Author: Eat Sleep Crypto

The Oracle of DeFi: Are You F**king High?

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Pythia Was a Trip

Pythia was the title of the high priestess of the Temple of Apollo at Delphi. She specifically served as its oracle and was known as the Oracle of Delphi, serving as Apollo’s mouthpiece.

Her contemporaries understood her powers to be supernatural. Modern scholars offer a different explanation – Pythia’s insights were hallucinogenic in nature, coming from an upwelling of natural gas.

In plain English, Pythia was high out of her mind.

High On Hopium

‘Hallucinogenic’ is also an apt description for today’s oracles in DeFi; DeFi oracles are in a similar position – hallucinating prices based on the hopium fumes of retail.

Protocols have lost a combined $394 million from oracle and price manipulation exploits since the advent of DeFi in 2020.

Oracles can be manipulated directly, where an oracle bribes or becomes the oracle to report a false price, or indirectly, where the price of illiquid token is manipulated, and the oracle simply passes on manipulated info.

The former we call “oracle manipulation” – the oracle is manipulated directly; the latter we call “price manipulation” – oracles simply report.

Price manipulation exploits are the most common economic vulnerability in DeFi. They are commonly attributed to thin liquidity, but this is symptomatic of an even deeper root cause.

Mark-to-market fallacies

Mark-to-market valuation is an accounting practice borrowed from TradFi.

Shares outstanding are valued at their last traded price to produce “market cap” – the total value of a stock.

It’s a crude way to value assets, and it makes a terrible assumption – that infinite demand exists for the asset at the last traded price.

Demand curves aren’t flat.

Furthermore, demand for financial assets is reflexive – demand for an asset decreases as more of it is sold.

Mark-to-market valuation is a useful accounting tool, and only works in traditional finance because in TradFi, these types of exploits are prevented (partly) by regulations – market manipulation is illegal.

In crypto, that doesn’t matter – code is law.

Rogue actors exist and take advantage of exploits as they’re coded. There is no way to stop them which preserves permissionless and credible-neutrality – two of blockchains’ core properties.

Any exploits that can happen, will happen, regulators be damned.

TardFi

As US regulators explore more lax restrictions, censorship-resistance is taking a back seat to “open finance” putting TradFi onchain.

Leading up to this, the trend of taking TradFi money through Silicon-Valley-washout VCs has already caused problems, turning what was formerly decentralized DeFi into “TradFi, but worse.”

Part of the problem is the profitability of bona fide scams built on the mark-to-market assumptions. VCs – those who would know best, would prefer to allow such faulty premises as mark-to-market valuation of assets to perpetuate trends like “low float, high FDV” at token launch, which inflates valuations long enough for them to dump on retail for an easy 10x.

The rest is simple lack of awareness – reasoning by analogy is imperfect; builders in crypto have the opportunity to build new primitives, from first principles.

In doing so, we should employ an inversion of Chesterton’s Fence – if you don’t know why a fence was built, don’t tear it down.

Similarly, if you don’t understand why a system was used, don’t copy it when building from scratch.

Conclusion

DeFi presents an alternative to the existing financial system – it is not merely a recreation of it “onchain.”

Building zero-to-one requires new patterns.

This also require new metrics to support reasoning about protocols which are not manipulable.

A few examples:

  • Nic Carter’s realized cap
  • Eric Waisanen’s loan-to-liquidity
  • Our own “chair ratio” – the ratio of unlocked supply to available exit liquidity

To tie it back to the original point, DeFi oracles can’t help but hallucinate when the foundations they’re built on are unsturdy, steaming with hopium gas.

At Token Dynamics, we reason from first principles, focusing on solid fundamentals to build a sturdy foundation for DeFi.

  • With @hoyu_io to refine their protocol: a novel, oracleless lending protocol that makes bad debt impossible
  • Designing @nuonfinance’s v2 with a veto-based governance to resist common governance attack patterns

In the process, we build valuable systems and help investors exit by ensuring deep liquidity with our tokenomics strategies.

Value creation through new protocols is not zero-sum – everybody wins.

If you’d like our help with your token, protocol, send us a message – we’ll tell you how you can improve the outcomes that matter and build from first principles – for the next century, not just the next cycle.

Sybil Disobedience: Cypherpunks Code Rights

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— Lysander Spooner, The Constitution of No Authority, 1870

The Bill of Rights in the U.S. Constitution was meant to enshrine freedom.

