native token (SNX). As an SNX holder, you can stake SNX, which generates a debt position denominated in sUSD. If the debt position is over-collateralized (+750%), a staker is rewarded with weekly protocol inflation, as well as the fees generated by users minting and trading synthetic assets. Currently, inflation is intentionally high relative to the fees (10:1) cycling back to stakers, but this is changing as the trading and creation of synthetic assets scales. Exchange fees currently generate roughly a 10% APR on a SNX position.
At a high level, SNX holders stake their tokens to provide the platform with liquidity, becoming a debtor counterparty to every trader and minter on the platform in a zero-sum game. If Synthetix can scale a balanced book, SNX becomes an infinite liquidity pool that can mint any asset with a reliable data feed against the collateral pool. In the near term, this looks like a decentralized version of Bitmex.
Vision(s) for the future of Synthetix
In the next 12 months, we expect Synthetix.Exchange to evolve into a decentralized version of BitMex, with multiple collateral types, a liquidation engine, and a SNX-denominated balance sheet to backstop trades. The market for synthetic assets is both a large and immediately addressable. In traditional finance, the derivatives market is estimated to be 10x the size of global GDP annually. In crypto, we are seeing similar dynamics play out with the success of BitMex and its perpetual swaps dwarfing corresponding spot markets. Our belief is that a non-custodial, decentralized, infinite liquidity version of BitMex would achieve product-market fit at scale.
Longer term, the business model for Synthetix might look a lot like franchising liquidity to generate additional fees. In this world, new exchanges, prediction markets, or other front ends pop up overnight, buying liquidity from Synthetix’s balance sheet, and competing on user experience to differentiate. A lot of the fundamental assumptions in the space surrounding liquidity, and the pecking order of business models, could change as a result. All of a sudden, a project wouldn’t need to aggregate users in order to aggregate liquidity.
How does Synthetix get there
Synthetix Core’s experience, work ethic and commitment to the community make them one of the most high-output teams in the blockchain space - they are absolutely incredible. Two years ago, Synthetix was called Havven, and focused solely on building a balance sheet to support a synthetic stablecoin. Nine months ago, Synthetix changed its name, token economics and broadened its synthetic asset mandate to monetize its balance sheet. The team is deeply committed to a test-and-iterate methodology for product and protocol development, taking direct feedback from the community and using rough consensus as a governance model to implement changes.
Looking forward, the path to Synthetix becoming decentralized BitMex is clear: the protocol must reach feature parity with professional derivatives exchanges, while becoming truly decentralized in order to differentiate in their go-to-market strategy. As a liquid, feature-complete and decentralized version of BitMex, Synthetix will leverage an absence of centralized custody, personally identifiable information, and jurisdiction gating to compete for trading fees. As a community, decentralization enables the open source collaboration that builds a strong community and massively accelerates the flywheel of improvements.
To get to feature parity, there are four main initiatives already underway that need to be completed:
1. Non-SNXCollateral Options: The process of buying SNX, staking, and then trading is cumbersome for most. Many traders would prefer to use assets like ETH or tBTC as collateral to enter the system. An added benefit of multiple additional collateral types is that this builds short exposure into the system, balancing a mostly-long order book. The Synthetix team is working on implementing ETH as a collateral type before EoY, while still accruing value to the SNX stakers.
2. Liquidation Process: The 750% collateralization level for SNX stakers limits the amount of synthetic assets that can be traded, and is due to the illiquidity of SNX and the lack of a liquidiation process for undercollateralized positions. To safely operate the protocol at scale, a liquidation process that has been designed will need to be implemented.
3. Robust Price Feeds: Currently Synthetix’s price oracles are operated in a centralized way that allows traders to front run price changes, and also leaves the price feeds vulnerable to attack. To solve this, the team is working to integrate Chainlink as a decentralized oracle provider, and a unique order management system to prevent front running.
4. Professional Trading Tools: The interface design, order types and speed of execution on Synthetix Exchange is not up to the standards of centralized exchange offerings. The team is redesigning the exchange, integrating more order types, and is exploring Layer-2 solutions to speed up transaction throughput.
To become truly decentralized the development, management and ownership of the network must continue to shift to the community. This process will be gradual and take time, but doing so builds a strong community, mitigates regulatory risk, enables Synthetix to move quickly, and solidifies its decentralized value proposition.
Sizing the prize
The opportunity for Synthetix as a decentralized BitMex is massive and straightforward to value using a DCF model. Because the token is utilized to build a balance sheet and represents a pro-rata claim on network fees, the value of Synthetix tokens grows proportionally to the volume traded on Synthetix Exchange. In Q3 2019, exchange volume was $298M, with September being the highest month to date with $252M in volume. This is tiny (1000x smaller) in comparison to both Binance and BitMex, which did $112Bn in spot and $320Bn in XBTUSD volume. Small shifts in volume from Binance/BitMex would represent huge gains for Synthetix.
Where do we fit in
Our view is that crypto-native investing isn’t a spectator sport, and that most venture firms are hamstrung by existing LP agreements, too much AUM, and a traditional equity investing mindset. Our style is venture investing, in tokens or equity, with a focus on active participation that pushes the network forward.
If you are building something interesting in the crypto space and want a partner, please reach out.
Special thanks to Kain, Jordan and Justin from Synthetix for helping flesh out these thoughts.