The Game of Efficiency and Fairness: An Analysis of the Core Mechanism of the Chronos Protocol

Author: Go2Mars Research

Liquidity is the cornerstone of finance. Whether in the stock market, real estate, or DeFi, liquidity is one of the key indicators to assess the quality of the market. In the DeFi market, the game between liquidity and fairness has been ongoing, and how to balance the two has been a similar challenge we faced in the 1980s.

However, today is different from the past. In DeFi, the financial tools we can use are more diverse, and the game mechanics are more flexible.

Therefore, this article will take traditional decentralized exchanges (DEX) as a starting point, using the Chronos exchange as a research subject, to detail how Chronos utilizes the ve(3,3) model to participate in this game of efficiency and fairness.

Traditional DEX: Initial Attempts at Liquidity Optimization

How to properly handle liquidity and fairness in the DeFi market has been explored through some effective attempts by the first batch of decentralized exchanges. Taking Uniswap, the leading DEX in the current DeFi market, as an example.

In the Uniswap V2 pool, liquidity is evenly distributed along the invariant curve xy=k. However, most trading activity occurs within a specific range at any given time, leading to underutilization of liquidity in other parts of the xy=k curve.

To maximize the value of market liquidity, Uniswap V3 concentrates liquidity within more active trading ranges. Although this mechanism can improve capital efficiency and allow liquidity providers (LPs) to earn higher liquidity returns.

The coordination between efficiency and fairness is not easily resolved; higher liquidity represents greater token utility loss.

The concentrated liquidity model of Uniswap V3 requires LPs to actively manage their positions, as they must adjust price ranges to optimize returns. Due to the high volatility of new token prices, LPs need to frequently adjust price ranges. This creates significant capital risks, which not only increases the liquidity costs of blockchain management but also means that LPs must passively forfeit their own pricing rights------

System failures under extreme market conditions: The concentrated liquidity model may not perform optimally during periods of high market volatility; for example, compared to version V2, Uniswap V3 was unable to function normally during the Luna crisis.

High entry barriers: For project parties issuing initial tokens, the liquidity management threshold of V3 is too high for long-tail asset pools launched by new projects.

Potential loss risk amplification: Concentrated liquidity acts as "leverage" by concentrating funds within specific trading ranges. This means that potential profits and liquidity within that range are amplified, but potential losses when asset trading exceeds that range are also amplified.

Ve(3,3) Model: A Financial Flywheel Insight into Human Nature

Liquidity Growth Flywheel Based on Four Major Trading Entities

Compared to the aforementioned veCRV model, the ve(3,3) model has a deeper understanding of fairness and efficiency. To facilitate reader comprehension, let's outline the four participants in the DEX economy:

• Traders: Comparable to investors in the stock market. Traders swap token A for token B from the liquidity pool, while paying corresponding trading fees (transaction fees) during the swap.
• Liquidity Providers (LPs): Comparable to corporate shareholders in the stock market. LPs deposit their idle tokens into the liquidity pool to receive token emissions. In exchange for TOKEN emissions, all trading fees earned from trades are sent to veTOKEN voters who voted for that specific liquidity pool.
• Protocols: Projects need liquidity so that users can purchase their tokens. To incentivize liquidity providers, projects can bribe voters to vote for their LPs. Protocols are also highly incentivized to acquire their own veTOKENs to guide emissions as a long-term solution to their liquidity needs, so they do not have to maintain bribery metrics indefinitely.
• veTOKEN Voters: Comparable to regulators in the stock market. Voters manage TOKEN emissions by voting on the gauge weekly. They are incentivized to vote for the most economical mining pools to maximize their income, as they receive fees + bribes from the pools they vote for.

The flywheel of the ve(3,3) model can be roughly divided into three steps:

Step 1: LPs deposit idle tokens, enhancing market liquidity. LPs place idle tokens (capital) into the liquidity pool, thereby lubricating the entire market, increasing market trading volume, and raising the workload of the protocols serving the market, while an active market also means higher token prices.

Step 2: Increased trading volume boosts veToken voter earnings. The surge in trading volume due to enhanced liquidity means that within limited trading "computing power," trading fees rise simultaneously, allowing veToken voters to earn more from trading fee shares.

