Synthetix – Bringing the World’s Assets Into DeFi

(9:12) Kain’s background and early experience in 2000’s era startup culture

(11:34) Starting Blushyft and getting into Bitcoin

(13:57) Playing cat and mouse, with banks, to provide fiat on-ramps for Australia

(15:26) Seeing the need for a crypto-native payments rail

(18:28) Pivot from stable-coins to all types of synthetic assets

(20:34) Organizational structure

(21:52) The token sale and Synthetix community

(23:13) Dealing with investors through pivots and road bumps

(25:44) How the Synthetix protocol works

(27:46) SNX token holders being counterparty to the creation of synthetic assets

(29:30) Deciding which assets to support and Uniswap’s role in price discovery

(34:21) Assets available via Synthetix

(36:02) Maintaining a peg

(38:38) Underlying mechanics, and incentive design

(40:15) Fees and staking

(41:25) Staking and minting assets for maximum user experience

(43:41) Initial supply, and inflation schedule

(44:28) Introducing ETH as collateral

(51:06) How the Synthetix exchange works, and relation with Uniswap

(52:44) More on the price oracle

(54:09) History with front running

(57:12) Ability to default on your debt, and proposed liquidation mechanism

(1:01:13) The role of under-collateralized systems, in the future

(1:03:45) The future for synthetix

Brian: Hi, we’re here today with Kain Warwick who’s the founder of Synthetix. Probably many of you have heard of it. It came from nowhere to the forefront of the defi attention space, and it’s now become the second largest protocol in terms of assets locked, after Maker. we’re really excited today to talk with Kain about how it works, how he got to it, and sort of the intricacies and vision of Synthetix. Thanks so much for joining us.

Kain: Yeah, absolutely. Thanks for having me.

Friederike: I often start by browsing the guests LinkedIn page, Kain’s was absolutely fascinating, your background is really eclectic. From your LinkedIn page, I got that you studied genetics at the University of New South Wales. You are United States Professional Tennis Association certified professional tennis instructor, and you were the vocalist and guitarist and keyboard of an emo punk rock band named the lies society, which performed in Victorian era outfits and toured the East Coast for a couple of years. You wrote a sci fi book named bending metal about an AI taking over, which can still be bought on Amazon. we can link to that in the show notes. You founded a number of companies, two of which you are still CEO. So who are you? What makes you tick?

Kain: My first real job out of University was working at a startup. A good friend of mine, we grew up playing tennis together. My dad was a professional tennis player, that’s where the tennis background comes from, my brothers and I play tennis, and one of my closest friends was a tennis player, as well. He went to the US and got caught up in this startup. He was like, “Hey, you should come to Seattle and work at the startup”.

In late 2000, early 2001, I turned up in Seattle to work at this startup. It was right before the Dot com crash, they were raising some money, and it didn’t work out. That got me into the idea of startups. I was involved in a couple of other startups after that, but I took a bit of a break again. The same friend of mine, we used to play guitar together, moved to Boston. He’s a psych professor. moved to Boston to get his PhD, and said, “Hey, why don’t you come to Boston and we’ll finally start this band?”

I moved to Boston, started a band, was there for five years. I’d been out of Australia for about 10 years and started to get the itch to come home, decided to come back and did another couple of startups. I’ve had a pretty diverse background, I suppose.

Brian: One company that you’re still involved with I’m curious about is called Blueshyft. What’s that? How did you start Blueshyft?

Kain: I was running an online retail business, and I shut that down. A friend of mine was working at a large consultancy, and I was looking for a job, to get out of the startup scene for a while. Take a break and go and just get a paycheck. So I started working at the consultancy, and about six or seven months in, a mentor of mine said, “hey, I’ve got this guy. He’s trying to launch this startup that needs a CEO. They’ve got funding but they don’t have any want to drive it. It’s basically going to take this network of independent owner operators and turn it into a National Retail network to provide services to a bunch of large national and multinational corporations.” And I said “Okay, that sounds interesting, but, no get away from me, I have no interest in doing a startup right now.”

He kept pestering me, and it took about four or five months, eventually I met the guy who was starting up, his name is Matt Hanbury, who is actually Rupert Murdoch’s nephew. He said, “I really want to do this thing. I’ve got the funding, you know I want you to do it” and so eventually I started it.

One of the reasons I started it, I saw the value in what we were trying to do, which was cash payments, over the counter, for cryptocurrency. From my online retail business in the past, I’d hooked up with a guy called Asher Tan, who runs CoinJar, and we started accepting Bitcoin for online retail purchases. There wasn’t much demand, this is going back to 2012, but I really saw value in being able to accept cash payments because of the chargeback issue for Bitcoin and other crypto. I reached out to Asher and I said, “Hey, would you be interested in doing this?” Eventually Asher came on, and a couple of other Bitcoin businesses, that were looking for a payment mechanism, to get money into crypto. So that took off. We’ve got some other services that we offer, but especially during the 2017 Bull Run, at one point we were processing $30 million a month, in crypto deposits, in Australia. Yeah, it was pretty crazy. Pretty crazy ride during that time.

Brian: So that was basically people would go to a convenience store, or something, they would give cash and then it would get credited to an exchange balance?

Kain: Yeah, yeah, exactly.

Brian: That’s so good. We just had Charlie Shrem on a few weeks ago and I don’t know if you remember his BitInstant business, which was doing exactly the same thing.

