Bankless: Why the Current State of ATOM is Poor and What ATOM 2.0 Will Bring

Author: Longsolitude, Investor at ZeePrime Capital

Compiled by: The Way of DeFi

Everyone has a favorable impression of Ethereum and applauds the efforts of core developers for the merge. However, unless you enjoy the MEV-boost dashboard, you might feel lost since the completion of the merge.

Weeks ago, the big names of the Cosmos ecosystem gathered at the Cosmoverse event in Medellín, Colombia, to discuss the future of ATOM. The key foundation of this event was "ATOM 2.0," which represents the vision of Cosmos core contributors on how to bring more utility and value to the ATOM token and the entire Cosmos Hub.

This article covers the reasons for ATOM's poor current status, what ATOM 2.0 will bring, and its impact on DeFi.

What We Don't Want is a Meme Coin!

ATOM has existed as a token for a long time, and unlike many contemporaneous tokens, it has not faded into irrelevance.

The Cosmos ecosystem provides top-notch tools for application developers to launch their own specific application chains (appchains), playing a significant role in the launch of many well-known projects like Osmosis, Thorchain, and the now-troubled Terra, among others. Key tools include the Cosmos SDK for developing blockchain logic execution layers, Tendermint for fast deterministic consensus engines, and IBC for secure blockchain interoperability.

Some of the main issues surrounding ATOM, which represents the Cosmos Hub, are its lack of utility and its untapped potential. Any application chain launched within the Cosmos ecosystem can operate without using the ATOM token. This is because the fee logic is native to each application chain (developers choose which token to pay gas with), and each application chain has its own validator network.

Cosmos advocates for sovereignty and the customizability of blockchains, so the utility of ATOM is not achieved through brute force, which makes sense, right? In simple terms, this is the birth process of the Cosmos "value accumulation" meme.

While some believe that other application chains airdropping to ATOM stakers is actually a form of value accumulation, let's be rational and honest—airdrops are neither sustainable nor a good use of application chain token capital. Airdrops should not be broad and untargeted—they should attract specific users and incentivize specific behaviors that benefit the application chain.

Currently, ATOM has a high staking APR (around 20%) to incentivize and compensate the work of Cosmos Hub validators. While people tend to ignore inflation in a "only up" market, it can cause losses in a bear market, adding extra selling pressure to the token. This is another reason for ATOM's frustrating performance.

This presents a dilemma for ATOM investors. Are you staking ATOM for a 20% yield, or are you using it in DeFi products within the Cosmos ecosystem, only to be diluted by inflation, as it is hard to find competitive yields in DeFi?

This dilemma has led to a low utilization rate of ATOM in DeFi, and it is only due to application chains providing substantial liquidity mining rewards in their native tokens (which are indeed generous). More usage of ATOM as collateral and deeper liquidity would benefit not only ATOM itself but also the broader ecosystem.

These are some of the issues that ATOM 2.0 hopes to address in the coming years.

Make ATOM Strong Again

The ATOM 2.0 whitepaper/proposal was released in the last week of September, and you can read it here. It is still in the community discussion phase.

To address the aforementioned issues, Cosmos developers are introducing four key pillars:

• Interchain Security (ICS)

• Liquid Staking

• Interchain Scheduler

• Interchain Allocator

Let's take a closer look at each.

Interchain Security

Currently, any application developer in Cosmos is responsible for launching a blockchain from scratch, guiding and maintaining the validator set of the application chain, and ensuring economic security. This is the essence of Cosmos: sovereignty. However, building both an application and a blockchain is no easy task. This has been acknowledged by the Cosmos community, and the new security concept is proposed to address this issue.

The idea behind ICS is simple. Instead of struggling with their own validators and questionable economic security, why not let application developers simply "rent" this security from a more robust monetary zone, such as the Cosmos Hub (ATOM) itself? Developers can focus on building applications while still enjoying most of the customizable benefits associated with application chains (owning block space, custom fee logic, etc.).

