[Web3] Sustainability Checks for Tokenomics and Protocols
Disclaimer: This post is for informational purposes only, and the author is not liable for the consequences arising from any investment or legal decision based on the information contained in this post. Nothing contained in this post suggests or recommends investing in any particular asset. Making any decisions based only on the information or content of this post is NOT advised.
TL;DR
1) Bear markets are a great opportunity to examine the sustainability of major protocols because they are free of the noise associated with speculation.
2) The sustainability of a protocol and the sustainability of tokenomics should be separated. Considering token incentives as spending, the total revenue generated by the protocol as revenue, and the portion of revenue that contributes directly or indirectly to the accumulation of token value as token value accrual, revenue must exceed spending for the protocol to be sustainable. Furthermore, for tokenomics to be sustainable, the token value accrual must exceed spending.
3) MakerDao, 1inch Network, and Perpetual Protocol serve as examples where both protocols and tokenomics demonstrate sustainability. Conversely, Lido, Aave, Uniswap, and GMX are examples of sustainable protocols, but tokenomics is not. Lastly, Balancer and Stargate are examples where neither protocols nor tokenomics are sustainable.
1. Introduction
The year 2022 posed challenges for crypto investors, characterized by falling asset prices compared to the rising trends of 2020 and 2021. However, bear markets provide a unique opportunity to contemplate the essence of blockchain and tokenomics. In bull markets, protocols may appear innovative, and tokenomics seems like a magical support system for the economy, but bear markets unveil the reality behind the illusion. The noise of bull markets can distract us from critically assessing protocols and tokenomics. Amid uncertainties about the current bear market, it is essential to take a closer look at the sustainability of major protocols.
For a protocol to be economically sustainable, the generated revenue and value must exceed spending. In this context, spending primarily comprises token incentives offered by protocols to encourage user contributions, such as DeFi liquidity providers and bounty program participants. These tokens, minted through smart contracts based on predetermined tokenomics, dilute the value of the tokens, directly affecting the utility and governance of the protocol. Consequently, the tokens provided as incentives are considered the protocol’s spending.
Protocols attract users through token incentives, while users contribute fees for their activities and usage within the protocol, constituting revenue. To achieve ultimate sustainability, the value of the token incentives minted to attract users must exceed the value of the fee revenue users pay to use the protocol. Consistently having the former greater than the latter is akin to real-world loss-making businesses.
It is crucial to differentiate between the sustainability of the protocol and the sustainability of tokenomics. For instance, while Uniswap’s protocol may be highly sustainable, the tokenomics of the UNI token, lacking a value accrual mechanism, may not be sustainable. In assessing tokenomics sustainability, it becomes necessary to examine how much of the protocol’s revenue contributes to the token's value. There are cases where the token’s value accrual mechanism and the protocol’s revenue generation can be separate, as exemplified by Uniswap.
As a final note before diving into the main protocol examples, I will summarize sustainability in this article as follows:
- Sustainability of the Protocol: This refers to a situation where the revenue generated by the protocol surpasses the value (spending) of the token incentives minted.
- Sustainability of Tokenomics: This pertains to a scenario where the value of the token incentives minted (spending) exceeds the total value of tokens accrued as revenue.
Let’s assess the sustainability of each protocol by analyzing their respective business models for revenue generation and the allocation of token incentives to foster network effects. The data for spending, revenue, and token value accrual is sourced from the token terminal, and I will provide a brief overview of how each protocol measures its revenue and token value accrual, as these metrics may vary from one protocol to another.
2. When Both the Protocol and Tokenomics Are Sustainable
2.1 MakerDAO
Overview — MakerDao is a stablecoin lending platform that enables users to deposit their cryptocurrency holdings into the protocol and lends overcollateralized stablecoins, known as DAI, to other DeFi protocols based on specified Loan-to-Value (LTV) ratios.
Spending (Minting) — In the context of MakerDao’s token MKR, minting or burning occurs under specific conditions during processes like liquidation. However, it is not typically minted for user incentives.
Revenue — MakerDao’s revenue originates from three primary sources: 1) interest paid by DAI borrowers, 2) fees collected from collateral liquidation events, and 3) fees associated with trading stablecoins on the Price Stability Module (PSM). The PSM module aids in maintaining the DAI’s peg to its target value.
