Synthetix Founder Technical Challenges and Future Road of Synthetix

Author: Kain.eth, Translation: LianGuai0xjs

Now, Synthetix V3 is “online”, which is a perfect opportunity to examine past assumptions and ensure community consensus on long-term vision. This article will focus on the SNX token and its role in the ecosystem.

Multi-chain

Synthetix’s vision has always been ambitious. Deploying the Synthetix protocol across multiple chains is much more challenging than most other DeFi protocols. This is because most protocols deploy independent instances on each chain, which introduces operational complexity, but it is definitely the simplest way to maintain presence on multiple networks. Many protocols subsequently control these different instances through unified governance. Although this introduces additional complexity, governance usually operates off-chain or on a single network. Some protocols even go further, where actions on one chain can affect all other chains. This can manifest in the form of bridges, liquidity management, or shared liquidations. Protocols can also support asset fungibility between chains through wrappers or bridges. As early as the beginning of 2020, the Synthetix community envisioned a grander vision: a single protocol spanning multiple networks, where the system behaves as if every action on each chain happened on a unified chain. Although we are closer to achieving this goal today than three years ago, it is still difficult to accomplish. Many unsolved technical challenges still need to be addressed. Considering the development of cryptocurrencies in recent years, it is worth reconsidering whether a multi-chain approach is still the best method.

Why share liquidity?

Imagine that Synthetix is deployed on instances of five different EVM networks. The SNX token can move seamlessly between any of these networks and be used to provide liquidity (SNX LP) on each network to support trading. Complexity arises when these SNX LP positions also support liquidity on other networks. If Alice only trusts Mainnet, she can do SNX LP there and provide liquidity for any of the other four supported networks. However, there is a potential contradiction here: if she only trusts Mainnet, why would she want to support liquidity on other networks? Bob can LP SNX on Optimism and provide liquidity for Mainnet, Optimism, and Base. Carol can LP SNX on Avalanche and only provide liquidity for that network. In theory, the market should be able to solve this problem, and liquidity will flow to where there is the highest demand for trading. This design assumes that each network has a certain percentage of users who only transact on that network and not elsewhere. If they cannot provide LP and trade on their chosen network, they will be completely excluded from Synthetix. We can question this assumption later; for now, let’s see what it takes to implement this.

Implementing shared liquidity

A complex approach is to deploy different markets and pools on each network and allow LP to provide cross-network liquidity from any network. For background information, in Synthetix V3, a market represents a single asset, such as sBTC, and a pool allows LP to send liquidity to a market aggregator, which then delegates liquidity on behalf of multiple markets. The main pool will be the SLianGuairtan Pool, consisting of all “officially supported” markets. In Synthetix V2x, there was only one pool that included all supported markets, and all LP were forced to delegate liquidity to this pool.

Okay, now let’s take a look at a specific trader to understand how this will affect them. Let’s assume this trader only trades on Base. They like to trade ETH on a short-term basis; in order to ensure that they can continuously open new positions, there must be sufficient liquidity delegated to the Base SLianGuairtan Pool and/or delegated to the Base ETH pool. Please remember, in this setup, it does not require anyone to provide liquidity on Base; all of this liquidity can come from the Mainnet or other chains. For Base traders, this is effective because the demand for sETH on Base will cause LP from other networks to directly delegate liquidity to this Base market through a single market pool or a pool that includes the ETH market.

In order to make this implementation method effective, a large amount of cross-chain communication is required, especially with the increasing number of supported networks. Through CCIP and the upcoming Chainlink infrastructure, it is possible to achieve this, but the question we must ask ourselves here is not “can we?” but “should we?”

What are we trying to achieve?

