Vincent A Saulys' Blog
DeFi Tokenomics
Tags: crypto defi
May 22, 2021

Decentralized finance has become one of the hottest trends in the past year. Aided by the programmable money of Ethereum and the permission-less nature of cryptocurrencies, decentralized finance (DeFi for short) has allowed all sorts of solutions to economic problems.

But an interseting development that fell out of this is that of DeFi tokens. While there are many guides to cryptocurrency DeFi, very few touch on these aspects. Unlike the ICOs or ERC20 tokens of the past, DeFi tokens are backed by real economic value. But why do they exist? What are they worth? Are they worth anything?

Why have DeFi tokens at all?

The core challenge of any DeFi ecosystem is how to keep liquidity present. People should be able to interact with it as seamlessly as they could with a centralized exchange. Without an entity backing the transactions, people would normally be forced into an ad hoc system where they have to find people for any specific trade. This creates a "betting" nature whereby people take one side of a trade solely to bet on that crypto. LocaBitcoins, Bisq, and other exchanges do work this way but ideally people on every side should prosper simply for participating.

Enter Uniswap. Though perhaps not the first DeFi exchange, it was (arguably) the first to get big. Uniswap incentivizes people to stake their money into a huge liquid pool, stored on the ethereum mainnet chain, which straddles two sides of a bet. Using simple equations to decide the spot price of a trade, people can swap any two tokens on the ethereum mainnet instantly for whatever amount they want.

Uniswap incentivizes people to become liquidity providers by giving them a cut of all fees (currently 2%). This system has worked brilliantly and Uniswap ended up with billions in total value locked (TVL).

Uniswap TVL

But can we do better?

Liquidity Provision as a token

Some liquidity providers opted to take a different route than Uniswap.

When you enter into a liquidity pool, Uniswap has your funds locked up into an ethereum smart contract. These can be thought of as programs. This money stays there until your wallet "unlocks" from the pool and you get your money back.

Compound Finance, Aave, and Yearn Finance (among many others) went a different route. Instead of locking your funds in a smart contract, they would issue you a different token. These tokens are prefixed by the real underlyin asset: cTokens for Compound, yTokens for Year, and aTokens for Aave.

Such tokens are best thought of as deposit receipts. Yearn Finance explicitly refers to them as such here. They entitle the person to a cut of the funds present in the liquidity pool plus some interest to incentivize keeping the liquidity present.

They all work a little differently. cTokens entitle you to an underlying principal of ethereum plus interest over time. At year X, this interest will be worth more so each cToken can be exchanged for more ethereum. [1] yTokens give you a guaranteed cut of the total pool of liquidity, which should become more over time. Under this system, all fees are added to the total liquidity pool instead of being redistributed.

This new token is now a new asset backed by real income denominated in ethereum. That's very different from past tokens whose value was theoretical at best! You can take this asset and trade it on other exchanges.

This is all reminscent of early finance. Starting in the 19th century, factory owners would build goods for a given merchant who would not pay until delivery. That meant the factory owner was out the cash until then. Factories would then sell these to banks for less than they would pay out so they could get some compensation upfront. Overtime, these commercial papers emerged in balance sheets. Banks eventually started to swap these agreements around as part of general trading.

That's the financial game going on here. People are swapping these minted proxy tokens for other assets. This dynamic, especially in this incredibly decentralized way, is less than a year old in the crypto space.

DeFi tokens as governance

Something to note with these decentralized exchanges is that they are, in fact, decentralized. Nobody owns them. They typically run on the ethereum network. You pay gas fees in order to execute trades on the underlying smart contracts. [2]

So how does this decentralized exchange make decisions?

Enter decentralized autonomous organizations, also known as DAOs. These orgs that live in the cloud vote on proposals, including disperal fees and otherwise.

They work by having a huge initial sale resulting in a net pool of money typically called a treasury. This treasury can then be spent however the governance token holders deem appropriate. How those governance token holders vote or contribute is on the discretion of the particular DAO.