Sustainability of the Protocol (Spending < Revenue) — The protocol demonstrates sustainability due to its ability to generate income without incurring expenses.
Token Value Accrual — MakerDao allocates its revenues for three key purposes: 1) supporting protocol development and covering operational costs, 2) maintaining buffer funds to handle unexpected liquidation events, and 3) executing buyback and burn activities of MKR tokens.
Sustainability of Tokenomics (Minting < Value Accrual) — The tokenomics of MakerDao is deemed sustainable as the protocol incorporates a mechanism for burning tokens in the absence of minting.
Overall Verdict — MakerDAO is currently experiencing steady protocol revenue without the need for spending token incentives. Over the past year, it has generated $62.1M in revenue. These revenues are primarily designated for burning MKR tokens, with a portion intended for stabilizing the value of DAI. However, there have been recent observations that the burning system has not been executed as planned, as highlighted in [Web3] Valuation of DeFi Lending Protocols: Compound, Aave, MakerDao by Kevin. To ensure the sustainability of tokenomics, it becomes imperative to restart or automate the burning system.
Despite not providing MKR token rewards to MakerDAO users, the demand for DAI is anticipated to remain steady. DAI has firmly established itself as one of the leading decentralized stablecoins in the Ethereum ecosystem, securing its position and serving as a prominent choice among users.
2.2 1inch
Overview — 1inch is a highly prominent DEX aggregator that operates as an intermediary between users and decentralized exchanges (DEXes) on the blockchain network. By utilizing algorithms, it strives to offer the most favorable trading conditions for users.
Spending (Minting) — The 1inch token is minted as an incentive to encourage liquidity provision in specific liquidity pools where the 1inch token is present. Additionally, it is utilized to promote behaviors that benefit the overall protocol.
Revenue — 1inch generates its revenue primarily from positive slippage occurring during the swap process. Slippage is the variance between the intended execution price and the actual execution price. Positive slippage signifies the slippage that results in revenue.
Sustainability of the Protocol (Spending < Revenue) — The protocol exhibits sustainability as the revenue generated surpasses the token incentive spending.
Token Value Accrual — The entirety of the revenue generated is directed into the treasury of 1inch DAO. Consequently, 1inch token stakers indirectly benefit from this arrangement as the treasury’s growth contributes to the value accrual of their tokens.
Sustainability of Tokenomics (Minting < Value Accrual) — The tokenomics of 1inch is deemed sustainable due to the sales value accrual surpassing the dilution of value caused by minting tokens as incentives.
Overall Verdict — 1inch has allocated $15.5M for token incentives in the past year while simultaneously generating $36.5M in revenue. This revenue is directed straight into the treasury, resulting in indirect benefits for both 1inch token stakers and participants involved in the platform’s governance. However, despite this setup, the tokenomics of 1inch lacks a direct causal relationship between the growth of the treasury and the token price. Token holders benefit from the growth of the DAO Treasury due to their control over it, but this benefit does not originate from a direct cause-and-effect relationship.
In contrast to tokens like GMX, which have a profit distribution system (to be discussed later), the absence of such a mechanism in the 1inch token raises questions about the sustainability of its tokenomics. Nevertheless, 1inch stands as one of the most prominent DEX aggregators, enjoying consistent service demand. This, in turn, contributes to the expectation that 1inch will continue to maintain its sustainability at the protocol level.
2.3 Perpetual Protocol
Overview — Perpetual Protocol functions as a decentralized futures exchange, allowing users to deposit collateral and engage in futures trading or, alternatively, earn trading fees by providing liquidity to the futures exchange.
Spending (Minting) — PERP tokens are utilized as incentives to incentivize liquidity providers and PERP stakers, encouraging their participation in the protocol.
Revenue — Perpetual Protocol generates revenue by collecting fees paid by traders utilizing the futures exchange for their transactions.
Sustainability of the protocol (Spending < Revenue) — The protocol exhibits sustainability as the revenue generated surpasses the token incentive spending.
Token Value Accrual — Perpetual Protocol’s revenue is distributed among various channels, including liquidity providers, token stakers, insurance pools, and treasuries. Some of the revenue also directly benefits PERP token stakers. It’s important to note that when analyzing statistics for 0.5 years instead of 1 year, the value accrual is lower than the minting, which indicates a potential lack of sustainability. (Refer to the last table in the provided data).