Spooner expressed this sentiment following the Civil War – how much more true is it now?

In the 21st century, free speech is curtailed. Privacy is dead. The right to transact is conditional, subject to support of the current regime.

In today’s age of lawfare and capricious regulation by unelected bureaucrats, that rule of law is a meme is becoming self-evident.

A document alone cannot protect human liberty. It never could. Only systems that make oppression too expensive can do that.

Freedom Is Not Given, It Is Coded

Spooner and Thoreau understood what most refuse to accept: rights do not exist unless they are enforced.

For centuries, enforcement meant violence. Judges interpret legal code. The state enforces it at gunpoint. Laws are upheld by force.

Crypto changes everything. In decentralized systems, code is law – not as a metaphor, but as reality. Smart contracts are not interpreted by courts. They execute autonomously. And unlike legal systems, they cannot be coerced or threatened.

For the first time in history, economic incentives replace violence as the primary enforcement mechanism.

The Economics of Enforcement

The 2nd Amendment itself is instructive of effective resistance.

In the United States, there are more guns than people. Attempts to confiscate them would be quickly met with overwhelming resistance.

So, the US remains – on the whole – one of the most free countries in an age where dying empires are oppressing their citizens en masse. And the takeaway is this – the 2nd Amendment doesn’t protect the right to bear arms – the arms do.

By raising the cost of enforcement prohibitively, freedom is secured.

This is how the world changes – not by asking for permission, but by making control economically infeasible.

Corporate Insurgency

We’ve watched this strategy succeed time and again for over 30 years on the internet.

In 1999, Napster cracked open the music industry’s monopoly, but it was centralized – and so was shut down.

But BitTorrent – now a crypto protocol – made enforcement so expensive that shutting down file-sharing became impossible.

File-sharing through torrents became so popular that the music industry, formerly dominated by extractive business models like iTunes’s – charging pre-teens $0.99 a song – collapsed as demand dried up in favor of the costless data replication that they called “piracy.”

Taking the view of Napster as a missionary, not mercenary organization, Napster won. Today, streaming services like Spotify and Pandora dominate as the leading business model in the music industry.

This taught us an important lesson: decentralization wins when it makes enforcement too expensive to succeed.

Crypto + Uber: Allies

We’ve see this approach succeed in startups as well. Legal scholar Elizabeth Polman calls this form of corporate civil disobedience “regulatory entrepreneurship,” citing Uber as a prominent success case.

Uber ignored outdated taxi laws which granted taxi organizations a monopoly on on-demand transportation in a given area. Rather than trying to uproot the entrenched bureaucracy through persuasion and asking permission, Uber expanded so quickly and amassed so much influence that regulators had no choice but to concede.

Likewise we’ve seen the strategy work in crypto. For a long time, prediction markets were extremely tightly controlled, as governments do not want to see these applications succeed. Polymarket broke the state’s control. Now, prediction markets are poised to upend governance – first in web3, and soon, in nation states.

The first crypto wars were fittingly won in the United States. Phil Zimmerman’s case for PGP turned cryptography into free speech. The U.S. government tried to classify strong encryption as a munition, illegal to export. Zimmermann published the code anyway, winning the first Crypto Wars and proving that releasing powerful code can change history.

But it wasn’t the court’s decision that won the freedom – the crypto cat was out of the bag, rendering enforcement moot.

Cryptoeconomic Authority

These are not isolated events. They are proof that when technology forces a shift in enforcement costs, (as James Dale Davidson predicted in 1995 with The Sovereign Individual), the old order collapses.

Satoshi understood this well; Bitcoin follows the same principle. Bitcoin is not secured by law – it’s secured by economic incentives.

Attacking Bitcoin is financial suicide. The incentives are aligned so that miners, even those who would prefer to subvert it, have only one rational choice: defend the system, because it pays more than breaking it.

”[A would-be attacker] ought to find it more profitable to play by the rules, such rules that favor him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.”

— Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System

This is cryptoeconomic security: the fundamental principle that a system remains intact only if attacking it is more expensive than cooperating with it.

The first Crypto Wars were won when Zimmermann ignored an unjust law and published PGP, giving the world encryption too powerful to ban. The next wars will be won the same way: by deploying unstoppable crypto protocols that make financial surveillance and censorship obsolete.

Cypherpunks Code Rights

Cypherpunks don't just write code, cypherpunks code rights.