Kain: Yeah, exactly. Yeah, it was an Australian version of that. Back then, and even now, but especially back then, the Australian banks were really adversarial and aggressively shutting down any crypto business shutting down their bank accounts. Cat and mouse games were being played, all the crypto brokerages would set up 10 different entities, cycling through them, and different banks and stuff. We provided a stable onramp for them, that was always there, because we had 1500 different locations and the individual operator would deposit into their own bank account. It was a way of obfuscating the payment flow to a certain extent. We were lucky to avoid being shut down, or shut out by the banks.

Friederike: And this is still operational?

Kain: Yeah, it’s still working. We’ve still got about 1500 sites. We process a big chunk of the volume for most of the domestic exchanges and some of the overseas ones. Binance, for example, uses us, there’s a couple of other international exchanges that use us as well.

Friederike: But so when did you move on to the payments use of blockchain?

Kain: We always saw ourselves as a facilitator. Just a fiat on-ramp. We weren’t handling crypto payments. We weren’t dealing with any of the sort of challenging side of crypto, we weren’t dealing with wallet security or custody or anything like that. It was literally just very standard API integrations to allow cash payments.

When I saw the opportunity for Havven, back in 2016-2017, we started to see the spreads, in some of the smaller crypto markets, Korea, Australia, etc, grow because of what was happening. There was no real mining business in Australia. All crypto was being imported. We knew the demand was there, just wasn’t enough supply to support that. Spreads just kept creeping up. You couldn’t get it out of Australia fast enough to bring it back in. it just created this arbitrage opportunity. At the time, Tether was the only viable option. People had concerns about that, obviously, and DAI hadn’t launched. so we looked at and said, what you really need is a crypto payment network. A closed loop payment network, a PayPal, or something like that would be able to close the loop on this problem. That was where the Havven idea came from.

Brian: Can you explain the example of a big discrepancy in the crypto prices in Australia versus maybe a US or Europe or larger markets, how would that project solve the issue?

Kain: The idea was that you would have an alternative payment rail that people could use to offset the potential fiat limitations. Even with Tether, it still needs to move around. You still need to get into whichever bank they were using. The idea of having a fully crypto native payment network, collateralized by crypto, could potentially offset that. Anywhere you had crypto, get the crypto in, convert into the stable coins, and you didn’t need to necessarily get the fiat out of it. It could become a closed payment network, to close those off cycles. We never really got to the point of being able to test it in the market. It’s not clear that it would have worked. Mainly because one of the assumptions, built into that model, was that regulated stable coins wouldn’t be a thing, which obviously has proven not to be the case. You’ve got USDT and Paxos and a whole bunch of regulated stable coins that launched in the last two years. That sort of invalidated the use case of a crypto native solution to this problem.

Friederike: So you augmented the scope of your project, to the extent that I would actually call it a pivot. It’s no longer just stable coins, but all kinds of synthetic assets.

Kain: Yeah, essentially, we were building a synthetic US dollar, that was crypto collateralized, and that was self collateralized. Demand for access to this network would create more value, and would capture more value, and create more supply and was very self referential, and self contained, which is the one of the positives and one of the negatives, because there’s risk there. The advantage is that it is self contained. Once we realized that this synthetic US dollar was very much marginalized in terms of the market potential by regulated stable coins and even Maker, when DAI launched and really got a lot of adoption, it pushed us in this very narrow niche. We had to do something. The solution was, at the time, let’s add more fiat currencies. We had this idea that if you’ve got this network that can move between different fiat currencies natively within the payment network, that might be more viable. It turned out that wasn’t the case at all. That was another really dumb assumption. It was not until we launched gold, and Bitcoin, and other more volatile assets that there was any demand. People really didn’t want to trade synthetic euros, from what we could gather.

Brian: The fundamental system was the same back then already? Was the token already called SNX and used to collateralize the issuance of these different stable coins?

Kain: It was called Havven, the token. Fundamentally, it was the same thing. It was just that the debt you were issuing against the collateral was only a synthetic dollar. That was the only thing you could issue, now you can issue 20 different types of synthetic debt, but they’re all backed by this token that accrues value through activity within the networks, through transaction fees, essentially.

Friederike: Let’s do a deep dive into the protocol, in a little bit. I would like to talk about your company set up, first. You have a Swiss Foundation?

Kain: We’ve actually got an Australian foundation, we did look into the Swiss Foundation, but decided to domicile in Australia, which is a fairly stable regulatory environment. Maybe not as stable as Switzerland, but not too bad. It’s an Australian Foundation set up as a not for profit, essentially.

Brian: And what are your takeaways from the organizational structure that you guys chose? And the learning in terms of how you approach that? And maybe how you approach it today?

Kain: Yeah, I mean a lot of things in crypto are very path dependent. In 2017-2018, when we were doing our token sale, if you came out and said “this is a pure DAO, there’s no legal entity there’s no documentation or anything, it’s all done by smart contracts”, that would have been very difficult to get much traction. But if I could get in a time machine and do it all over again, I probably would push more aggressively on that and try and avoid some of these more traditional legal structures, I suppose.

Friederike: At the time, in 2017, you also did the token sale, correct?

Kain: Yes, it was early 2018. Feb of 2018.

Friederike: You collected 30 million? Is that correct?

Kain: Yeah, about 30 million US dollars, and a few hundred BTC.

Brian: Tell us about who participated, what does the Synthetix community look?