Sustainability of Tokenomics (Minting < Value Accrual) — The tokenomics of Perpetual Protocol is considered sustainable, as the sales value accrual outweighs the dilution of value caused by minting tokens as incentives.
Overall Verdict — Over the course of a year, Perpetual protocol allocated $6.3M for token incentives and generated $24.6M in revenue. The generated revenue is distributed diversely among various stakeholders, making it an appealing protocol economy with favorable tokenomics. The pace of token incentive spending is currently slowing down, and futures exchanges continue to be in high demand on the blockchain, indicating that Perpetual Protocol is likely to remain sustainable in the foreseeable future.
3. When the Protocol Is Sustainable, but Its Tokenomics Is Not
3.1 Lido
Overview — Lido serves as the largest liquid staking platform, enabling users to stake native tokens from different networks, including Ethereum, and obtain securitized tokens for further utilization in various DeFi applications.
Spending (Minting) — Lido’s native token, LDO, is not regularly minted but instead utilized as token incentives to enhance liquidity across different liquidity pools or bridges.
Revenue — Lido’s revenue primarily comprises the rewards generated from staking activities.
Sustainability of the Protocol (Spending < Revenue) — Lido demonstrates sustainability as its revenue surpasses the token incentive spending.
Token Value Accrual — Approximately 10% of the revenue is allocated between the node operator and the Lido Treasury. However, the graph indicates that the value accumulated in the Lido Treasury managed by LDO holders is currently less than the token incentives minted, implying a lack of sustainability at this stage.
Sustainability of Tokenomics (Minting > Value Accrual) — In practice, the value accumulated in the Lido Treasury through LDO token holdings falls short of the token incentives minted, suggesting that the current tokenomics is not sustainable.
Overall Verdict — Over a year, Lido expended $102.3M in token incentives and yielded $326.9M in revenue. To ensure sustainability, Lido may need to reevaluate the value accrual mechanism of the LDO token or potentially reduce token incentives in the future. Despite leading in the liquid staking domain, Lido may benefit from reducing token incentives while increasing revenue as the network effect grows and protocol usage surges.
3.2 Aave
Overview — Aave is a prominent lending protocol that enables users to deposit various cryptocurrencies and borrow other cryptocurrencies using their collateral.
Spending (Minting) — Aave’s native token, AAVE, is issued as an incentive to both depositors and borrowers for specific cryptocurrencies. The rate of token issuance is gradually decreasing.
Revenue — Aave’s primary revenue stream comes from the interest borrowers pay on the borrowed amounts.
Sustainability of the Protocol (Spending < Revenue) -Initially, the protocol experienced higher spending than revenue, but this situation has been reversed, and it can now be considered sustainable.
Token Value Accrual — A portion of the revenue is allocated to holders who stake AAVE tokens in the Safety Module, which functions as an insurance pool.
Sustainability of Tokenomics (Minting > Value Accrual) — At present, the sustainability of tokenomics is not achieved due to the limited amount of revenue distributed to AAVE token stakers compared to the token incentives being issued.
Overall Verdict -Over the course of a year, Aave spent $185.8M on token incentives and generated $209.0M in revenue. Aave exemplifies the successful implementation of tokenomics, building a network effect through early token incentives. Although the protocol itself hasn’t been sustainable, the established network effect ensures continued revenue generation even with reduced token incentives in the future as users continue to utilize the protocol. However, regarding tokenomics, further consideration is needed to refine the mechanism for value accumulation in AAVE tokens.
3.3 Uniswap
Overview — Uniswap stands as a leading decentralized exchange allowing users to trade and provide liquidity for various cryptocurrencies, earning interest in return.
Spending (Minting) — UNI tokens were distributed to liquidity providers early on, and no further issuance is currently in place for token incentives.
Revenue — Uniswap’s revenue is derived from transaction fees paid by users, with all fees being directed to liquidity providers.
Sustainability of the Protocol (Spending < Revenue) — The protocol exhibits sustainability, generating revenue without incurring spending.
Token Value Accrual — Presently, all transaction fees generated by Uniswap are directed to liquidity providers, with no value accumulation mechanism for the protocol’s treasury or UNI holders.
Sustainability of Tokenomics (Issuance = Value Accrual = 0) — With no token issuance and no value accrual, the sustainability of tokenomics is challenging to discern.