Cypherpunks have a singular opportunity to enshrine human rights into unstoppable, economically self-enforcing systems. But rights are not real unless they are secured.

Legal systems are enforced through coercion, often arbitrarily.

Crypto systems are absolute, enforced through incentives.

That is the future. But only if we build it correctly.

Conclusion

Freedom is not granted. It is taken. It is coded. And it is defended by those who understand what’s coming.

At Token Dynamics, we design and assess cryptoeconomic systems with precision, ensuring that the cost-to-attack is astronomical, and making participation irresistibly profitable. This is how you secure a protocol. This is how you enshrine rights in code.

If you’d like our help with yours, reach out to @tokendynamics or message me directly.

Let’s build for the next century, not just the next cycle.

Crypto’s P/E Ratio: Price-to-Floor (P/F)

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In traditional finance (TradFi), the Price-to-Earnings (P/E) ratio is used to assess the relative attractiveness of a stock.

P/E is calculated by dividing the price per share of a company’s stock by its earnings per share (EPS). The formula is: P/E Ratio = Stock Price / Earnings Per Share.

A high P/E ratio typically indicates that investors are willing to pay a premium for the company’s earnings, which suggests they have high growth expectations. A low P/E ratio may indicate that the company is undervalued or that investors have lower growth expectations.

There are other ways to interpret P/E, but exploring these is beyond the scope of this article.

Valuing Cryptoassets

Valuing cryptoassets is clearly different than valuing stocks, but how has not been entirely clear to most. What is clear is the desire for a metric like P/E to measure the relative value of cryptoassets.

Market Cap

Market cap was an early attempt at such a metric. Market cap is borrowed from equities; it’s calculated as price times shares outstanding.

Market cap is flawed to begin with – the “marked-to-market” fallacy underlies many economic security exploits, but ignoring this, it’s a blunt tool borrowed from traditional finance.

Alternatives have been proposed, including Nic Carter’s “realized cap” and our circulating supply, but again – these metrics do not tell the full story, and are only applicable to some cryptoassets.

TVL

TVL, total value locked is another metric which has been proposed. The issue with TVL is that most protocols’ tokens don’t directly benefit from increased TVL. Their value is loosely correlated to TVL, at best. At worst, TVL is more of a liability than an asset. In Bitcoin, for example, onchain assets which are bridgeable out of the ecosystem can be profitably double-spent.

Fees

Fees are an useful metric for some protocols, but even in these cases, fees don’t tell the whole story.

https://cryptofees.info

Even tokens to which protocol fees accrue value are not 1:1 analogs.

Ethereum

Tokens are valued according to their tokenomic mechanisms – the ways they are used in a protocol which cause them to accrue value.

ETH gets some of its value through fees, but also accrues value through other mechanisms: use as a medium of exchange, as collateral, and through coin burns in EIP-1559.

This unique combination of tokenomic mechanisms causes ETH to accrue value differently than other tokens, even those which are used to pay fees.

Monero

XMR is also used to pay for fees, but most of its value comes from its use as a medium of exchange. This makes monetary base and circulating supply more relevant when comparing XMR to other cryptoassets.

Synthetix

Synthetix allows users to speculate on assets not native to Ethereum via its sAssets, synthetic assets backed by ~400% of their value in SNX tokens. Synthetix also takes fees, but it’s the TVL that most directly affects the value of SNX.

Synthetix's "c-ratio"

SNX’s price floor is proportional to the value of assets collateralized by SNX, and the collateralization ratio or, c-ratio.

Price Floor

A tokens’s fundamental value is reflected in its price floor – the minimum possible price for it to sustain before overwhelming demand buys it up on the order books.

Another way to describe a price floor is the price of a token if all speculators were forced to sell.

Price floor is absolute, like the book value‡ of a stock, but not that valuable in isolation.

In bear markets, you can take advantage of price floors on red days by placing strategic buy orders, but most tokens rarely hit their price floors, though there are notable exceptions.

Red candlestick chart

Price-to-floor, P/F

A token’s price can be envisioned as its price floor, plus a speculative premium.

Together, the price and price floor provide a measure of risk.

If you can accurately identify a token’s price floor, you can find its P/F.

Price-to-floor, then, is a measure of risk/reward of investing in a token.

This ratio can be used to compare all crypto assets over time, and relative to each other.