Step 3: A quality market attracts more external investors, completing a positive cycle. In a good market environment, more external investors are attracted to swap their idle tokens for locked tokens, further supporting the market price. On the other hand, since LP earnings are strongly correlated with token prices, higher prices lead to higher LP earnings, prompting LPs to deposit more idle tokens into the liquidity pool, starting a secondary cycle.

Secondary Reinforcement of Liquidity and Fairness: "Bribery" and "Inflation"

In the ve(3,3) model, there are also two important rule mechanisms that promote market liquidity and fairness: "bribery" and inflation.

To promote market liquidity, the ve(3,3) model adds an interesting "bribery" mechanism on top of the original flywheel------LPs can use part of their earnings to "bribe" veToken voters, guiding them to consider their mining pool as the most economical one, thus attracting more external investors. This overt "bribery" further enhances overall market liquidity.

Beyond liquidity, the ve(3,3) model also introduces an inflation mechanism------the more tokens invested in the early stage, the more the value of returns will increase after inflation. Inflation is a gradual process of governance redistribution, which over time will benefit those who are more loyal to the community and the market.

In our case study using the Solidly model, loyalty is expressed through the continuous accumulation of TOKEN and the locking of veTOKEN. This allows projects to maintain on-chain liquidity at effective costs and keep the flywheel spinning.

In addition, the advantages of the inflation mechanism include:

1. Distributing voting rights and allowing new participants (projects) to enter the economy and obtain fair voting shares through bribery or veTOKEN accrual.

2. Incentivizing projects to continuously accumulate more veTOKENs to maintain their emission shares, thus creating total demand for TOKEN.

3. Ensuring that veTOKEN voters strictly use their funds (votes) on the most productive mining pools. Failing to do so would mean they are losers.

4. Maintaining the ve(3,3) flywheel by providing sufficient compensation to liquidity providers.

Secondary Distribution After Inflation: 100% Rebase Ratio Mechanism

While the inflation mechanism strengthens the personal earnings of veToken voters, it also dilutes their voting rights. The existence of the 100% Rebase Ratio mechanism is another innovative attempt to suppress such dilution.

Rebase ratio: It reduces the degree of dilution of ve token locker rights due to inflation, mathematically calculable as the ratio of the total veTOKEN proportion after incentive emissions in each cycle to the proportion before emissions. When it reaches the upper limit of 100%, inflation cannot dilute existing locker rights.

This model aims to maintain the ownership position of veTOKEN holders by distributing additional veTOKENs to them in proportion to the number of tokens launched in each period.

At the same time, ve(3,3) also sets relevant dilution caps. The anti-dilution cap aims to balance early adoption incentives with long-term project health. The model provides 100% anti-dilution until a 30% locking rate is reached, after which the rebase ratio decreases as the locking rate increases.

Although it sounds appealing in theory, the 100% rebase ratio model can have some negative effects.

1. Concentration of voting rights: Over time, this model can lead to unhealthy concentration of voting rights among early users, as they continue to accumulate tokens without being diluted.

2. Suppression of new participants: The concentration of voting rights makes it increasingly difficult for new participants to enter the ecosystem, reducing competitiveness and market accessibility.

3. Inflation pressure: By redistributing inflation from liquidity providers to veTOKEN holders, the model introduces unnecessary inflation, thus reducing the value of purchasing and locking tokens.

The more veTOKENs there are, the less income each veTOKEN receives, so the value of purchasing new TOKEN issuance for locking and voting decreases. This is a key part of the flywheel, which can be damaged by excessive repositioning.

Chronos Improvement: 0 Rebase Ratio and maNFT

0 Rebase Ratio

The Chronos team determined that the zero rebase model is the best method for the project's lasting stability and sustainability. This model not only ensures the most favorable economic incentives for all participants but also attracts new protocols and alleviates supply centralization among early adopters.

However, the protocol also recognizes that early locking of veCHR tokens carries certain risks. Therefore, to reward early adopters without compromising the long-term sustainability of the project, Chronos has reserved 5% of the initial supply of $CHR (2.5 million tokens) as an airdrop reward for users who lock more than 1,500 $CHR for two years. These users will receive 20% of their locked positions as a reward in the form of $veCHR NFTs.

ma (Maturity-Adjusted) NFT

While ve(3,3) has played a significant role in attracting token liquidity, it has been less effective in maintaining liquidity over the long term, as LPs seeking optimal investment returns are still driven by high APRs.