A big example of this is MakerDAO which issues DAI, a stablecoin that backs every dollar with an overcollateralized amount of digital assets like ethereum. People can vote to change all the fees associated with this. For the sake of time, it will not be gone into detail here though its interesting to read its whitepaper.

Uniswap issued its own governance token last year in September. It is now the 13th most valued crypto on CoinGecko as of this posting. The only value of its governance token is to vote in proposals. Other governance vote-only tokens include $YFI on yearn finance.

Pancakeswap's CAKE token as guarnateeing liquidity

Using proxy tokens like aToken is not the only way to guarantee liquidity. Pancakeswap has created a way of guarnateeing liquidity by making people stake its own minted CAKE token.

picture of
pancakeswap

When you open up Pancakeswap, you may notice that there's a lot to do. There's staking and farming, liquidity swap pools, loterries, and so on and so forth.

In order to faciliate all this activity, pancakeswap did away with specific incentives like liquidity pools and opted for a staking mechanism. [3] What you do is provide Ethereum or any number of assets, and $CAKE is generated. Right now, there is a lot of $CAKE being generated.

picture of current CAKE
APR

This cake token is then used to participate in other parts of the sites. When redeemed or otherwise used, it is burned off.

The idea behind staking is simple: you put in ethereum or any other asset. This adds ethereum to the total pool and guarantees it can be used for liquidity pools in all sorts of applications. You are given a new token as a reward which, while not a clean proxy like the yTokens mentioned above, is a piece of ownership in the liquid system of Pancakeswap.

This system enables bootstrapping and allows for more creative uses of the total liquidity. This includes, for instance, loterries which would otherwise be difficult, if not impossible, to incentivize in a decentarlized way.

Governance tokens go farther with Duck

Governance tokens don't just allow for voting. You can do a lot more with them.

Take AAVE. This is the governance token of the aave protocol. It entitles the user to smaller fees.

Most interesting is the DUCK protocol at unit.xyz. This token entitles the user to a cut of the liquidation fees.

The Unit protocol exists to collateralize any asset into an equivalent dollar asset minted as USDP minus stable fees. If the user is unable to pay back the USDP, the asset is liquidated. Duck uses oracles to determine the price of assets.

When this asset is liquidated or stable fees paid, each holder of the duck token gets paid. That amount is yielding 20% right now (!) as margin traders borrow on their assets to buy more using the minted USDP. This is an incredibly lucrative token to own as a result.

Do these tokens inflate the value?

During the DeFi craze, many exchanges offered hefty token returns to get people to stake on their protocol. Most notorious was Compound Finance with its COMP governance tokens which were given at high rates for either borrowing or lending. Such a huge increase in COMP tokens has likely cramped the value of them.

This bears noting as Pancakeswap gives you 100+% APR return on staking ethereum in its ecosystem. Are those CAKE tokens really worth as much as a result? Crypto enables you to peek at how much CAKE tokens exist so perhaps you have some indication.

These practices have heard cries of "ponzi!" attached to them. If you're getting all these tokens for free on every action, aren't you making value "out of thin air" without assets to back it?

It's not entirely clear to what extend this is true. No judgement is being passed on whether its legitimate. Rather, its mentioned to give you something to think about.

The End?...

(Incomplete) List of Defi Projects

Footnotes

[1] Thus, there is expected to be a natural increase in price of each cToken. cTokens are burned upon the exchange.

[2] All these are available for looking at which too. You can see Uniswap's on Github or on Etherscan. You'll note that Etherscan is a bit harder to read; exchanges are typically spread amongst a few smart contracts.

[3] Use of "staking" and "liquidity pool provider" is virtually the same mechanism in practice: participating in an ecosystem by providing more liquid assets (bitcoin, ethereum, etc.) and getting fees or proxy tokens in return. Thus they are used interchangeably though some may take issue with that.

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