Exploring DeFi Token Economics: Staking Rewards, Burning Deflation, and Long-Termism
DeFi has always had issues with token value accumulation and retention, and now is the best time to address this problem.Written by: Will Comyns, Shima Capital
Compiled by: Deep Tide TechFlow
This article will explain why DeFi tokenomics needs adjustment and what new models might look like.
Tokens as Income Rights
Holding tokens can provide governance capabilities, which creates a compelling reason, but many tokens still struggle to effectively accumulate and retain value.
As a result, there is an increasing consensus within the Web3 community that tokens must begin to offer income shares as well as governance.
It is worth noting that tokens providing income sharing to holders may make them appear more like securities.
Many people will use this point to oppose DeFi tokens offering income sharing, but it is indeed the case that without this change, DeFi as a whole will continue to exist as a market for mass speculation.
If DeFi is to gain mainstream legitimacy, it is impossible for all token price movements to be nearly positively correlated, as in that case, the different profit levels of protocols are not reflected in token price movements.
While one concern is that enhancing tokens' capture of protocol revenue will increase their securities-like attributes, the argument that limiting tokens to governance rights is better when considering the path to long-term adoption is clearly flawed.
As summarized in the DeFi Man article, protocols currently distribute income to token holders primarily through two methods:
Buying back native tokens from the market and (1) distributing them to stakers, (2) burning them, or (3) keeping them in the protocol's treasury.
Redistributing protocol revenue to token holders.
Yearn.finance stirred up a storm after announcing updates to its tokenomics and buyback plan last December, with YFI's price rebounding 85% in the short term. While this was just a temporary spike, the strong desire for better token models is evident.
However, in the long run, distributing shares of protocol revenue is clearly superior to token buybacks.
The primary goal of any DAO should be to maximize the long-term value for token holders. As Hasu wrote, "Every dollar owned by a protocol or received as revenue should be allocated to the most beneficial use for it." Therefore, a DAO should only buy back its native tokens when they are undervalued.
We can build a valuation framework for these protocol tokens based on the cash flow established by providing income shares to native token stakers. By paying incentives to stakers, we can value the tokens while also needing to reconsider the incentives paid to LPs.
When analyzing the revenue generated by protocols, a common approach is to categorize revenue into two types: protocol and LP. Evaluating the value of tokens based on the revenue allocated to token stakers exposes the true nature of LP revenue—operating costs.
An increasing number of protocols have begun to establish revenue sharing with governance token stakers. Notably, GMX has set a new precedent. GMX is a zero-slippage, decentralized perpetual futures and spot exchange based on Avalanche and Arbitrum. GMX stakers receive 30% of protocol fees, while LPs receive another 70%, with fees calculated in $ETH and $AVAX rather than $GMX.
Similar to growth stocks retaining their earnings instead of distributing dividends, many believe that paying fees to token stakers rather than reinvesting them into the protocol's treasury 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 stakers, GMX continues to innovate and develop new products, such as X4 and PvP AMM.
In general, reinvestment only makes sense when a protocol or company can better utilize accumulated funds rather than distributing them to stakeholders.
DAOs often have lower efficiency in managing capital and a decentralized network of contributors outside their core team.
For these two reasons, most DAOs should distribute income to stakeholders earlier than their centralized Web2 counterparts.
Learning from the Past: Burning and Staking
Terra
Although the collapse of Terra caused harm, it has strong educational value and provides some references for shaping the future of sustainable token models.
In the short term, Terra proved that token burning is an effective way to accumulate and gain value for tokens. Of course, this did not last long. By manipulating the burning rate of $LUNA through the Anchor Protocol, Terra caused an arbitrary and unsustainable reduction in the supply of $LUNA. While supply manipulation ignited the fuse for self-destruction, the collapse of Terra ultimately occurred even after experiencing a series of supply contractions. Ultimately, we found that the growth of $LUNA circulation was so easy.
(3,3) Tokenomics
At the end of 2021, the decline of (3,3) economics also brought many references.
OlympusDAO demonstrated that staking a significant portion of a protocol's native tokens can lead to a substantial short-term increase in token prices.
However, we later saw that if stakers were allowed to exit at any time with little impact, they did so at the expense of other stakers.
Implementing rebasing is intended to strengthen people's incentives to participate in staking. If a user stakes, he/she receives "free" tokens to maintain his/her current market value share.
In fact, anyone wanting to sell does not care about being diluted when unstaking.
Due to the nature of rebasing, those who enter and exit first profit by utilizing newcomers as their exit liquidity.
To implement sustainable staking in the future, stakers must face harsher penalties for unstaking. Additionally, those who unstake later should benefit more than those who unstake earlier.
ve Tokenomics
The common reason for all previous failed token models is the lack of sustainability. Curve's ve model is a widely adopted token model that incentivizes token holders to lock their tokens for up to 4 years in exchange for inflation rewards and expanded governance power, attempting to implement a more sustainable staking mechanism.