As APR changes from one epoch to the next, liquidity providers simply move their funds to the pool generating the highest returns. Liquidity is not "sticky"------it does not stay in one place for long------these fluctuations make it difficult for protocols to accurately predict their liquidity needs------and what incentives they need to provide------to help them achieve their goals.

Liquidity supply on Chronos works the same way as on other ve(3,3) DEXs. Users deposit liquidity to receive LP tokens, which can be staked for $CHR rewards. After staking their LP in Reliquary, users will receive a special NFT (called maNFT) that tracks the time and amount of tokens staked by the LP, as well as the time elapsed since the LP provided liquidity.

As the LP staking time increases, the incentive multiplier for each cycle increases accordingly.

Chronos chose a linear curve to ensure that new LP depositors still receive a fair share of rewards, which will grow in sync with their time in Chronos. It also reaches a maximum within six weeks to ensure that very early and long-term held LP positions do not imbalance the pool due to the collection of large fees while new entrants gain nothing.

In a market where maNFT positions can be sold in a matured state, the value of this liquidity position will exceed the sum of its underlying content. By introducing a time value component that increases the incentive multiplier over time, the Chronos protocol has normalized liquidity across a long-term time dimension.

The Ultimate Form of Innovation: The Chronos Flywheel

When the price of CHR falls, a counter-cyclical effect supporting the flywheel occurs, leading to an increase in veCHR APR. A lower price with the same income results in a higher APR, making CHR a more attractive investment. Ultimately, buyers will seize this pricing opportunity, stabilizing the price of CHR and allowing the flywheel to continue spinning.

Previous ve(3,3) projects faced difficulties in maintaining the flywheel during market volatility. When DEX token prices fall, liquidity is often withdrawn as APR decreases. In the case of falling DEX token prices and escaping TVL, stabilizing the price of DEX tokens and restarting the flywheel becomes very challenging.

Chronos introduces the concept of maturity-adjusted limited partners, enabling liquidity to be managed over time, reducing liquidity outflows.

Summary

Chronos benefits liquidity providers by adopting a maturity-adjusted LP model that introduces a time value component into their LP positions. At the same time, this model supports the protocol by creating a stickier and more stable total locked value (TVL), thereby better supporting the issuance of $CHR.

For the protocol, it will benefit from continuous, predictable liquidity. Capital is less likely to shift from one pool to another in pursuit of the highest annualized return (APR). Liquidity providers now need to weigh their choices more carefully between short-term incentives and long-term profit potential. Additionally, projects can increase the liquidity owned by the protocol by directly purchasing matured LP positions------maNFT from the secondary market.

For liquidity providers, over time, they will benefit from the increased earnings multiplier and potentially sell matured liquidity positions at a premium in the secondary market.

For $veCHR holders, their earnings from bribery will increase. Due to the high opportunity cost of LP liquidity in the short term, projects seeking initial liquidity will need to invest more in bribery. This will further encourage projects to direct more incentives towards their liquidity pools to attract LPs. Moreover, due to the smaller fluctuations in TVL, they can expect a more stable stream of trading fee income.

In the Chronos protocol, treating liquidity provider (LP) positions------maNFT as a special financial instrument with underlying returns that gradually increase in value over time, we have reason to believe that secondary derivatives formed on this basis will soon emerge. These derivative protocols may include various innovative features, providing market participants with more diverse and rich investment and trading options.

In the future, secondary derivative protocols may appear in various forms, such as options, futures, swap contracts, etc. These financial instruments could further combine and segment LP positions to meet investors' needs in risk management, arbitrage, and portfolio diversification. Meanwhile, these emerging financial products may also attract more capital into the market, thereby enhancing market liquidity and trading activity.

As market researchers and observers, we will closely monitor developments in the DEFI field, aiming to stay informed about market changes and emerging trends. In this rapidly evolving market, we will strive to delve into the operational mechanisms and risk characteristics of various innovative products to help readers better understand these phenomena.

References:

[1] Case Study: Why ve(3,3) Needs Sticky Liquidity

[2] The Pillars of Chronos Pt. 3--- Understanding the Chronos Flywheel

[3] The Pillars of Chronos Pt. 2--- Introducing Maturity-Adjusted LPs

[4] Solidly Deep Dive Pt.1: Economics, Inflation, Rebasing, Sustainability

[5] Solidly Deep Dive Pt.2: Concentrated Liquidity and ve(3,3) vs. Uniswap