Conclusion

P/F is just one metric. As with equities, no single metric tells the whole story. But like P/E, P/F provides a lot of color.

As crypto matures, P/F will become even more useful to investors. For now, it’s a good measurement of the risk-reward of an asset.

None of this is financial advice. If you’d like more insight into how exactly to calculate price floors, P/F, and other metrics, I’ll be hosting a class where we walk through the examples listed here in more detail, as well as other examples of tokenomic mechanisms, valuation practices, and heuristics to identify valuable tokens and protocols.

Sign up for this one-time offering here.

* When price dips below price floor, the market purchases a token in speculators’ absence
‡ More accurately, the liquidation value of a company’s assets and liabilities

How To Make Fuck You Money

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What is ‘fuck you money?‘

While there’s no dictionary definition, the general understanding of ‘fuck you money’ is the amount of money you’d need to live how you want, with the option of saying ‘fuck you’ to any unwelcome demands.

That number varies for everyone. It’s subjective – not because of what it buys, but because of what it represents; fuck you money is not about the money, it’s about freedom.

Bitcoin is fuck you money

“Bitcoin is fuck you money.”

This is not a new idea. There’s some truth to it. Bitcoin is a permissionless, borderless, unconfiscateable, censorship-resistant vehicle for transferring wealth, but it’s not fuck you money – yet.

Disclaimer:

I don’t recommend investments or sell trading strategies, and I’ll spare you the history lessons on how Bitcoin was taken over, as well as any ideological monologues about how Bitcoin has strayed from its original path – this article isn’t about any of that.

No, this article is about how cryptocurrencies can become a universally accepted medium-of-exchange that is resistant to all forms of capture, the ultimate tool for censorship-resistance.

In fact, all of crypto is about that.

Censorship-resistance

"The main benefits are lost if a trusted third party is still required..."
“…the main benefits are lost if a trusted third party is still required…”

In the first paragraph of the Bitcoin white paper, Satoshi lays out the reasons for Bitcoin, among them: Bitcoin’s ability to disintermediate. Satoshi frames this property in the context of efficiency gains created for users. While Bitcoin provides some cost savings compared to traditional payments infrastructure, the unique value proposition of blockchain-based applications is somewhat emergent: censorship-resistance.

It’s unclear whether Satoshi viewed censorship-resistance as a unique value proposition of Bitcoin, but censorship-resistance is clearly desirable for many of those using cryptocurrencies today. Furthermore, censorship-resistance is the only 10x value proposition of blockchains. All other benefits are achievable with preexisting technologies at a lower cost.

Bitcoin is only partly censorship-resistant

In my talk at Token Engineering Barcamp in July, I described how censorship-resistance comes from the convergence of two properties: permissionlessness and privacy. Bitcoin has one; consequently, its been losing market share as a medium of exchange, a context where both properties are desirable.

Privacy may not at first appear to have much to do with censorship-resistance, but its absence gives rise to an insidious form of censorship – self-censorship.

People are reluctant to take certain actions and positions publicly, as evidenced by the popularity of Twitter anons and alt accounts. People only feel free to share their thoughts given a degree of anonymity.

In smart contracts, this has played out with Tornado Cash.

Tornado Cash

#FreeRoman

Tornado Cash, a privacy protocol, is censorship-resistant by traditional standards, but it’s not fully censorship-resistant because most of its participants still lack privacy.

This is not a criticism of Tornado Cash. For one, that would be in poor taste given the circumstances. More importantly, there is no way for Tornado Cash to achieve this property. Tornado Cash is built on Ethereum, which is not private by default; privacy, like other economic security constraints, is inherited.

Following the OFAC sanctions of August 2022, participants in Tornado Cash were censored by different means.

Seeing Alexey’s imprisonment, countless other developers have self-censored by declining to release their protocols, creating a chilling effect.

Additional factors

Money is unique among physical goods in that its value depends entirely on a counterparty’s willingness to accept it. This is a deficit of Bitcoin and its competitors. For a combination of reasons outside the scope of this article, not everyone is willing to accept cryptocurrencies. Suffice it to say, adoption as a medium of exchange is a necessary step for Bitcoin and other cryptocurrencies to gain wider adoption.

To do that, it needs a combination of supporting applications – basic banking tools, private means of coordination, and perhaps an entirely private financial system, all with good user interfaces. For the purpose of this article, I’ll call these infrastructure. This infrastructure is what’s needed for Bitcoin and other cryptocurrencies to become “fuck you money.”