Although ve performs well in the short term, the model has two main issues:
- Inflation acts as an indirect tax on all token holders and negatively impacts token value.
- When the lock-up period eventually ends, there may be a massive sell-off.
When comparing ve and (3,3), they share a similarity in that both offer inflation rewards in exchange for token holders' commitment to staking. Locking can serve to suppress sell-off pressure in the short term, but once inflation rewards become less valuable over time and the lock-up period expires, a large sell-off occurs.
In a sense, ve can be compared to time-locked liquidity mining.
Ideal Token Model
Unlike the unstable token models of the past, the ideal token model of the future will sustainably adjust incentives for users, investors, and founders. When Yearn.finance proposed its ve tokenomics plan (YIP-65), they claimed to have built their model around several key motivators, some of which can be applied to other projects:
Implementing token buybacks (distributing income to token holders)
- Establish a sustainable ecosystem
- Incentivize a long-term perspective for the project
- Reward loyal users
- Considering these, I propose a new token model that provides stability and value accumulation through a taxation method.
Income and Taxation Model
I have previously identified that an ideal token design would grant holders governance rights and a share of protocol income when staked. For this model, users must pay a "tax" to unlock rather than using a lock-up period. While the tax/penalty for unstaking is not unique to this model, the related taxation mechanism is.
The unlocking tax that users must pay is determined by a percentage of the number of tokens they have staked, with a portion of the taxed tokens being proportionally distributed to other insured parties in the fund pool, and another portion being burned. For example, if a user stakes 100 tokens with a tax rate of 15%, they will spend 15 tokens to unlock. In this example, if the user chooses to unstake, ⅔ of the tax (10 tokens) will be proportionally distributed to other stakers in the pool, and ⅓ of the tax (5 tokens) will be burned.
This system rewards the most loyal users, with those holding tokens for longer benefiting the most. It also reduces downside volatility during market sell-offs.
Theoretically, if someone unstakes, it is because income has declined or is expected to decline in the near future.
When viewing protocol income as a pie, a reduction in income can be seen as the total pie shrinking. In the previous example, the taxed tokens are allocated to those who are still staking, increasing their slice of the pie and reducing their losses.
The burned ⅓ will exert deflationary pressure on the token supply, thereby increasing the overall token price. In the long run, burning will cause the token supply to follow an exponential decay pattern. The above figure shows that during market sell-offs, if holders continue to stake, their losses may be mitigated, while the figure below shows how the burned tax portion reduces losses for all token holders, whether staked or unstaked.
The figure reflects that due to the reduction in protocol income, token demand shifts inward. Thus, a portion of investors unstake their tokens for sale. During the unstaking process, a portion of their tokens is burned. The burning mechanism reduces the total token supply and shifts the supply curve leftward, resulting in a smaller decline in token price.
If protocol income declines significantly and whales decide to unstake and dump their tokens, this could represent the worst-case scenario for this model. Given that Convex currently controls 50% of all veCRV, this could mean half of the tokens being unstaked and sold. If most tokens were locked before the sell-off, even with taxes, this would inevitably cause a collapse in token prices in the short term.
This emphasizes that regardless of what staking/burning mechanisms a protocol may implement, if the underlying protocol cannot generate income, the tokens are still worthless. However, assuming in this example that protocol income rebounds in the near future, those who remain staked after the whale sell-off will receive 5% of the total token supply, while the total token supply will decrease by 2.5%, significantly increasing their share of future income.
Since whales are inevitable, a further improvement to this proposed tax could be a progressive tax. While a progressive tax may be difficult to implement, protocols could utilize analytical tools like Chainalysis or build their own internal tools to enforce it. It is hard to say what the best solution for implementing a progressive tax would be. Clearly, more research and development are needed to answer this question.
Whether implementing a flat tax or a progressive tax, protocols should adopt this income-sharing and taxation model only after accumulating a significant amount of TVL. In the early lifecycle of a protocol, guiding liquidity, decentralizing its tokens, and establishing attractiveness should take precedence. Thus, in the early stages of protocol development, token models built around liquidity mining may positively contribute to 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 that better align economic incentives with new objectives.
Compound is an example of a protocol that did not change its token design to meet its maturity stage. Despite accumulating a significant amount of TVL and generating substantial income, this value creation is rarely absorbed by $COMP holders. In an ideal world, a protocol's profitability should be reflected in its token price; however, in reality, this is only occasionally the case.
Conclusion
The most important point of this proposed token model is that it is sustainable. Staking incentives are more sustainable because they benefit those who "come in late" rather than the typical first-in-first-out (FIFO) principle.
The token burning element in the design also reinforces sustainability because it is one-way (supply can only contract). If there is any lesson to be learned from the recent market downturn, it is that sustainability is crucial.
While the development path of Web3 will be led by disruptive innovation and greater user adoption, none of this will be possible without a more sustainable token model that can effectively accumulate and retain value.
