Synthetix Founder Reassessing Synthetix’s Multi-chain Vision and Liquidity Sharing

Synthetix Founder reevaluates multi-chain vision and liquidity sharing.

This article will focus on the SNX token and its role in the ecosystem.

Author: Kain.eth

With the official launch of Synthetix V3, now is the best time to question past assumptions to ensure that the community stays aligned with the long-term vision. This article will focus on the SNX token and its role in the ecosystem.

Multi-chain

• Vitalik Buterin’s latest paper How Privacy Pool Protocol Protects User Privacy and Meets Regulatory Requirements.
• Consensys Strategic Director Decentralized Infura to be launched by the end of this year
• Data Interpretation Performance Comparison between GMX V1 and V2

Synthetix has a grand vision. Deploying the Synthetix protocol on multiple chains is much more challenging than most other DeFi protocols. This is because most protocols deploy separate instances on each chain, which introduces operational complexity but is the simplest way to maintain presence across multiple networks. Then, many protocols control these different instances through unified governance. While this adds additional complexity, governance usually operates off-chain or on a single network. Some protocols go even further, where an operation on one chain affects all other chains. This can be achieved through cross-chain bridges, liquidity management, or shared clearing, among other forms. Protocols can also support interoperability of cross-chain assets on-chain through wrappers or bridges. As early as early 2020, the Synthetix community envisioned an even grander scenario: a single protocol spanning multiple networks, where the system behaves as if every operation on each chain happens on a unified chain. While we are closer to achieving this goal than three years ago, it remains challenging. There are still many unresolved technical challenges that need to be addressed. Given the developments in the cryptocurrency space in recent years, it’s worth reconsidering whether this multi-chain approach is still the best way forward.

Why Share Liquidity?

Imagine deploying Synthetix on five different EVM networks. SNX tokens can seamlessly move between 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 provide SNX LP there and offer liquidity for the other four supported networks. However, there is a potential contradiction here: if she only trusts Mainnet, why would she support liquidity on other networks? Bob can provide SNX LP on Optimism and offer liquidity for Mainnet, Optimism, and Base. Carol can provide LP on Avalanche and offer liquidity only for that network. The market should theoretically solve this issue, with liquidity flowing to where there is the highest trading demand. This design assumes that each network has a certain proportion of unique users who only trade 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 liquidity providers to offer cross-network liquidity from any network. In Synthetix V3, a market represents a single asset, such as sBTC, and a pool allows liquidity providers to send liquidity to a market aggregator and then delegate to multiple markets. The main pool will be the SLianGuairtan Pool, which will contain all “officially supported” markets. In Synthetix V2x, there is only one pool that contains all supported markets, and all liquidity providers are forced to delegate liquidity to this pool.

Okay, let’s take a look at a specific trader to understand what impact this will have on them. Let’s assume this trader only trades on Base. They like to engage in ETH swing trading; in order to ensure they can continually open new positions, there must be sufficient liquidity delegated to the Base SLianGuairtan Pool and/or delegated to the Base ETH pool. Please note that in this setup, it doesn’t require anyone to provide liquidity on Base; all of this liquidity can come from the Mainnet or other chains. This is effective for Base traders because the demand for sETH on Base will cause liquidity providers on other networks to directly delegate liquidity to this Base market through a single market pool or a pool containing ETH markets.

In order for this implementation to take effect, a large amount of cross-chain communication is required. In fact, this is a very large task, especially as the number of supported networks increases. This can be achieved through CCIP and some upcoming Chainlink infrastructure, but the question we must ask ourselves here is not “can we do it?” but “should we do it?”

What do we want to achieve?

In the end, we want to have an efficient liquidity market where the demand on any chain can be met by the supply on that chain. One assumption is that liquidity is limited, so we must be able to share liquidity between networks to avoid liquidity fragmentation, which means trading can be done on each network, but due to the limited liquidity being overly dispersed, liquidity on all networks is poor. This leads to a cold start problem: insufficient liquidity on any network will suppress demand, reducing the incentive to provide further liquidity. Currently, liquidity is limited, but some liquidity is more limited than others. Part of the reason for this multi-chain complexity is that the community realizes that in the short term, SNX liquidity is unlikely to be sufficient to meet the demand on all networks. Therefore, in order to avoid introducing other collateral, we must twist ourselves into various forms to achieve this cross-chain liquidity system and avoid fragmentation of limited SNX liquidity. What I want to point out here is that I believe that in the long run, if there is demand, the SNX token will expand to support the required liquidity level. The problem is that in a bear market, this is a lagging process and the demand does not increase SNX collateral enough. Therefore, we are forced to make a compromise: increase the complexity of the system to consolidate the role of SNX as the primary collateral, or find a compromise.

Why not just stay on Optimism?