Kain: Yeah. Back in back in those days, about 90% of the sale came from institutional fund entities, there were some syndicates, and some other things around. Funds like Blocktower, Blockassets, some of the Asian funds went in, and then about 10% of it was retail. That structure of a large presale and then a small open public sale was the thing at the time. In hindsight, we could have had a better distribution. The impact of that distribution, what happened throughout 2018, as the price went from 65 cents down to three cents, was somewhat a reflection of that poor distribution.

Brian: Interesting. Those original investors, how did they deal with the pivots and strategy changes? Now, of course, Synthetix has found quite a lot of traction success, but there’s a lot of things in between where it didn’t look so good. How was it dealing with your investors?

Kain: Yeah, one of the mistakes that we made, which was definitely a mistake, but somewhat helped us was the fact that there was very little awareness of the project because we were off in the hinterlands in Australia. There weren’t too many people in San Francisco and even in Europe or other places that were aware of the project until really a few weeks before the sale.

What happened, there was a mad rush of people, stable coins were becoming a huge thing. Basis had done a big sale, and a few other projects were doing quite well, Maker was becoming a pretty hot project. We ended up in a situation where no one really got a large allocation of tokens. The maximum that anyone got was one and a half million dollars of that sale, which is pretty unusual for the time. Back then, oftentimes a single institution might take 10%, or 20%, or 30% of the tokens. What that meant is we were never that relevant to anyone. So even as the token price went down, and we failed to get traction and kept launching things and doing things but not really having any meaningful impact, I don’t think many people cared that much, to be honest.

We got to a point in December of 2018, after we launched multicurrency, and started to think about launching these alternative assets, and changing the monetary policy. We went out and canvassed the investors, they pretty much all said, “Do whatever you want, I don’t mind the token price is four cents, What? How much worse can it get?” That’s the thing where it was it was somewhat lucky that we were backs to the wall, where we had to take a pretty big swing at something and throw a hail mary to have the room to do what we did. If we’d been in a better position, it would have been much harder to get people to go along with such a huge pivot and change a whole bunch of things about the project.

Friederike: Thank you for those super candid insights. Throwing things at the wall and seeing what sticks is a lot of what startup life is about. Let’s deep dive into the protocol. Synthetix is a protocol for creating tokens that track the value of another asset. How exactly does it work?

Kain: We’ve got a single form of collateral, this will change, but we can go into it later, because we’re adding Ether, in the next few weeks, as a form of collateral. At the moment, you’ve got this collateral token called SNX. SNX is a governance token, and it’s a value accrual token. Whenever any activity happens within the network, the people who are staking SNX are paid fees. Whenever an exchange happens, an Synthetix exchange fee is collected and it’s paid to the token holders, and the token holders who are staking, essentially lock SNX into something akin to a CDP on maker, and mint these synthetic assets, and synthetic debt, that can be priced in any supported price feed. We’ve got six or seven different fiat currencies, commodities, gold and silver, a bunch of different crypto assets. We’ve got some crypto indexes, centralized exchange token index and a defi index. You’re really only limited by having a stable price feed that you can use to price this debt, people are issuing.

Friederike: So, these synthetic assets, are they just regular ERC 20 tokens?

Kain: They are. At the moment, all of them are freely tradable fungible ERC 20 tokens. If you get synthetic Bitcoin, for example, the ticker is SBDC. You can go on Etherscan, you can see that contract, you can see the total issued, amount of SBDC, the holders all the normal things you get with an ERC20 token.

Friederike: Okay, cool. just to make me fully understand how it actually works. I have SNX, and I stake them to create these synthetic assets, who’s actually the counterparty to that?

Kain: What’s probably the most novel \ crazy, depending on your perspective, aspect of this system is that it’s a pooled Counterparty model. All of the SNX holders are essentially a pooled Counterparty to all of this outstanding debt. So if you are holding debt, irrespective of whether you’ve minted it, if you’ve just bought it off market, Synthetix gives you the right to re-price that debt using any one of the oracles into anything you want. Let’s say you go to Uniswap and you buy some synthetic US dollars for DAI. Now you’ve got synthetic US dollars and just by holding those synthetic US dollars you have the right to turn up at Synthetix exchange and convert at the current spot rate into synthetic Bitcoin, synthetic Ether, or any one of the supported assets, like synthetic gold. The counterparty to these repricings, or exchanges, are the pool of SNX holders who have minted. They essentially take the other side of all these positions. It’s somewhat similar in the traditional finance paradigm to a clearing house. A clearing house within a bank, or a similar structure where anyone can come and trade against that clearing house and clearing house absorbs all that flow, and then externally hedges that flow, as they’re taking on those trades. That’s probably the closest analogy to what’s happening.

Friederike: So who curates the list of the supported assets? Do the SNX holders have some governance?

Kain: Yeah, so we still use a form of rough consensus. We don’t use on chain voting or anything like that. We believe, in the early days, it’s far safer to avoid things like plutocracy in token voting. We have fairly vigorous debates within our Discord community about which assets should be listed.

For example, there was an incident recently where we listed Maker, almost six months ago. When we listed it, we did a review of the liquidity, the number of exchange venues it was trading on, the average liquidity across those venues, total trading volume, asset distribution, how concentrated and centralized was it? That was all well and good, it passed our test. In hindsight, it probably shouldn’t have, we might not have been as stringent as we could have been, but over the last six months liquidity of Maker has declined significantly, when some of those venues that had significant volume dried up.