Ultimately, what we want is an efficient liquidity market where the demand on any chain can be met with the corresponding supply on that chain. One assumption is that liquidity is limited, so we must be able to share liquidity between chains to avoid liquidity fragmentation – a situation where you can trade on each chain but liquidity is very poor due to limited liquidity pools on all chains. This leads to a cold start problem: insufficient liquidity on any chain suppresses demand, thereby reducing incentives to provide further liquidity. Now, while liquidity is limited, some liquidity is more limited than others. Part of the complexity of multiple chains is the recognition that SNX liquidity is not sufficient to meet the demand on all chains in the short term. Therefore, in order to avoid introducing other collateral, we must bend ourselves to prevent the limited SNX liquidity in this cross-chain liquidity system from being fragmented. I should point out here that I believe that in the long run, if there is demand, the SNX token will expand to support the required level of liquidity. The problem is that in a bear market, this is a lagging process and demand is insufficient to increase SNX collateral. Therefore, we are forced to make trade-offs: increase the complexity of the system to consolidate the role of SNX as the primary collateral, or find a compromise solution.

Okay, but why not just wait for everyone to wake up on Optimism?

One key assumption in this research is that the market must exist on each chain. I think this is a reasonable assumption. But it’s an assumption we should question. The equivalent scenario in this case is if Coinbase had a different exchange for each operating system, so that no matter which operating system you prefer, you can trade. How much liquidity would you expect on Coinbase: Debian? This analogy is slightly off; a better analogy is if Coinbase offered different markets for each database engine, so users can use the database engine of their preference on the trading platform. It is absurd to think that users have such strong preferences for database engines that it would affect their use of the trading platform. However, this is exactly the situation we face in the current cryptocurrency world. There are staunch advocates for specific chains who refuse to acknowledge or trade on other chains. Unfortunately, I am one of them… Why does this happen on smart contract platforms but not on databases? In this analogy, databases are the state storage layer of CeFi and DeFi, and L1/L2 networks are the execution and/or state storage layer of DeFi. The reason is simple: it’s called tokens. Although advocates for database engines may be as annoying as your typical cryptocurrency responder saying, “Akkkktually, Clickhouse is not a real database engine at all!” there is no mechanism to pass this technological tribalism to end users. In cryptocurrency, we have built a very powerful incentive mechanism to promote this user preference. This phase may eventually pass, but for now, I think it is reasonable to assume that there are different user groups on most chains.

Forever Fragmented?

Okay, so this fragmentation of users at the execution layer isn’t ideal, and it seems like we’re stuck in it. While users ultimately want useful functionality, they also have a strong incentive to only access that functionality on the chain they support. Therefore, we can build optimized exchanges, but if they only exist on one chain, they will be isolated and won’t gain the traction they could potentially achieve. This is especially true in the case of centralized exchanges, where they can choose any technology stack and place all users in a single database without anyone caring. This means that all their liquidity is contained in a single silo, which is a huge advantage for cross-chain DEX. By the way, one way to solve this problem is network abstraction, more like a centralized exchange; this is an experiment that Infinex intends to conduct. From Synthetix’s perspective, it’s a valuable experiment. But Synthetix needs to optimize for the reality that Infinex failed, which means meeting every chain where each user wants to trade or provide liquidity.

What are our options?

If we accept that the Synthetix protocol needs to meet users where they are, how do we get there? From my perspective, there are three approaches.

Deploy forks of Synthetix on each chain and let God sort it out.
Implement a unified cross-chain protocol where state changes must be pushed to all chains.
Deploy independent instances on each new chain and minimize cross-chain messages and liquidity fragmentation by leveraging non-SNX collateral.