One key assumption of this investigation is that the market must exist on every chain. I think this is a reasonable assumption. But it is an assumption that we should question. A similar situation is if Coinbase had a separate exchange for every operating system, so no matter which operating system you prefer, you can trade. On Debian, how much liquidity can be expected on Coinbase? This analogy deviates slightly from the point; a better analogy is if Coinbase had different markets for each database engine to cater to user preferences. Do users have strong enough database preferences to influence their use of trading platforms? However, this is exactly the situation we currently face in the cryptocurrency field. Some people firmly support specific chains and even refuse to acknowledge or trade on other networks. Why do we see this situation on smart contract platforms but not on databases? In this analogy, databases are the state storage layer of CeFi, while L1/L2 networks are the execution and/or state storage layers of DeFi. The reason is simple: it’s called tokens. While supporters of database engines may be annoying, there is no mechanism to pass this technological tribalism onto end users. In the cryptocurrency field, we have established 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 networks.

Perpetual Fragmentation?

Well, it’s not surprising that there is user fragmentation at the execution level, and it seems that we are temporarily stuck in this situation. Although users ultimately want practicality, they are also highly motivated to have this practicality only exist on the network they support. Therefore, even if we build the most optimized exchange in history, if it only exists on one chain, it will be isolated and unable to receive the attention it deserves. This is particularly evident when competitors – centralized exchanges – can choose any technology stack and put all users into a single database, and no one cares. This means that all their liquidity is on one island, which is a huge advantage that cross-chain decentralized exchanges cannot compare with. By the way, one way to solve this problem is to abstract the network and make it more like a centralized exchange; this is exactly the experiment that Infinex intends to try. From the perspective of Synthetix, this is a valuable experiment. However, Synthetix must optimize for the reality of Infinex’s failure, which means that as a protocol, it must meet users on every chain where they want to trade or provide liquidity.

What choices do we have?

If we accept that the Synthetix protocol needs to appear where the users are, how can it get there? In my opinion, there are three methods.

1. Deploy a forked version of Synthetix on each chain;

2. Implement a unified cross-chain protocol where state changes must be pushed to all chains;

3. Deploy a separate instance on each new chain and minimize cross-chain messages and fragmentation of liquidity by utilizing non-SNX collateral.

Choice 1: Forking all the way

This is not a feasible method, although it may be interesting to do so. The main issue that prevents us from doing this is the dependency on SNX tokens as collateral. If you have 10 forked SNX tokens, they are likely to depreciate and significantly reduce liquidity on each fork, thus defeating the purpose of avoiding liquidity fragmentation. Most protocols simply need to deploy new instances of their contracts and let liquidity flow to the new network on its own; Aave and Uniswap are good examples. For Synthetix, we need a substantial amount of SNX as collateral on the network, and we also have a lot of governance overhead. Therefore, we may need to fork SNX tokens on each network. You can test this process with Base. We can deploy a brand new instance of Synthetix, including SNX, and prefix ‘b’ to all tokens. So, we will have bSNX, bsUSD, and bsBTC. Although this may be interesting, I don’t think it’s our best hope. But again, this could be very interesting, and I’m not saying we shouldn’t consider this method. One advantage of forking today compared to a few years ago is that deployment has become easier. In the past, even deploying Synthetix to a network could take several days. At that time, even if each deployment was independent, deploying multiple instances across networks was not feasible.

Option 2: Unified Liquidity Theory

This method only requires solving all technical issues and building a network protocol that can sustain all necessary cross-chain messaging. Then we can continue to rely solely on SNX collateral. This is theoretically good, and we are moving in this direction, but what if our assumptions above are wrong? What if none of these chains have enough independent users to generate incremental trading volume? What if we spend too much time building this supporting infrastructure, and another protocol builds a much better single network solution than all other decentralized exchanges, and users start migrating to that protocol? There is a precedent here: dYdX, but they have built a powerful enough trading engine that traders are willing to migrate there. If their new engine on Cosmos is much better than all other DEXs, will Ethereum Virtual Machine users migrate on a large scale? 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 conduct some experiments to determine if there is enough trading volume on other chains to justify the need for cross-chain solutions.

Option 3: Explore the Forbidden Zone

Some of us OGs have a dogmatic belief in pure SNX collateral. Anyone challenging the sanctity of pure SNX collateral must be burned or thrown into the lake (a metaphor). Even Fifa and ha-oN, the noble duo, would not be spared from this fate if they were tempted by the dirtiness of Ethereum collateral. However, we have an excellent opportunity to test potential network demand assumptions without the need for cross-chain SNX collateral. We can deploy perpetual contracts to Base and use Ethereum as the sole collateral. This will reduce the risk of transferring SNX liquidity from Optimism. It requires almost no cross-chain communication. The main issue will be migrating and burning fees to Optimism. But there is another potential option: we can use the fees generated on that network to buy back and burn SNX. This allows us to test two novel approaches simultaneously with relatively low risk. If one of the methods is ineffective, we have already established a foothold on the new network to later upgrade and replace Ethereum collateral with SNX. We can also switch back to burning debt on that network instead of conducting buybacks. This brings up the final question: the optimal incentive mechanism for liquidity providers is to burn debt only on the network where liquidity is provided, rather than burning global debt. Regardless of where they provide LP, we create a “free-rider” problem, and it may be beneficial to camp on the “safest” network even if it is not the highest-demand network, even if that network doesn’t have the highest demand, it may be profitable to stay on the “safest” network.