What’s actually happened is the vast majority of price discovery is happening on Uniswap. Uniswap is interesting for a number of reasons. I’m a huge fan of Uniswap myself. This is not necessarily criticism, but one of the idiosyncratic things about having price discovery on Uniswap, a trade on Uniswap is very deterministic as opposed to a trade in normal Counterparty matching venue. If you turn up at Binance, for example, and try and dump a whole bunch of something into the market, market makers are going to move away from you. People might try and counter-trade, a whole bunch of things can happen. With Uniswap, you have none of that. You literally turn up and you say, I’m going to dump this many tokens, and predict exactly what the price is going to be.

Someone did exactly that and started manipulating the spot market and taking the opposite position in Synthetix exchange and profiting from essentially manipulating the spot market into this derivatives market, which is interesting in a permissionless setting, because in the normal financial world, that would be illegal and it’s market manipulation, but in defi there’s not much you can do. We got to a point where we monitored, the community was looking at it. Interestingly, people did start counter trading this person on Uniswap, so it did become significantly less profitable. But it was still very high risk. so the community collectively after some debate decided that we would de-list, or at least pause, maker until we could review it. It’s very much a moving target in terms of which assets should be listed and the risk profiles, etc.

Brian: Interesting. This is maybe a slight detour, but do you know why makers volume is dried up so much?

Kain: It’s a number of factors, the transition to MCD caused some people to pull maker off exchanges, the float was very low to begin with, on exchanges. Going back maybe six months or a year ago, was 3%, or something that. It’s now less than 1%, if I remember correctly. There’s a really cool site called ViewBase, where you can view all of the ERC 20 token floats on all of the centralized exchanges and even decentralize exchanges. If you look at the graph of the maker float, it’s just really declined. To be totally honest, I’m not 100% sure. This is something that, in the future, we need to have much better handle of, in our continuous risk framework, monitoring these things and being aware of it.

Brian: So what this person did, they basically manipulated, they traded on Uniswap, and then Synthetix would use Uniswap as a price Oracle, do something there and benefit from it on Synthetix, and game the system that way.

Kain: Yeah, well, it’s interesting. There was, I think, a bit of misunderstanding in that people thought we were only relying on Uniswap. The issue was that so much of the price discovery had occurred to Uniswap for Maker, that it was somewhat irrelevant what was happening in other trading venues. Literally a trade would happen on Uniswap and the OB would go up, but the market was so thin on all of the other venues that the OB was really inefficient, and it would just move the price. Effectively, even though you’re looking at 10 different trading venues, you are really just looking at one.

Brian: Tell us a little bit about the assets you can trade. You mentioned before we different fiat stable coins, then there are some crypto assets, and also the inverse of crypto assets, where you can basically go short. Why those assets, and what plans for other assets do you have?

Kain: Yeah, so the idea was essentially being a clearinghouse, What you don’t want is things like adverse selection, and you don’t want to have a highly skewed market. We want something that’s as close to market neutral as possible. We do have significant adverse selection now, because most of the people who were trading on Synthetix exchange are SNX holders. SNX holders, like a lot of people in defi, tend to be fairly bullish on the overall prospects of defi, crypto, and Ethereum and all those things. We have a very high skew towards a long bias. Even in the decline from July, we were still extremely long, even while the rest of the market was fairly net short. This is something we introduced as a way to balance the market these inverse synths, but the adoption hasn’t been as good as we would like, mainly because we don’t have a very good organic cohort of traders who are more representative of the overall market, which is a reflection on just where the project is. We haven’t put as much focus on building out marketing and awareness, as we will this year.

Friederike: So for all of your assets, how do you maintain your peg? If you look at sUSD, it often trades for significantly less than $1. Why is that?

Kain: It’s somewhat about price discovery, I suppose. It depends on where you’re looking at that price. Coinmarketcap only takes into account KuCoin, which is the only centralized exchange that sUSD trades on, and the volume daily of sUSD on KuCoin is a few thousand dollars. The vast majority of the volumes occurring on Uniswap. But CMC doesn’t take into account Uniswap, which isn’t to say that the peg is perfect. It tends to be somewhere between %2.5 and 1% off. This is something that obviously we’re working on. We’ve got similar issues to what maker had last year where there was an oversupply and we need to correct that. But oftentimes you’ll see on CMC, it might be trading at 93 cents or something. but $50 worth of trades happened at that price. So it is a little bit of a reflection of poor information that’s contained on some of these sites. The best place is to look at Uniswap.info, for example, where you see the effective rate, the real rate.

Friederike: So what levers do you have, in order to stay closer to the real peg?

Kain: Probably the strongest one is the collateralization ratio. We made a decision last year mid last year, because the price of SNX had risen quickly, there was an oversupply of synthetic assets. The market really wasn’t absorbing them quickly, so we made a decision to raise the ratio from 500 to 750, which essentially had the impact of people needing to buy back debt, to be fully collateralized, and able to claim fees, and do the stuff we wanted them to do. That worked fairly effectively, it brought the peg back up, obviously, the price has continued to rise even through that point. The price was 30 cents or something that when we raised the C ratio, so that’s a big lever that we could still pull. I think you alluded to the capital inefficiency of that. There is a psychological threshold where you raise the C ratio up to 1,000%, or something, and people start looking at it as a super inefficient system. There’s a bit of tension between those things.

Friederike: Okay, let’s look at the underlying mechanics first. You talked about the collateralization ratio being 750%, meaning you actually have to deposit 750% in collateral for any things that are created. What happens if the value of SNX falls or the value of SNX rises? When it rises, not that big of a problem. But say falls and you’re under collateralized, so you’re way below 750%.