The path of innovation

There are two ways to interpret this article’s title – both beg the question. To the first interpretation, I offer the second.

How do you get fuck you money?

You make it.

Bitcoin – as a catch-all for cryptocurrency – is not “fuck you money” yet. It requires applications built around it to draw users who will accept it as a censorship-resistant form of payment.

Getting users should not be hard; people follow their natural economic incentives. Faced with a choice between a CBDC and a censorship-resistant analog with a copycat interface, most of them will choose the latter.

99.99999% of money is not censorship-resistant, including Bitcoin. No money in existence is fuck you money. So to answer the question, how do you make fuck you money – you start by building the infrastructure for it.

There are 3 steps:

  1. Build protocols which are useful, valuable, secure, and private
  2. Provide good UIs to those
  3. Onboard users
The Principles of Tokenomics
Token Dynamics is helping builders with the first.

For the second, we’ve seen an explosion of talent in UI design pouring in through “Web3” the last couple of years. It may just take a step across the aisle.

And for the third, there are thousands of OG cypherpunks, crypto fanatics, and aligned influencers waiting for a good crypto product to share with their audience. Build these applications with a clean UI/UX and they will share it relentlessly.

Conclusion

So no one has fuck you money – yet.

What is needed for us to get there is not another VC-funded cash-grab, but censorship-resistance. In a world obsessed with how to get fuck you money, there will be plenty along the way for those who actually make it.

And the thing about fuck you money is, once we make it, all money becomes fuck you money.

Nerds, Normies, And Grifters: Keeping Crypto Weird

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The Twitter thread this article is based on was originally published in 2021 by the now-banned @EatSleepCrypto account.

Geeks, MOPs, and Sociopaths by @meaningness is one of the top 5 pieces I’ve ever read.

If everyone in crypto read it, we would be far wealthier, and would achieve mass adoption within 2 years.

The article describes the evolution of subcultures that ends in their inevitable demise.

The author attributes subculture demise to the dilution of an initial scene of geeks by two groups: MOPs – members of the public, and sociopaths. In this context, sociopath is supposed to mean nihilistic and status/profit-oriented.

Defining subcultures

Subcultures are created and sustained by geeks.

There are two types: creators, and fanatics – sound familiar?

Creators invent a New Thing which fanatics rave about.

The New Thing catches the attention of MOPs who dilute and change it over time.

Sociopaths see MOPs’ affinity for a subculture and come in, posing as geeks in order to extract social and financial capital.

Eventually, the dilution of a subculture by MOPs and its perversion by sociopaths drives geeks away. MOPs follow geeks, and only sociopaths are left.

In this way, a subculture dies.

Quality Control

@meaningness suggests three ways to resist the dilution of a subculture by MOPs and sociopaths:

  • Geeks can refuse to admit MOPs
  • Fanatics can convert MOPs
  • Creators can “be slightly evil,” or profit-oriented

In crypto we are uniquely able to do all three.

The crypto analogs of geeks, MOPs, and sociopaths are nerds, normies, and grifters.

Our New Thing is the blockchain and its novel implications, namely, inalienable individual sovereignty. Crypto, DeFi, and Web3 are the manifestations of the New Thing, but not the New Thing itself.

Gated Communities

Using crypto terminology now, crypto is unique because nerds – builders and fanatics, can refuse to admit normies.

This is enabled by the token-gating of events and discussions through NFTs, decentralized identifiers (DIDs) and verifiable credentials (VCs).

Fanatics in crypto are also uniquely positioned to convert MOPs.

Normies are more closely aligned with the principles of individual sovereignty than ever in history; political fallout is accelerating the trend.

@meaningness’s third suggestion is to “be slightly evil” – a better way to put it might be, be slightly profit-oriented.

Crypto is uniquely positioned to do this, but it’s not a given.

Goal of subcultures

Every subculture’s implied goal is to self-perpetuate.

From Meaningness’s article, we can see that a subculture’s survival depends on the profit-orientation of its early adopters.

Too much, and it alienates members of the subculture, and the subculture becomes a parody of itself.

Too little, and the subculture goes broke as grifters come in and destroy it.

Takeaways

I see three major takeaways from the article.