New Hope

If we release ETH collateral on a new network, I think Base is the best choice. This will allow us to increase trading volume without threatening transaction revenue on Optimism. It also has lower risks compared to Arbitrum. This should be a win for SNX liquidity providers. The counterargument is that if we have people 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 for SNX liquidity providers, the risk is minimal because we have governance control. We can conduct this controlled experiment and then decide the best option for SNX holders based on data. This test is not one-way; if we have too much SNX collateral on Optimism, we can allow SNX to migrate to Base and use it as collateral. This will dilute the earnings from ETH and achieve a new balance. We can even impose limits on ETH liquidity or remove it as collateral altogether. That’s why governance must be fully in the hands of SNX liquidity providers. It is crucial that this experiment proves a point, that there is incremental trading volume on a new network without harming the existing volume on Optimism. As long as the fee split for SNX is high enough, we should be able to understand the incremental revenue we can generate. I think we should start at a lower level and adjust as we progress. Capturing 40% of fees from SNX liquidity providers is a good starting point, and we can adjust from there. We need to determine if ETH liquidity providers are willing to join the network; if the fee split for SNX is too high, we won’t be able to accurately test people’s inclination to provide ETH liquidity.

What if this plan works?

If we conduct this experiment and see strong demand for LP ETH and trading on the new chain, should we burn SNX tokens? I don’t think so. If this plan works, we can extend the experiment to other chains; Arbitrum and Polygon may be the most obvious choices. By then, we may have enough data to realize that Optimism trading is also limited by SNX liquidity. If that’s the case, we can also allow ETH as collateral on Optimism. Furthermore, if it appears that ETH-backed liquidity demand is much higher than SNX-backed liquidity demand, we can even decide to disable SNX liquidity on Optimism. However, if we do that, I think we need to take additional measures.

Our own chain

If, after conducting these experiments, the market shows a much higher demand for ETH-backed transactions than SNX-backed transactions, we have to accept this and leverage it. The next step will be to create an AppChain on the Optimism superchain. This will allow us to migrate governance to a chain controlled by us; it will also be the place where you can get leveraged sUSD loans on SNX. This is still a key feature of the Synthetix network and one of the main benefits of collateralizing SNX. I don’t think we even need to enable trading on this network because there is very little ETH liquidity on that network. This will be the network where all the backend functionality of SNX resides. If in the future we believe we can efficiently develop a cross-chain shared liquidity system, this will be the place where liquidity exists and is delegated to other chains.

Open Network

Providing liquidity for SNX has always been challenging and highly risky due to the need for hedging. This problem, coupled with high inflation rates, means that few integrators are willing to create staking solutions for SNX. By migrating to an AppChain, we can reduce the risk of staking SNX and completely eliminate inflation. This will potentially allow staking SNX to be integrated into more platforms and open the network to a wider range of users. Now, due to hedging requirements, the risk-adjusted returns for liquidity providers are much lower. SNX may still serve as the insurance fund for the network, but this does not require active maintenance and carries much lower risk than continuous hedging.

What about cross-chain swaps?

They can still be supported in this new design; they will require CCIP, but in principle, even with liquidity on each chain, we can still support the interchangeability of Synths between chains. This does require cross-chain messaging, but it is not as cumbersome as supporting cross-chain liquidity. Cross-chain is still a very lucrative and emerging market, and although focusing on perpetual contracts is currently the optimal strategy, we should definitely continue to experiment with Synth Teleporters and other innovative mechanisms.

Summary

In summary, we face several technical challenges: we can bypass these challenges and test one of our core assumptions. Is there potential demand for transactions on other networks? We can achieve this by leveraging ETH collateral with minimal risk. If this solution proves successful, we can expand this experiment to other networks. If this path looks promising, we can migrate to our own AppChain and collect fees from multiple networks, utilizing ETH collateral and only using SNX to coordinate and govern the protocol. We give up a portion of the total fees, but we can scale quickly and avoid another protocol dominating. We can test exclusive SNX collateral on any network at any time and limit ETH collateral or other collateral as needed. This allows us to quickly expand to multiple chains with minimal technical overhead. There is a lot of data to collect in this process, and we should test each step gradually, as we have always done in Synthetix.

The key question I want to raise is: are we willing to obtain a certain percentage of the total addressable fees now or wait longer to capture 100% of future fees when we are ready to deploy a true cross-chain implementation? The good news is that we have the possibility to have both. If it proves more profitable, we will ultimately have a more accessible network where anyone can easily stake and join the network with much lower barriers to entry.

We will continue to update Blocking; if you have any questions or suggestions, please contact us!