Kain: So we don’t currently have liquidation built into the system, mainly because the collateralization ratio is so high. The likelihood we go from 750 to 100% or become under collateralized is pretty low. During 2018, I think the absolute worst was about 150% collateralized,from 500%, which was a 70% draw down in price, I think, across the entire network from where people minted. Part of the reason for that is the incentives to restore your C ratio were not strong enough, that was only based on the exchange fees, which were quite low, or the transfer fees which were quite low. People were basically just sitting there and not fixing their ratios and the price continued to decline. The incentives are much stronger now. Because we have the inflationary supply, people tend to respond fairly quickly. There’s still a bit of a lag. That’s a two week lag, because we do have two weeks where you can claim your fees. If you’re under collateralized for more than two weeks, you’ll start to lose fees.

Friederike: Let’s go back a little bit. you can’t be liquidated, but you do face some consequences in that you don’t collect fees. We haven’t actually spoken about the fees yet. tell us about how when you’re not under collateralized, what fees are issued and what you need to do to get them, and then to what extent are they taken away as soon as you’re under collateralized?

Kain: Yeah, so so when you are staking, you are eligible for fees, and those fees accrue across each fee period, which is a one week period.

Friederike: Who pays them? where do the fees come from?

Kain: The fees come from two places. One is from inflation, as part of our monetary policy, paying inflation to people who remain collateralized and maintain the network. Then the second incentive is coming from exchange fees. Every time people convert one synthetic asset to another, they pay a 50 basis point fee, which is put into a pool. Depending on your proportion of the network that you represent, you get your pro-rata share of those fees each week.

Brian: Yeah, and the thing worth pointing out here, is that just to clarify, is that what you’re doing when you talk about staking. What that means is you’re putting up SNX as collateral and you take one of those assets. So, in a way, it’s almost a hybrid form of mint an asset, and you’re staking, then you getting rewarded for that. It also means that if you’re a SNX holder and you want to benefit from the future potential of SNX from the trading fees and all that, you have to mint an asset. At least to do it fully right, so that you get the inflationary rewards, and the staking fees. It’s a nice design in terms of forcing people to actually engage with the system.

Kain: Yeah, yeah. I mean, that was the intent. I come from Bitcoin land, back in the day. I used to run mining software, on my PC at home, and went through all the pain of trying to get that up and running. Bitcoin did a very good job of incentivizing people to understand how the network worked by getting people to install mining software and try to mine and do all those things.

One of the flaws I suppose, in the token boom, in Ethereum the ICO boom, was that the ERC 20 standard has a default fixed supply of tokens. We’re going to mint, a million tokens 10 million, 100 billion, whatever crazy number you want. You just mint that number of tokens and they magically appear, and scarcity is supposed to take care of all the rest of the problems. The reality is that if a protocol, in the early days, can’t incentivize people to understand how to use it, then it’s very, very hard for to get adoption and get people to do the thing that you want. That’s the reason why we changed the monetary policy to, as you say, force people to learn how the system works, and then make a decision if they like it or not.

Friederike: That’s a super smart move. Can you put some numbers on this? So how many SNX tokens were initially created, and what does the inflation look like, currently?

Kain: There were 100 million created, then in March of 2019, we went out to a lot of stakeholders and said, this isn’t working we’re not incentivizing this properly, we want to change the policy. Over the next four years, we want to go from 100 million to 250 million. With initially 75 million in the first year, additional tokens minted so by the end of the first year, we’d be at 175 million, and then having each year after that. That was the initial intent was to go from 100 million to 250 million. Which is pretty high inflation, but our argument was we needed strong incentives to turn things around.

Brian: You mentioned other types of collateral, ETH will also be supported in the future. What’s that going to look like? How is it going to differ from the usage of SMX, as collateral? In the case of ETH being used as collateral, do you still consider that staking or something different.

Kain: It’s a hybrid lending, staking. What it means is that some of the synths in circulation, the synthetic assets are backed, by Ether. But the people who have minted those ETH backed synths still have the right, like any other synth, to trade those synths into any other asset, they can reprice them. The risk or the counterparties to those trades are only the SNX stakers. If you lock ETH, and you get synthetic ETH and you start trading and you are in profit, the cost of those profits are borne by all the SNX stackers, and the trade off is that the SNX stakers get all of the fees from all of the trades, and they get all of the inflation rewards from everything that the system is generating. The people who have minted synthetics with ETH get nothing all they get is the ability to trade. It’s a different way to get in a system that’s lower risk, but hopefully will generate more trading activity.

Friederike: So how do you hope to compete with this against Maker, because currently, I mean you can stake Ether, and other assets with Maker. If you produce DAI, you can also collect savings, which I believe is around 6%. How do you think Synthetix can compete with this?

Kain: It’s appealing to two different categories of people. The people who are locking ETH and getting synthetic ETH, eventually, trading on synthetic exchange, maybe trading 10, 50, 100x leverage Bitcoin contracts. That’s a very different prospect to Maker where it’s the idea is to lock some ETH and get a stable yield, maybe you’re getting some ETH leverage. They’re very different risk profiles for the different groups of people that we’re targeting.

Brian: That ties into a little bit if you previous thing around this inverse, lack of interest in going short. It feels like an almost obvious consequence. I mean, if you have to have a long SNX exposure to mint one of those assets, who is going to have long SNX exposure, but short ETH, the intersection may be small. How do you think that’s going to be addressed in the future?