Overall Verdict — Uniswap generated $1.0B in revenue within a year without any token incentive spending. This sustainability is attributed to its substantial network effect as a leading decentralized exchange. Despite lacking token incentives, Uniswap generates significant transaction fees due to the high number of users conducting trades on the platform. At the same time, liquidity providers earn sufficient income from their own transaction fees without additional incentives. However, it is notable that 100% of the transaction fees currently go to liquidity providers, resulting in no return to UNI token holders, despite the platform’s substantial revenue. The Uniswap community is actively discussing a fee switch in governance to direct some transaction fees to the treasury, potentially establishing a value accumulation mechanism for the UNI token, which will be an intriguing development to monitor.
3.4 GMX
Overview — GMX is a decentralized futures exchange that has made a lot of noise this year and has a very unusual system for processing prices supplied by an oracle (which has also led to attacks this year.)
Spending (Minting) — GMX utilizes two types of tokens: a governance token called GMX and a liquidity provider token named GLP. The GLP token is offered as an incentive to counteract downward price pressure on the GMX token by holding escrowed-GMX tokens.
Revenue — GMX generates its revenue from trading fees paid by users.
Sustainability of the Protocol (Spending < Revenue) — In the initial stages, spending exceeded revenue; however, this situation has been reversed, and the protocol can now be deemed sustainable.
Token Value Accrual — 30% of the revenue directly goes to GMX holders who stake governance tokens, while the remaining 70% is allocated to GLP holders providing liquidity.
Sustainability of Tokenomics (Minting > Value Accrual) — It is evident that the value dilution caused by spending outweighs the value accumulation of the token. Under the current circumstances, this situation is not sustainable unless there is a substantial increase in token demand.
Overall — GMX has allocated $93.7M in token incentives over the course of one year while concurrently generating $99.8M in revenue. Despite initial acclaim for GMX as a beneficiary of the real-yield concept, where transaction fees are directly provided to token holders, a closer examination reveals that the value of tokens issued (spent) and the revenue generated by the protocol are nearly identical. Given that only 30% of transaction fees contribute to the value of GMX, token holders are actually experiencing greater losses due to value dilution than the value they earn.
Nonetheless, GMX’s unique system of directly distributing a portion of the actual transaction fee revenue has garnered significant interest throughout 2022, particularly in a DeFi landscape where governance tokens often lack a direct value accrual mechanism or rely on indirect methods such as treasuries. Considering the sustainability of the protocol, it is expected to endure as long as trading volume remains stable, with hopes that the tokenomics will also prove sustainable through incentive reductions and increased trading volume.
4. If Both the Protocol and Its Tokenomics Are Not Sustainable
4.1 Balancer
Overview — Balancer is a prominent decentralized exchange on the Ethereum network, primarily designed for facilitating token swaps similar to Uniswap. However, what sets Balancer apart from Uniswap is its distinctive Automated Market Maker (AMM) mechanism, enabling it to perform token liquidations at arbitrary ratios, such as 2:1 or 4:1, unlike Uniswap’s fixed 1:1 ratio.
Spending (Minting) — BAL tokens are utilized as incentives to reward liquidity providers.
Revenue — Balancer generates its revenue primarily from transaction fees paid by users participating in the platform.
Sustainability of the Protocol (Spending > Revenue) — Initially, the revenue exceeded the spending, but this trend has now reversed, and it is not sustainable at the moment.
Token Value Accrual — Revenue mostly flows to liquidity providers, with some accumulating directly to BAL stakers.
Sustainability of Tokenomics (Minting > Value Accrual) — In a scenario where revenues are smaller than spending from the outset, the value accrued in tokens represents only a fraction of the revenues, resulting in a substantial disparity between the value accrual from revenues and the value dilution caused by token issuance. This imbalance is not sustainable in the long term.
Overall Verdict — Balancer expended $70.6M in token incentives over the course of one year while generating only $55.6M in revenue. To enhance its sustainability from both a protocol and tokenomics perspective, Balancer must consider reducing its token incentives and devising strategies to incentivize users to increase their platform usage. Despite stiff competition in the decentralized exchange space, Balancer stands out as a contender among strong competitors like Uniswap, Curve, and SushiSwap in the Ethereum and EVM ecosystems. However, its trading volumes do not compare favorably with these competitors, prompting Balancer to undertake efforts to expand its user base through collaborations with entities such as Beethoven X, Element Fi, Aave, Aura, and others. With the prospect of an upcoming bull run, the sustainability of Balancer’s operations is expected to improve as trading volume sees an upswing.
