Rethinking DeFi Tokenomics What is the ideal token model?

Tokens must start providing revenue share as well as governance.

A token is a right to earnings

The underlying tools of modern token design can be traced back to the goal of reducing the speed of utility tokens. While governance capabilities create a more compelling reason to hold utility tokens, many of these tokens are still struggling to accumulate value efficiently and lack mechanisms to retain value in irrational market behavior. As a result, there is a growing consensus within the Web3 community that tokens must start providing revenue share as well as governance.

It’s worth noting that offering revenue-sharing tokens to holders may make them look more like securities. While many would use this to object to DeFi tokens offering revenue share, it is also true that unless this change occurs, DeFi as a whole will continue to exist as a mass speculative market. If DeFi is to gain mainstream legitimacy, it is unacceptable that all token price movements experience near-perfect positive correlations, in which case the protocol’s different profitability levels are not reflected in token price movements. While there is an obvious concern that transitioning to tokens becoming earning rights may increase their security-like properties, it is misleading to think that tokens would still serve only as governance rights when considering the path to adoption over the long term.

As summarized in DeFi Man’s article, today there are two main ways to distribute revenue to token holders:

  1. Buy back the native protocol token from the market and (1) distribute it to holders, (2) burn it, or (3) keep it in the protocol’s treasury.
  2. Redistribute protocol revenue to token holders

Yearn.finance made waves after announcing plans to update its token economy model and issue buybacks last December. As a result, YFI prices rebounded by 85% in the short term. While this is only a temporary spike, the strong desire for a better value-added token model is palpable. However, in the long run, the share of distributing protocol revenue is clearly better than token buybacks. The primary goal of any DAO should be to maximize the value of long-term token holders. As Hasu writes, “Every dollar owned by an agreement or received as revenue should be allocated to its most advantageous use (translated to the present)“. Therefore, a DAO is only ideal if its native token is undervalued.

A protocol for the adoption of revenue shares for its token holders establishes measurable cash flow, enabling a standard valuation framework that applies to all tokens. Valuing tokens through the income paid to token holders also requires a reassessment of income paid to liquidity providers. When analyzing the revenue generated by an agreement, a common approach is to divide the revenue into two categories: the agreement and the LP. Assessing the value of tokens through the income distributed to token holders exposes the true face of LP income – an operating fee.

Rethinking DeFi tokenomics, what is the ideal token model?

More and more protocols have begun to establish revenue sharing with governance tokenists. GMX, in particular, has set a new precedent. For context, GMX is a zero-slippage, decentralized Avalanche and Arbitrum perpetual futures and spot exchange. GMX subscribers receive 30% of the agreed fee, while LPs receive the other 70%. Fees are paid in $ETH and $AVAX instead of $GMX. Similar to growth stocks that keep their earnings instead of paying dividends, many believe that paying token holders fees instead of reinvesting them into the protocol’s pool is detrimental to the long-term development of the protocol itself. However, GMX shows that this is not the case. Despite sharing revenue with token holders, GMX continues to innovate and develop new products such as X4 and PvP AMM.

In general, reinvestment only makes sense if an agreement or company is able to make better use of the accumulated funds rather than distributing them to stakeholders. DAOs tend to be less efficient at managing capital and have a decentralized network of contributors outside of their core teams. For these two reasons, most DAOs should be in distributing revenue to stakeholders earlier than their centralized, Web2 counterparts.

Learn from past experience: burn and staking

Terra

Although Landra’s collapse is harmful, it is highly educational and offers many insights into shaping the future of a sustainable token model. In the short term, Terra proved that burning tokens is an effective way for tokens to accumulate and capture value. Of course, however, this did not last long. In manipulating the burn rate of $LUNA through the Anchor Protocol, Terra caused an unwarranted, unsustainable reduction in the supply of $LUNA. While supply manipulation ignited the fuse for self-destruction, Tera’s collapse was ultimately due to how easy it was to expand the supply of $LUNA even after a series of supply contraction.

Rethinking DeFi tokenomics, what is the ideal token model?

(3,3) Tokenomics

At the end of 2021, the decline of (3,3) game theory also brought many revelations. OlympusDAO demonstrates that staking a significant portion of a protocol’s native token can drive a significant increase in short-term token prices. However, we later learned that if stakers are allowed to exit at any time, and the impact is minimal, they do so at the expense of other stakers.

Rethinking DeFi tokenomics, what is the ideal token model?

Rebases is implemented to actively strengthen staking. If a user takes a stake, he/she receives “free” tokens to maintain his/her current market cap share. In reality, anyone who wants to sell doesn’t care about being diluted when unlocked. Due to the nature of rebases, those who enter first and exit first profit by utilizing newcomers as their exit liquidity. In order to implement sustainable dividends in the future, harsher penalties must be imposed on those who cancel them. In addition, those who release their staking later should benefit from those who release them earlier.

Ve tokenomics

The common theme of all previously failed token models is their lack of sustainability. A widely adopted token model that attempts to sustainably increase the accumulation of token value is Curve’s ve model. By incentivizing token holders to lock up their tokens for up to 4 years in exchange for inflationary rewards and increased governance power, the model attempts to implement a more sustainable staking mechanism. Although the short-term effect of VE is good, there are two main problems with this model:

  1. Inflation is an indirect tax on all token holders that negatively affects the accumulation of token value
  2. When these lock-up periods finally end, there may be a massive sell-off.