Kain: It’s a very good point. So at the moment, it’s this very self contained system right where the 95% of the trading activity is people that already minted. The intent was never for that to be the case, the intent is that minters are providing a service. The people are staking SNX and providing this debt are taking a risk and taking playing a role in providing this service. It should be totally separate people that have no idea necessarily how minting and staking and risk management and hedging or how any of those things work. All they know is they can get some sUSD or whatever and they can open up a leverage long position trading Bitcoin on a totally non custodial dex, in a similar way to say Bitmex, but they don’t need to be stakers in order to do that. They just need to have acquired some synthetic assets somewhere on Uniswap or wherever.

Brian: But stakers still have to worry about the assets they’re issuing, even if they’re selling it after it’s because if that asset let’s say it goes up then they have put more collateral, so they have this interest.

Kain: 100% our expectation is that SNX stakers are likely to be net long. They’re net long SNX, to your point. Things are highly correlated, they’re probably going to be net long ETH or BTC or whatever. But someone who’s coming on to Synthetix exchange who wants to, say, short Tron doesn’t have any interest in necessarily you know what the stakers position is. They can just go on and start trading, and we should have a much more representative sample, I suppose, as the organic trading activity happens, of what the regular markets are doing.

Even if you look at the last six months, the market has been net short, price has been going down. yet we’ve been super net long that entire time. It’s representative that we don’t have organic trading activity going on yet. That’s, to be totally honest, been a purposeful exercise. We haven’t wanted to bring external organic traders from other trading venues onto Synthetix exchange because experience is terrible right now. It’s a really bad experience. it would be extremely porous funnel for us to try and bring people into this exchange, the only people who are willing to put up with how bad the experience is, are the Synthetix minters themselves right now. It’s a consequence of the structure and where we are as a project, I suppose.

Friederike: So the way that the project is currently set up the total amount of synthetic assets that can be minted, it has to be smaller than the market cap of SNX. I mean, that’s going to change as soon as you allow ETH as a collateral. How do you see this working? So basically, what share of synthetic assets do you expect to be backed by Ether? What was the thought process behind creating it this way?

Kain: The core assumption behind that is that you’re going to have a fairly high velocity of the synthetic assets. We’ve seen this, even just today, we crossed a billion dollars worth of trading activity. The maximum synthetic assets that we’ve ever had on issue over last year was 35 million or 40 million or something like that. The velocity has been something 25 or 30x last year. To be honest, that’s very low in a trading venue like this. If you look at something like Bitmex, the total deposits versus the trading activity daily it could be 100 or 200 times higher, particularly when you factor in leverage. We look at this as not a huge constraint, I suppose, because it’s really the velocity of those assets within the exchange rather than the total supply that’s available, obviously with bigger supply, you can have more trading activity. We don’t see it as a short term constraint certainly.

Brian: With regards to trading and exchanging you’re talking about Synthetix as an exchange. When you try out the Synthetix exchange, the product there, you also send to Uniswap, at various times. Can you explain a little bit how the Synthetix exchange works? Where does Uniswap come in? And how did the two play together?

Kain: When Uniswap launched, because we have this need for an on-ramp, we need a way to onboard people into the synth ecosystem, they need access to synthetic assets. Once they’ve got synthetic assets, they can do all the cool stuff, they can reprice them, they can trade them etc. You need a deep liquidity pool between the regular ETH ecosystem, and the synth ecosystem, otherwise people will have high slippage and high friction to get in and out. We, alongside the community, came up with the idea of incentivizing a large and deep liquidity pool on uni-swap, to ensure that there was a very liquid on-ramp and off-ramp between Synthetix and the wider Ethereum ecosystem. If you’ve got ETH and you want to avail yourself of this ability to trade synthetic Bitcoin, you need to get that ETH into synthetic ETH or synthetic USD somehow. As we stand now, we’re the deepest pool in Uniswap, about 40% of the total liquidity and Uniswap is in the synthetic ETH pool. So you can trade 10 or 15, or $20,000 worth of ETH with pretty minimal slippage into synthetic ETH, and then start trading on Synthetix exchange. It’s the deposit mechanism into the exchange, if you will.

Friederike: So let’s talk about the price oracle for a bit. You alluded to this previously. It’s a mix of different exchanges that you’re using for the price oracle, can you go a bit into how exactly it works?

Kain: When we launched this, we needed a price oracle, obviously. There really wasn’t anything on the Ethereum mainnet that was a price oracle. There were pretty minimal solutions, Maker had their ETH\USD oracle, which is pretty slow. Fairly robust and fairly decentralized but very slow, and not really going to be suitable for what we were doing, which needed five minute updates, at the worst case. We had to build our own oracle, because there wasn’t anything that was available. We, after building that, realize the amount of effort and upkeep and issues that are entailed by running your own centralized oracle, it’s a massive attack vector. We’ll maybe talk about that attack vector in a second. But we made a decision mid last year to really try and find a solution that would allow us to offload this Oracle responsibility on to another project focused on that. After a bunch of research, we landed with Chainlink. Late last year, we moved all of our fiat currencies onto Chainlink. Fiat currencies are a lot less volatile than crypto. It was a safe first step. Then over the next probably month or two will migrate the rest of our assets on the Chainlink.

Brian: There’s a history, having an issue with the price Oracle, tell us what happened back then.