ICS will turn the Cosmos Hub into a "provider chain," while application chains become "consumer chains." The exchange between them is direct—the provider chain produces blocks for the consumer chain, which then issues block rewards (inflation) to the former and its validators. The level of economic security obtained in this manner depends on how many provider chain validators choose to produce blocks for a specific consumer chain. Currently, the Cosmos Hub has selected five consumer chains to support starting in 2023.

Interchain security will be a significant change, but it is not the only way to address the security needs of Cosmos application chains.

For more information, refer to Zee Prime's recent article discussing different versions of ICS, which covers trade-offs and available alternatives.

Liquid Staking

Cosmos Hub hopes to see the adoption of liquid staking products through a competitive process among different providers. Teams like Quicksilver, Persistence, Stride, and Lido will provide liquid staking not only for ATOM but also for other tokens in the Cosmos ecosystem.

From the perspective of the Cosmos Hub, the goal is to ensure trust minimization and security, so the alliance between its validators and liquid staking providers makes sense.

Quicksilver will obtain the full economic security of the Cosmos Hub through ICS, which may mean it will be the preferred liquid staking provider for ATOM (but not mandatory for stakers).

In the context of using liquid staking to replace staking rewards, it should be noted that liquid staking inherently requires stakers to take on more risk through DeFi activities. Therefore, in ATOM 2.0, the yields for stakers will differ from the current situation and carry higher risks.

Interchain Scheduler

The Cosmos ecosystem is a set of asynchronous blockchains. This creates an opportunity to establish a cross-application chain block space market, secured by ICS.

This is one way to create a more equitable method for distributing MEV (Maximum Extractable Value), which might otherwise concentrate solely in the hands of searchers and validators, rather than transaction initiators.

Consumer chains within ICS will voluntarily choose to sell their block space in this market enabled by the scheduler module. Traders can then bid for block space simultaneously on two consumer chains, ensuring strong execution for their cross-application chain arbitrage.

The proceeds from the sale will be distributed between the consumer chain selling its block space and the interchain scheduler enabling the block space. However, the latter's profits will not directly belong to ATOM token holders but will be used to fund the interchain allocator and develop the Cosmos ecosystem. This design achieves the NFT-ization of order flow rights, which can also be resold to other willing market participants.

There are several design approaches to MEV in Cosmos. In addition to the interchain scheduler, there are Skip (an on-chain module for application chains to capture their own native MEV, such as arbitrage) and Mekatek (an off-chain market for block building, similar to what Flashbots does).

Essentially, each application chain must decide how to handle MEV and monetize it for the benefit of its own ecosystem.

Interchain Allocator

Unlike other ecosystems like Solana or Ethereum, the Cosmos Hub does not play an active role in directly investing in ecosystem projects or funding public goods.

The interchain allocator changes this. Its role will be to fund new on-chain projects within the Cosmos ecosystem and provide support in an incentivized manner. This aims to accelerate the pace of new projects in the ecosystem and enhance the relevance of the services that Cosmos Hub can provide (some of which are ICS and the interchain scheduler).

This collaboration can take many different directions, but some preliminary ideas include token swaps, helping to bootstrap liquidity, financial management, participating in each other's governance processes, low-collateral financing, etc.

These will be formalized through so-called on-chain contracts, simplifying coordination between protocols.

Perhaps the most interesting question related to the allocator is how ATOM governance participants will organize themselves to successfully deploy and manage the increasing capital across different objectives, and what kind of checks and balances will be established, etc.

At today's ATOM price, the treasury is expected to hold about 55 million ATOM, or $700 million. What will venture capital firms focused on Cosmos do?

Reducing ATOM Inflation

The combination of these initiatives—most notably ICS and liquid staking—will reduce ATOM's long-term inflation and replace it with other sources of yield. Validator rewards will no longer be distributed in the form of ATOM. This is where the intersection between liquid staking and DeFi becomes important, as well as receiving token rewards from ICS consumer chains. ATOM will experience a new inflation schedule over 36 months, most likely starting at the end of 2023.