To preserve crypto culture:

1) We must create our own spaces and support token-gating

2) Fanatics should focus on onboarding normies

3) Builders must be profit-oriented

Token-gating crypto spaces

By the time this debate arises, this position will – by definition – be unpopular, which is why we should support it now.

Token-gating events and discussions should become standard as the tech to facilitate it develops.

There are plenty of ways to do this, from requiring NFTs to attend events, to systems of trust which are being developed in ReFi-adjacent spaces.

Onboarding normies

Due to draconian measures by governments worldwide in 2020-2021, normies have never been more aligned with crypto principles.

All that’s needed is UI/UX improvements, and education.

Builders need to emphasize UI/UX; fanatics can focus on education.

Profit orientation

To be profit-oriented, builders need to get better at value capture.

The cryptocurrency market will not remain speculative forever.

Many tokens are fundamentally worthless; when the market figures this out, they will be priced accordingly.

In order to do this, builders should focus on the demand for their token, rather than supply reductions to generate artificial scarcity.

This is the premise of demand-side tokenomics.

The future of crypto

We have been witnessing the perversion of crypto’s essential cypherpunk subculture through its dilution by normies for the last 10 years.

A few key events in the timeline:

  • Bitcoin’s rebranding from A peer-to-peer electronic cash system to “digital gold”
  • Coinbase and other exchanges’ degeneration into shitcoin casinos
  • The rise of pfp NFTs and “web3” as distinct from cryptocurrency

While these events are disheartening, the intended message of this article is that these trends don’t need to affect the core subculture of crypto.

Because of its ability to exclude and convert MOPs, it’s possible for the crypto subculture to persist, untainted.

But if builders fail to capture value, and fanatics don’t onboard normies, crypto will follow the open-source movement and fail to make an impact outside of itself.

I hope builders and fanatics alike take note and begin to capture value.

It’s for this purpose that the entirety of Tokenomics 101 exists.

Building defensibility in open-source crypto protocols

Posted By under Tokenomics , ,

Defensibility is the competitive advantage of a protocol. It’s what keeps consumers from going to your competitors.

In short, moats.

The more defensible a protocol, the more value it can capture, and the more overtly it can do so.

Maximizing defensibility results in a monopoly.

In Peter Thiel’s famous talk at Stanford, he describes why you want to have a monopoly in your industry – monopolies can capture nearly all of the value they create.

It’s difficult to have a monopoly in crypto, as it’s hard to build defensibility in open source – how do you compete when your competition knows your secrets?

Still, there are various ways to build defensibility, and the more defensibility you have, the more value you can capture.

Moats in crypto

There are many reasons to build defensibility into your crypto protocol, and there are five moats – concrete ways of doing so.

These are:

  • Network effect
  • Lindy effect
  • Documentation
  • Brand
  • Gas efficiency

Network effect

Network effects build defensibility proportional to value created.

From Metcalfe’s Law, we know that networks become exponentially more useful to participants as the number of participants grows.

Metcalfe’s Law was originally used to describe fax and telephone networks.

Because crypto protocols share a network topology with these earlier telecommunications networks, Metcalfe’s Law also describes the utility of crypto protocols increasing exponentially with the number of users.

Protocols may use a first-mover advantage to generate strong network effects which increase utility, and therefore defensibility.

Lindy effect

The Lindy effect is a theorized phenomenon whereby the longer something has been around, the more likely it is to remain.

Lindy is somewhat of a meme in crypto, where it’s perceived as a somewhat irrational phenomenon. Yet it makes an excellent moat for very rational reasons.

The length of time a given protocol has persisted without being hacked is a testament to that protocol’s security (especially in DeFi protocols, where black hat hackers are strongly incentivized to take advantage of a protocol).

The more unique the protocol, and the greater its TVL, the more Lindy “staying power” is ascribed to it.

Lindy effects become a strong moat for unique, high-TVL protocols over time as users prefer the security of battle-tested protocols to slight improvements in utility, or decreases in value capture.

Documentation

Good developer documentation is an under appreciated moat in crypto.

Good doc invites developers to build on top of a protocol.

In this way, documentation is important for primitives and other protocols that aspire to be money legos.

Brand

Never underestimate the power of a good brand.

At a certain point, marketing takes care of itself for crypto protocols with good branding.

It can be difficult to displace incumbent protocols which have developed a good reputation, even becoming synonymous with their protocol’s function.