Kain: We’ve had front running bots, and people hear front running and think, I know what that is. In the context of a pooled liquidity model, it’s a bit different to a Counterparty matching situation where bids and orders are getting sniped. Ox, for example, front running is different to our front-running. In our case, what people were doing is front running the oracle. They would look in the mempool, see when a price oracle update was happening, trade into that asset and then trade out of it and provided the delta between the prices was above the fees are being charged, they could profit from it.

We’ve had this cat and mouse game to improve the system, to mitigate that and reduce that. Before we implemented a lot of those solutions, there was an Oracle outage. One evening Australia time was two in the morning, we had an issue the previous day one of the API’s for forex had gone down. Then another API also started failing. We had this issue, we used a medianiser, but the medianiser didn’t understand this price was an outlier, because the price was going up and down. It was publishing a price, and then changing the price, and the difference between the two prices was 1000x on the Korean won.

We had this situation where one of the front runners said, Oh, okay, I noticed a discrepancy. It didn’t care or even know the discrepancy was 1000x. It was just looking for any discrepancy above 30 basis points. It traded into Korean won from synthetic ETH. When the price changed back, 20 minutes later, traded back in, and over the course of four or five trades generated something like $10 billion worth of synthetic ETH through these trades.

At the time, as CTO was overseas who’s in Madagascar on dial up internet or something, and we were alerted to this through some monitoring, and the community and a few other people started talking about it. Unfortunately, I was asleep. I was woken up at 630 in the morning, we had this catastrophe. Luckily, our CTO and a couple of the other team members were able to pull the system, we have the ability to hold the system.

Then we started this essentially hostage negotiation with the person who had done this was looking for some cash to get essentially paid out to roll the trades back. We had a tense negotiation to work out a way to roll the trades back so we didn’t have to fork the system and have some catastrophic rollback. Thankfully, we were able to negotiate with the person and sorted out it subsequently degenerated and there was a lot of acrimonious finger pointing back and forth about how it was handled and what have you. But luckily for the system’s sake, we were able to resolve it. That’s the risk of oracles that are not robust enough.

Friederike: That’s a valuable lesson to learn. in retrospect, and actually, it’s quite an entertaining story. I’m sure it was absolutely nerve wracking at the time, being in a hostage negotiation like that. When we’re on the topic, I’d like to speak about a second attack vector of way to exploit the system, which wouldn’t bring it down, but… you currently require 750% collateralization. Seeing that the only thing that is actually done, if you don’t comply, you don’t get fees. As soon as you get below the 100% mark you, in essence, have a free option of actually defaulting on your debt. Paying it in the future if the price of SNX goes up or the price of the asset goes down. Was this a deliberate design choice?

Kain: It was done, I suppose, as an expedient design choice in the sense that we had a view that the incentives as they stood, combined with the high collateralization ratio, were probably sufficient to avoid a scenario where we got close enough that liquidation was even going to kick in. We also had internally especially in the early days, when we were writing the white paper and discussing some of these mechanism designs, significant dispute between a couple of the team members about how liquidation should be handled, and even how asset issuance should be handled.

We decided to kick the can down the road and say, let’s see, in practice, how it works with this high collateralization ratio, observe it and then we can make a decision as to how to implement liquidation based on what we observed empirically. In a way that was good, it was high risk. A lot of things that we do we tend to take a fairly high risk approach to, let’s gather empirical data, even if that empirical data might kill us. We’re sitting here x raying ourselves, right, and not realizing sometimes the impact of it.

The end result is we do gather much more valuable and important data, at times, then we would if we attempted to constrain the system more. We now have a fairly robust liquidation mechanism that’s been proposed, that will be implemented in the next month or two. What that really unlocks for us, it removes the Black Swan optical risk, which we’ve absorbed now to 50 plus percent corrections over the course of a pretty small amount of time without system blowing up. But what it also does is allows us, not in the short term, in the future, to reduce the collateralization ratio from say, 750 down to maybe something more like 250% or 200%, over time. That’s only possible if you have liquidation. It just allows the system to grow but at the moment, we’ve been able to survive without it, thankfully, but it’s definitely an issue people see as a risk factor.

Friederike: About this proposed liquidation, how will it work?

Kain: If you fall below a threshold, which is yet to be determined, but let’s for the sake of argument, call it 200%. If your position falls below 200% collateralization ratio, anyone in the system will be able to send synths, so we’ll be able to essentially pay your debt back for you. They will be able to collect the equivalent amount of SNX plus a penalty that was backing that. In the case of 200%, let’s say you’d be able to send your $10,000 with the sUSD, you get $10,000 worth of SNX plus 10% penalty.

Friederike: So this is very close to the maker mechanism.

Kain: It’s very similar, anyone can essentially just turn up and pay your debt for you. The difference to the maker system is that the entire CDP doesn’t get unwound. It’s proportionally unwound, so we fix the C ratio And then you still have the chance to come back and fix it. You can get hit again, etc. It doesn’t unwind the entire thing. It just unwinds it by little slices.

Friederike: Oh, that sounds super promising. I’m looking forward to that.

Brian: Synthetix is an over collateralized system, and your maker and in general the defi has relied on this maximum collateralization for its security. In the traditional finance world, there’s a lot of under-collateralization. it seems it’s something that’s starting to get explored a little bit in the blockchain world. What are your thoughts on that? Do you think defi in the long run and Synthetix will rely on over-collateralization? What’s going to be the role of under-collateralized systems?