The idea here is to strengthen inflation in the initial months to help kickstart the treasury of the Cosmos Hub, allowing the interchain allocator to function. In reality, this comes at the expense of ATOM holders, as the inflation rewards applicable to them do not rise proportionately. In the first nine months, the inflation rate of ATOM will be up to three times higher compared to the current situation, but then it will rapidly decline due to the inflation rewards from liquid staking and ICS consumer chains.

The temporary increase in inflation should not be a source of concern. Instead, the question is who can ensure that the ATOM entering the treasury achieves good economic returns, how to achieve this, and how much time it will take. For this issue, multiple secondary DAOs are expected to be responsible for allocation. They can also incrementally gain capital based on their ability to achieve Cosmos Hub goals.

In the long run, the outstanding ATOM is expected to decrease significantly (as security subsidies will no longer be issued to validators), but there are many economic assumptions surrounding the revenues from ICS and liquid staking products that could lead to inflation being higher than currently expected. After the 36-month window, the expected annual issuance rate of ATOM is slightly below 1% (compared to over 10% now), and this will only point to the Cosmos Hub treasury.

DeFi in Cosmos

The collapse of UST has cast a long shadow over Cosmos DeFi. UST was adopted not only on the Terra application chain but also on Cosmos's largest DEX, Osmosis, and elsewhere. DeFi without stablecoins is a futile endeavor.

Now, this situation is changing for the better, as Circle will launch a native USDC from one of the consumer chains secured by ICS in early 2023—demonstrating the utility of shared security design. Additionally, the decentralized stablecoin IST is being built on Agoric, aiming to become a multi-collateral asset like DAI on Ethereum, with plans to launch in October this year.

Liquid staking is currently being rolled out through multiple providers, essentially unlocking capital efficiency and allowing more capital to flow into money markets and DEXs. ATOM should be the primary beneficiary, but this also applies to application chain tokens.

One potential issue could be the fragmentation of liquidity—there may be many different versions of staked ATOM. That said, this issue can be resolved by establishing stableswap pools or wrapped versions to aggregate all different staking derivatives.

Since each application on Cosmos is its own application chain, there are asynchronous execution issues across different DeFi environments. To address this, Cosmos is utilizing IBC, the Inter-Blockchain Communication protocol, and interchain accounts to send cross-chain messages and execute smart contract calls.

For example, Mars Protocol, which can be seen as a leveraged primitive with credit accounts, will have its own application chain for governance and coordination of primitives, deploying smart contracts via so-called "outposts" on each supported application chain, starting with Osmosis.

Then, IBC will be used to transfer liquidity from one application chain to another and return the earned fees back to the Mars application chain.

IBC is also a perfect choice for having on-chain oracles. Instead of relying on off-chain systems, the price oracles of the Osmosis DEX can be utilized throughout Cosmos.

ATOM 2.0 is Coming

The idea behind ATOM 2.0 is to kickstart a flywheel effect that makes ATOM more popular and useful within the ecosystem.

It all starts and ends with ICS—the more it is adopted, the greater the economic appeal of ATOM. Liquid staking will help in this regard as it tightens monetary policy and strengthens ATOM's role as the default and ideal collateral.

The interchain allocator and scheduler will not directly bring value to ATOM token holders, but they will provide valuable services and funding to the ecosystem, thereby increasing demand for ICS. If ICS is under-adopted, ATOM's inflation will return to compensate validators.

ATOM 2.0 is a multi-year effort with high complexity.

Given the adaptation time required for the inflation schedule, its success or failure will not manifest in the next year or two.

We also do not believe these changes will lead to massive value accumulation for ATOM. There will be alternative security methods to ICS on Cosmos, with different trade-offs, and the staking yield of ATOM 2.0 will carry higher risks as liquid staking and potential validators may be penalized across multiple consumer chains.

That said, the Cosmos ecosystem seems to be one of the most participatory communities likely to push the application chain theory to its conclusion while correcting its course along the way.