Choice One: Full Forking

This is not a feasible approach, although it would be very interesting. The main reason preventing us from doing this is the dependency on SNX token collateral. If you have 10 forks of SNX tokens, they are likely to have reduced trading volume and significantly lower liquidity for each fork, contradicting the goal of avoiding fragmented liquidity. Most protocols simply need to deploy new instances of their contracts and let liquidity find the new chain, Aave and Uniswap are good examples. For Synthetix, we need a significant amount of SNX on the network to serve as collateral, and we also have significant governance overhead. Therefore, we may need to fork the SNX token on each chain. You can test this process with Base. We can deploy a completely new instance of Synthetix, including SNX, and prefix everything with ‘b’ before anything else. So we’ll have bSNX, bsUSD, and bsBTC. Although this could be interesting, I don’t think it’s our best hope. But again, it would be very interesting, and I’m not saying we shouldn’t consider it. The forking approach has an advantage today compared to a few years ago because deployment is now easier due to the release of Canon. In the past, even deploying Synthetix on one chain could be a multi-day process. Even though each deployment is different, cross-chain deployment was not feasible at that time.

Choice Two: Unified Liquidity Theory

Alright, solve all the technical issues and build a network protocol that can support all the cross-chain message transmission needed. Then, we can continue to rely solely on SNX collateral and we will all be saved. In theory, this is great, and we are moving in this direction, but what if our premise above is incorrect? What if there aren’t enough independent users on all these chains to generate incremental trading volume? What if we spend too much time building this supporting infrastructure, and another protocol builds a better single-chain solution and users start migrating to that protocol? There is a precedent here; dYdX was obsessed with deploying to the ghost chain, but they have already built a powerful trading engine that can allow traders to migrate there. What if their new engine on Cosmos is much better than all other DEXs, to the extent that EVM users migrate en masse? I think we should focus most of our energy on core product features rather than supporting infrastructure. But at the same time, we should at least run some experiments to determine if there is enough trading volume on other chains to prove that cross-chain solutions are viable. But how do we do this?

Choice Three: Testing Profane Waters

I and some other OGs are responsible for the doctrine of pure SNX collateral, but our disciple Samantha, with many aliases, has elevated it to a crusade. Anyone who challenges the sanctity of pure SNX collateral must be burned alive or tied up and thrown into the lake, or preferably both. Even the noble duo of Fifa and ha-oN would not be forgiven if they were tempted by the filth of Ether collateral. However, we have a great opportunity to test potential network demand assumptions without the need for cross-chain SNX collateral. We can deploy perps on Base and enable ETH collateral as the only collateral. This will reduce the risk of transferring SNX liquidity from Optimism. This requires almost no cross-chain communication. The main challenge will be migrating fees to Optimism and burning them. But there is another potential option: we can use the fees generated on this network to buy back and burn SNX. This allows us to test two novel approaches simultaneously with relatively low risk. If either of these methods proves ineffective, we have established a foothold on the new network where we can subsequently upgrade and replace ETH collateral with SNX. We can also switch to burning debt on that network instead of conducting buybacks. This raises the final question: the optimal mechanism for incentivizing liquidity provision is to burn debt only on the network where liquidity is provided, rather than globally burning debt. If liquidity providers burn their debt regardless of which network they are on, we will have a free-rider problem, where it may be profitable even on a network with less liquidity, so we must accept that Synth tokens on multiple chains are either valid or invalid.

A New Hope

If we want to unlock ETH collateral on a new network, I believe that Base is the best choice. This will allow us to test incremental transaction volume without jeopardizing the transaction revenue on Optimism. It also has lower risks compared to Arbitrum. This should be beneficial for SNX LPs. The counterargument is that if we migrate SNX to Base and provide liquidity there, SNX will capture 100% of the fees on both networks instead of sharing fees. This is true, but the risk is small for SNX LPs because we control the governance. We can conduct this controlled experiment and then decide the most advantageous option for SNX holders after collecting data. This test is not one-way; if we have excess SNX collateral on Optimism, we can allow SNX to migrate to Base and enable it as collateral. This will dilute the yield of ETH and achieve a new balance. We can even implement an upper limit on ETH liquidity or remove it as collateral entirely. That’s why governance power must be fully in the hands of SNX LPs. It is crucial that this experiment will prove a hypothesis: there is incremental transaction volume on the new network without cannibalizing the existing transaction volume on Optimism. As long as the fee allocation for SNX is high enough, we should be able to understand the incremental revenue we can generate. I think we should start with a lower fee share and adjust it after gaining momentum. Capturing 40% of the fees for SNX LPs is a good starting point, and we can fine-tune from there. We need to determine if ETH LPs are willing to join this network; if the fee share for SNX is too high, we won’t be able to properly test the inclination of LP ETH.