Kain: I used to have a view that under-collateralized permissionless systems were somewhat of a contradiction in terms right. You need some trust there. Over the last few months, I’ve spoken to several different teams and I’ve come across several different other projects and are working on systems that rely on some Web of Trust type model, where I know you and therefore I’ll lend to you, I’ll vouch for you. I take some risk on your behalf.

Ultimately under-collateralized loans resolve to some legal enforcement. People with guns turn up in your house eventually, and say you need to pay this back, or throw you into debtors jail or whatever. Traditional system has been reliant on that, to the point of not needing to solve that problem. If you’ve got people with guns, they’re pretty good solution to people who aren’t paying their debts. It seems there are some potential design patterns and mechanism designs that could allow for this to happen. Particularly, once you get fully on-chain assets that could potentially be used but confiscatable.

For example, someone wants to get some NFT or some game card, like God’s unchained, and they want to buy it and it’s $10,000 to buy this item in the game, it would be possible to create some wrapped contract whereby if they don’t pay back that loan over time, then eventually the assets confiscated in the same way that your house would be confiscated if you didn’t pay your mortgage, provided that asset is fully natively on the blockchain. It’s when you get off chain stuff that it becomes more interesting, but I’m much more hopeful than I was six months ago.

Brian: That makes sense. I’m curious also with Synthetix, what is your very long term vision? What do you hope this system will look like in five or 10 years, and what impact on the world it will have.

Kain: I mean, Synthetix is interesting right now because people are very excited about the potential. The way I see Synthetix the analogy that I use is it’s really just a giant hole in the ground. If you want to build a skyscraper or a big building or whatever you need a really deep hole first. Certain people turn up and go, Wow, that’s a really big hole, I can see what’s coming, and there’s certain people just see that’s a giant hole. What are you talking about?

We haven’t yet even come close to demonstrating the effectiveness, in the reality. We’ve got a very theoretical value that we’ve created, some people can see that the next year for us is going to be all about finding genuine product market fit, bringing in those organic traders and seeing will someone come and trade on this venue given the alternatives they have at Binance or Bitmex or Derabit or FTX or whatever. That’s the first step.

We can get that right and we can prove that dexes work and that derivatives dex or a futures dex or whatever, can gain significant traction. which I personally believe. The next step from there is how do we extend that? That’s where we start talking about some of the other asset classes that we could add, equities, indices, etc. that’s where it gets really exciting because now you’re making available these asset classes that are maybe not as accessible, in a lot of places in the world. They don’t need a bank account, all they need is some fiat on ramp, some way to get fiat into Ethereum ecosystem, and they can get access to ETFs and equities and bonds, and all kinds of money market, all kinds of assets that we take for granted, and vice versa. The first stage is let’s prove that this is viable and that it’s self sustaining, that it can actually generate enough activity and enough users that it can work, and then we can start building from there.

Friederike: So you’ve come out pretty strongly in favor of decentralization, also as a means of sidestepping compliance to a certain extent. I mean, even when you were talking just now you were pitting DEX against centralized exchanges. How do you think that’s going to develop in the future?

Kain: Bitcoin proved that you can build something that is unregulatable. That’s phase shift in a lot of people’s minds. That’s what got people very excited about Bitcoin. All of the touch points in the real world with Bitcoin that allow it to be functional, the exchanges and fiat on ramps and all that stuff. All that infrastructure is regulated, centralized exchanges, and OTC desks and all of that stuff that we’ve built up to make Bitcoin work.

The thing that is most exciting about Ethereum is that all of that infrastructure is being absorbed into the chain itself. You don’t need as much infrastructure on the outside to support the functionality of the system. as more and more of that’s absorbed into Ethereum you have this fully unregulatable infrastructure that anyone can build on.

For me the most exciting thing about that is when you lower barriers to entry, and you create a highly competitive environment, you get much faster innovation and iteration and get some really cool stuff. we’ve just crossed a tipping point with that in theme over the last six to 12 months where you just can’t even keep up with the crazy stuff that people are building now, on an hourly basis. someone’s, hey, there’s this thing and this thing and this thing, and a lot of that stuff is not going to work and no one’s going to care, and they’re not going to want it. If even one out of 50 of those things becomes hugely valuable to a large group of people, we’re just in a different reality. For me, that’s the most exciting thing about this.

Brian: Oh, yeah, I mean, that’s definitely a clear vision as well, you have this exchange, down the line, where you can trade all kinds of assets. You see this being 10s of thousands, hundreds of thousands of assets at some point and just a gigantic market?

Kain: The challenge that we have, in this model of Synthetix exchange, we’re somewhat constrained in the assets we can list because of the counterparty risk that all the stakers take on. As opposed to say something like UMA as a purely Counterparty driven system, they’ve got liquidity challenges, potentially, but they don’t have the counterparty risk challenge that we have. we’ve made a different set of trade offs. If you look at how something like UMA and Synthetix could fuse down the line and composability could enable that, then you could actually have an ecosystem where people could borrow some liquidity from Synthetix exchange to create these highly exotic things like the shitcoin index that they were talking about for San Francisco, and some really cool assets that track different price feeds, for example. As these things coalesce you’ve got a whole bunch of products that Maker, DYDX, maka protocol, you will make us all these different synthetic asset issuance platforms. There will be some convergence that will enable us to have every asset that exists on Ethereum and then a whole bunch of assets that have never existed.

Brian: Well, okay, thanks so much for coming on. It’s great to learn about Synthetix, super exciting, what you guys are building and what’s coming up. I look forward to following and seeing how it develops.

Kain: Awesome. Thanks so much guys, I had a great time.