A good brand can be developed through organic or paid marketing activities, eventually causing the marketing activities to take on a life of their own.

very meme, so trend – wow

Gas efficiency

Gas efficiency is another moat, which, combined with the Lindy effect will give your protocol defensibility.

Gas efficiency is especially important for hyperstructures, or money legos. Because they are non-upgradeable contracts, hyperstructures must optimize everything possible before launching a version of the protocol.

Conclusion

Defensibility is one of the most important aspects of designing a protocol.

Building defensibly plays a part in the optimization between utility and value capture.

If you don’t design defensibly using these moats, your protocol will be copied by a competitor, who will capture less value.

Optimizing for defensibility is one of the topics we focus on in Tokenomics For Founders.

If you’re interested in learning more about mechanism design to help your protocol capture value sustainably, creating win-win-win situations for all participants, reach out to us and tell us what you’re building.

The hierarchy of value capture

Posted By under Blog, Tokenomics , , , , , , ,

The hierarchy of value capture is the axis along which protocols and the tokenomic mechanisms they employ can be ordered.

Protocols face a challenge in navigating this hierarchy when designing their value capture: mechanisms in the hierarchy of value capture can be ordered simultaneously as ascending in value capture, and descending in defensibility.

In essence, the more value a protocol captures, the less defensible it is.

This phenomenon epitomizes the tradeoffs between the first two principles of tokenomics: value capture, and utility; it will be helpful to understand a bit about these concepts before reading further.

Utility and value capture have tradeoffs because of their interdependence – the maximum value you can capture is the total value you create. As more value is captured, less is left for consumers.

Value creation, or utility, and value capture in crypto protocols resemble those of traditional companies, but they are not perfect analogs.

In a traditional business, value creation is the total value ascribed by consumers to a product or service; value is most frequently captured through profit, a percentage of the value created.

In crypto, utility is the same – the value created by a protocol, for users, but value capture is often different.

Value can be captured in more ways than in traditional businesses because of the types of tokens that are able to be created, and the underlying utility and flexibility of the blockchain back end.

But for both crypto protocols and traditional companies, the ability to capture value long-term is proportional to two things: value creation and defensibility.

Defensibility

Defensibility is the competitive advantage of a protocol. It describes how much value can be sustainably captured before comparable utility is offered by a competitor.

The more defensible a protocol, the more value it can capture, and the more overtly it can do so.

Maximizing defensibility results in a monopoly.

In Peter Thiel’s famous talk at Stanford, he describes why you want to have a monopoly in your industry – monopolies can capture nearly all of the value they create.

It’s difficult to have a monopoly in crypto, as it’s hard to build defensibility – how do you compete when your competition knows your secrets?

Still, there are various ways to build defensibility, and the more defensibility you have, the more value you can capture.

Tokenomic leverage

The ratio of value captured to value created is called tokenomic leverage. Higher tokenomic leverage in a tokenomic mechanism or protocol overall is analogous to higher profit margins in a traditional business.

Tokenomic mechanisms further up the hierarchy have higher leverage. And it’s possible to have a tokenomic leverage greater than 1 – indicating more value is being captured than created.

Synthetix’s tokenomics are an example of high tokenomic leverage.

Users of Synthetix can create sAssets – synthetic TradFi assets collateralized by several times their dollar value in SNX tokens.

Synthetix governance decides this collateralization requirement, but it generally stays between 300% and 500%.

This means that SNX will necessarily be worth 3-5 times the value of all necessary sAssets.

So the tokenomic leverage of this mechanism in the protocol is between 3 and 5, depending on the current collateral requirement.

Synthetix’s collateralization mechanism introduces economic security issues only mitigated by active management of the c-ratio, and heavy inflation. As a result, Synthetix has begun to pivot its design toward other tokenomic mechanisms with lower value capture – but not for fear of competition.

Synthetix still has a monopoly on synthetic assets in the Ethereum ecosystem. If economic security were not also a concern, SNX could retain its inordinate tokenomic leverage.

This is only possible because the protocol has a monopoly; higher tokenomic leverage requires extreme defensibility.

Capturing value creatively

In traditional businesses, profit comes at the consumer’s expense – there is a direct tradeoff between value creation and value capture.

McDonald’s Corporation, however, is a notable exception.

McDonald’s captures value differently.

McDonald’s share price has grown nearly 1,000,000% in its 58-year history – and they didn’t do it charging $12 a burger.

McDonald’s is a real estate company – it accumulates properties and rents them out to franchisees, selling them when appropriate.