4.2 Stargate
Overview — Stargate Finance is a cross-chain bridge built on the LayerZero protocol, enabling seamless asset transfer for users through Stargate’s liquidity across multiple blockchain networks.
Spending (Minting) — STG tokens are utilized as an incentive to reward users who contribute liquidity for bridging assets to each chain.
Revenue — Stargate’s revenue comes from a flat fee that users pay when bridging assets.
Sustainability of the Protocol (Spending > Revenue)- The current situation is deemed unsustainable due to the substantial disparity between spending and revenue, with spending significantly outweighing revenue.
Token Value Accrual — Revenue is allocated to stakers who have fully staked their STG tokens, thereby demonstrating a clear tokenomics business model.
Sustainability of Tokenomics (Minting > Value Accrual) — However, it is worth noting that tokenomics is also deemed unsustainable due to the revenue generated being inadequate in comparison to the expenditures associated with token incentives.
Overall Verdict — Stargate is a relatively new protocol, yet it has already expended $47.0M in token incentives since its launch, generating only $2.3M in revenue. The early days of the launch were marked by significant token incentive spending, and the latest 90-day statistics indicate an unsustainable pattern of $4.3M in incentives compared to just $0.9M in revenue. One glaring concern for Stargate’s sustainability lies in its token incentives, which are entirely tokenized, unlike other protocols that offer a combination of token incentives and actual fee revenue to compensate liquidity providers. This is in stark contrast to platforms like Uniswap, where liquidity providers receive 100% of transaction fees, leading to substantial revenue generation.
To ensure the sustainability of the protocol and tokenomics, it would be prudent to consider modifying the compensation structure. Despite the challenges, given that Stargate Finance is still in its early stages, there is hope that the token incentives will contribute to a network effect and eventually lead to increased revenue from higher usage, surpassing the expenditure on token incentives.
5. Closing
So far, we have assessed various protocols based on the definition of sustainability outlined in the introduction. The graph above provides a summary of my analysis, showing that a protocol is deemed sustainable when Protocol Revenue exceeds Token Incentive. Furthermore, for tokenomics to be sustainable, value accrual must surpass token incentive (note that value accrual cannot be greater than protocol revenue, as value accumulation for tokens only occurs with revenue).
Our evaluation revealed that MakerDAO, 1inch, and Perpetual Protocol demonstrate sustainability in both the protocol and tokenomics aspects. On the other hand, Lido, Aave, Uniswap, and GMX exhibited sustainable protocols but unsustainable tokenomics. Meanwhile, Balancer and Stargate showed that neither their protocols nor tokenomics are sustainable. While these evaluations involve representative protocols in their respective fields, it is essential to recognize that a steady demand for their usage is expected. However, in cases of unsustainability, it would be advisable to consider reducing token issuance or further contemplate mechanisms for revenue generation and value accumulation.
Before concluding this article, a few caveats deserve mention. Firstly, the approach to token value accumulation must be handled cautiously, as each protocol employs a distinct method. For example, in 1inch and Lido’s case, there is no direct value accumulation for token holders; instead, it occurs indirectly through sales driving treasury growth. Conversely, MakerDAO conducts token buybacks via sales, and GMX employs direct accumulation by distributing a portion of sales to token holders. While the growth of a treasury is often considered to transfer value to token holders with voting rights in treasury management, this is an indirect method that needs a clear distinction from direct return mechanisms. Secondly, the setting of the time range is crucial. For instance, Perpetual protocol demonstrated sustainability in both protocol and tokenomics using statistics from the last 365 days, but the tokenomics showed unsustainability when considering data from the last 180 days. It is vital to recognize that token issuance and user usage can significantly fluctuate depending on the time frame.
Tokens are not a universal solution. Token issuance serves as a means to establish initial network effects, but excessive issuance can create future liabilities. Ultimately, the true determinant of sustainability lies in the actual user demand for the protocol and its underlying business model. It remains intriguing to observe whether the existing protocols can endure the next bull run and thrive or if new protocols will emerge, introducing fresh tokens used as incentives to gain attention and recognition.
6. References
— All for Sustainability