When comparing ve and (3,3), one similarity between these models is that they both offer inflationary rewards in exchange for the promise of token holders. The lock-up period can act as a curb selling pressure in the short term, but once the inflationary reward becomes less valuable over time and the lock-up period expires, there will be a large sell-off. In a sense, VE is comparable to time-locked yield mining.

Ideal token model

Unlike the volatile token models of the past, the ideal token model of the future will sustainably adjust the incentives for users, investors, and founders. When Yearn.finance’s ve-based tokenomics initiative (YIP-65) was proposed, they claimed to have built their model around several key motivations, some of which could be applied to other projects:

  1. Implementation of token buybacks (distribution of revenue to token holders)
  2. Build a sustainable ecosystem
  3. Motivate a long-term view of the project
  4. Disproportionately reward those who are most loyal

With these principles in mind, I propose a new token model that attempts to provide stability and value accumulation through taxation.

Patterns of income and taxation

As I determined earlier, an ideal token design would entitle holders to governance, as well as a share of the protocol’s revenue when staking. In this mode, the user must pay “tax” to unlock the lockout, not the lock-up period. While unlocked taxes/penalties are not unique to this model, the mechanism associated with taxation is. The unlock tax that users have to pay is determined by a percentage of the number of tokens they stake. A portion of the taxed tokens will be distributed proportionally to other policyholders in the pool, and the other portion will be burned. For example, if a user stakes 100 tokens and the tax rate is 15%, they will spend 15 tokens to unlock. In this example, if the user chooses to unstake, 2/3 of the tax (10 tokens) will be distributed proportionally to the other policyholders in the pool, while 1/3 of the tax (5 tokens) will be burned.

This system disproportionately rewards the most loyal users. Token holders who stay longer benefit the most relative to their peers. It also reduces downside volatility during market sell-offs. Theoretically, if someone unpledges, it’s because revenue has fallen or is predicted to decline in the near future. When viewing agreement revenue as a pie, the decrease in revenue can be seen as the overall pie shrinking. In the previous example, the taxed tokens were distributed to those who were still staked, increasing their piece of the pie and reducing their losses.

Rethinking DeFi tokenomics, what is the ideal token model?

The burned 1/3 of the tax will exert deflationary pressure on the token supply, thereby increasing the overall token price. In the long run, burning will push the token supply to follow an exponential decay pattern. The chart above shows how holders may lose less if they continue to hold during a market sell-off, while the graph below shows how the burned tax portion reduces losses for all token holders, held or unheld.

Rethinking DeFi tokenomics, what is the ideal token model?

The graph reflects the inward shift in token demand due to reduced protocol revenue. As a result, a portion of investors unstaked their tokens for sale. In the process of unstaking, a part of their tokens are burned. The burning mechanism of the tax reduces the total token supply and shifts the supply curve to the left. The result is a smaller drop in the token’s price.

If protocol revenue drops significantly and whales decide to unstake and throw their tokens, the worst of this model will happen. Given that Convex currently controls 50% of all veCRV, this could mean half of the tokens being unstaked and sold. If most tokens are staked before selling, even with taxes, this will inevitably crash the token price in the short term. This underscores that regardless of what staking/burndown mechanism a protocol may implement, tokens remain worthless if the underlying protocol cannot generate revenue. However, suppose in this example, protocol revenue will rebound in the near future. Those who remain staked after the whale dump will receive 5% of the total token supply, which will be reduced by 2.5%, greatly increasing their share of future revenue.

Since the prevalence of whales is inevitable, further refinement of this proposed tax could be the implementation of a progressive tax. While progressive taxation may prove difficult to implement, agreements may utilize analytical tools, such as Chainalysis, or build their own in-house tools to enforce it. It is difficult to say what the best solution to implement progressive taxation will be. It is clear that more research and development is needed to answer this question. We look forward to any further studies clarifying this issue.

Whether a flat tax or a progressive tax is implemented, the agreements should adopt this revenue-sharing and taxation model only after accumulating a significant amount of TVL. At the beginning of a protocol’s lifecycle, priority should be given to channeling liquidity, decentralizing its tokens, and building market traction. Because of this, in the early stages of the protocol’s development, the token model built around yield farming may play a positive role in its long-term development. However, as the protocol matures, its priorities must shift from guiding TVL to creating long-term, sustainable token value accumulation. Therefore, it must adopt different token models to better align economic incentives with new goals. Compound is an example of a protocol that has not changed its token design to meet its stage of maturity. Despite accumulating a large amount of TVL and generating a lot of revenue, these value creations are rarely realized by $COMP holders. In an ideal world, the profitability of a protocol should be reflected in its token price, however, this is only occasional.

Rethinking DeFi tokenomics, what is the ideal token model?

Compound TVL + market capitalization

Conclusive reflections

The most important thing about this proposed token model is that it is sustainable. Staking incentives are more sustainable because they benefit those who are “first-in, first-out” rather than the typical first-in, first-out (FIFO) accounting principle. The token burning element in the design is more sustainable because it is unidirectional (supply can only contract). If there’s one takeaway from the recent market downturn, it’s that sustainability matters. While Web3’s path will be led by disruptive innovation and greater user adoption, none of this would be possible without a more sustainable token model that effectively accumulates and retains value.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/rethinking-defi-tokenomics-what-is-the-ideal-token-model/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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