What if this plan succeeds?

If we run this experiment and see strong demand for LP ETH and trading on the new chain, will we destroy SNX tokens? I don’t think so. If this plan succeeds, we can extend the experiment to other chains; Arbitrum and Polygon will be the two most obvious choices. At this point, we may already have enough data to realize that Optimism transactions are also constrained by SNX liquidity. If it seems to be the case, we can allow ETH collateral on Optimism. Furthermore, if it seems that the liquidity demand supported by ETH is much higher than the liquidity demand supported by SNX, we can even decide to disable SNX liquidity on Optimism. But if we do that, I think we need to take additional steps.

Owning our own chain

If, after running these experiments, the market demand for ETH-supported transactions is significantly higher than the demand for SNX-supported transactions, we must accept this fact and embrace it. The next step will be to create an application chain on the Optimism superchain. This will allow us to migrate governance to a chain we control; it will also be the place where you can obtain SNX leveraged sUSD loans. This is still a key feature of the Synthetix network and a key benefit of collateralizing SNX. I don’t think we even need to enable trading on this network because there is almost no ETH liquidity on it. This will be where all the backend functionality of SNX exists. If in the future, we believe we can efficiently develop a cross-chain shared liquidity system, this will be the place for liquidity deposit and delegation to other chains. It will require attracting ETH liquidity to the chain, but LPs may migrate to this chain if the returns are high enough.

Open Network

The LPs of SNX have always faced challenges due to the need for hedging, which poses very high risks. This, combined with high inflation, means that there are very few integrators willing to create equity solutions for SNX. By migrating to an application chain, we can reduce the risk of collateralizing SNX and completely eliminate inflation. This is expected to allow SNX collateral to be integrated into more platforms and open the network to a wider range of users. Currently, due to the need for hedging, the risk-adjusted returns for LPs are much lower. It is possible that SNX will still serve as the insurance fund for the network, but this does not require active maintenance and the risk is much smaller than continuous hedging.

What about cross-chain exchanges?

This new design can still support them; they will require CCIP, but in principle, even if the liquidity on each chain is independent, we can still support the interchangeability of Synths between chains. This does require cross-chain message passing, but it is not as cumbersome as supporting cross-chain liquidity. Bridging is still a very profitable and emerging market, and although the current best strategy is to focus on perpetual contracts, we should definitely continue to try Synth Teleporters and other novel mechanisms. This approach does not exclude this.

In summary

In summary, we face several technical challenges; we can bypass these challenges and test one of our core hypotheses. Is there a potential demand for trading on other networks? By leveraging ETH collateral, we can test this with almost no risk. If this plan is successful, we can expand this experiment to other networks. If this route appears to be correct, then we can migrate to our own application chain and charge fees from multiple networks, using ETH collateral and only using SNX to coordinate and manage the protocol. We will lose a portion of the overall market, but we can quickly scale up and avoid another protocol taking the dominant position. This is not a one-way door; we can test dedicated SNX collateral on any network at any time and set limits on ETH collateral or other collateral as needed. This allows us to quickly expand to multiple chains with almost no technical overhead. There is a lot of data to collect in this process, and we should iterate and test each step, as we have always done.

The key question I want to raise is: Would we rather have a portion of the overall market now, or would we be willing to wait longer to obtain 100% of future fees when deploying a real cross-chain implementation? The good news is that we may be able to have both. If the former is more profitable, we will eventually have a more accessible network where anyone can more easily collateralize and join the network, reducing the barrier to entry.

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