This alternative method of value capture enables McDonald’s to subsidize their actual product – burgers and fries – crippling the competition and making for a defensible business, while still capturing value for shareholders.

McDonald’s alternative means of monetization is a prototype of mechanism design, the most crucial aspect of tokenomics.

Mechanism design is the construction of sets of incentives to create desired outcomes. Good mechanism design follows the principles of tokenomics, which are the focus of the demand-side tokenomics framework.

Curve’s CRV

Curve is an example of a protocol which has captured value creatively.

Curve gets a lot of press, both good and bad for its vote-escrowed or ve tokenomics.

But Curve’s ve tokenomics are only a part of its creative value capture methods.

Like McDonald’s, Curve subsidizes their product, trading, with their alternative method of value capture.

Curve’s captures value through bribes – the more bribes being paid to LP’s, the more demand there is for CRV.

The subsidization of trading fees is also proportional to the value of bribes paid to LP’s.

Systemic consequences

Navigating the hierarchy of value capture is a stumbling block for most protocols designing their tokenomics.

Failing to see the problem clearly, many protocols overcompensate in capturing value.

When a protocol captures too much value, attempting to use their own token as a medium of exchange for example, they alienate users, enabling their competitors to copy their protocol without using a native token, capturing value through fees or another tokenomic mechanism with tokenomic leverage.

If a protocol captures too little, they lose out on the opportunity to capture value at all, and doom any competitors to the same fate.

Uniswap’s failure to capture value from the start led to the need for Curve to capture value creatively in the first place.

But in reality, Curve didn’t only capture value creatively.

Curve had to create additional utility to compete with Uniswap, because Uniswap had set the AMM market’s barrier to entry at zero value capture or less.

Subsequent AMMs capture even less value, issuing evermore inflationary tokens to subsidize their operations; as a result of Uniswap’s initial failure, all future AMMs are forced to capture negative value just to compete.

And while Curve’s innovation of ve tokenomics was clever, Curve would have been able to capture more value, with better margins had Uniswap captured value as well.

Avoid at all FOSS

Arguably the worst fate for crypto would be to follow in the footsteps of the FOSS (free, open-source software) movement.

Linux was built by similarly ideologically motivated developers who believed, as a faction of crypto does, that software should be free.

The result was unsurprising: software with poor UX, which most people hate.

Linux has been relegated to a small percentage of computer users, while competitors Apple and Microsoft were left to capture inordinate amounts of value extractively because of the duopoly they were left with.

Crypto has a unique opportunity to do open-source right; in Linux’s day, the internet had no native currency – no way to transfer value, charge microtransactions, or accrue value to native assets.

Now, there is more opportunity than ever to create valuable, yet open-source software and get paid for it.

The study of that monetization is called tokenomics.

Conclusion

Tokenomics can be hard to get right, and there’s a lot riding on them, both for your protocol and for the broader industry.

We walk founders and developers through these important questions with the Demand-Side Tokenomics framework – a series of questions and worksheets designed to evoke the optimal design for your protocol based on the principles of tokenomics.

If you’re building a protocol and would like help, or a step-by-step guide on how to design for optimal utility, token price, and longevity of the protocol, reach out to us and tell us what you’re building.

Tokenomics 101: The Principles of Tokenomics

Posted By under Tokenomics, Tokenomics 101 , , ,
Ray Dalio, Principles

Tokenomics describe the relationship between a token’s use and its price. Done right, tokenomics can align the interests of protocol participants, leading to a valuable token, and securing the protocol from economic exploits.

Designing a protocol requires keeping track of many moving parts – to this end, it is helpful to have a framework.

Enter demand-side tokenomics.

The demand-side tokenomics framework can be distilled in three principles: utility, value capture, and economic security.

There are tradeoffs between each of them, so the goal of tokenomics, according to the framework is to maximize the aggregate of these three.

Utility

Utility is the usefulness of a protocol to all participants.

There can be multiple groups of participants in a protocol. To maximize utility, these groups’ interests should be synchronized.

This can be done by matching demands of each group.

For example, MakerDAO matches the wider market’s demand for stablecoins with degens’ demand for leverage.

Value Capture

The second principle of tokenomics is value capture.

Many protocols create value – utility, but fail to capture any of the created value to a token.

For example, Uniswap has $1.2 trillion in all-time trade volume, but UNI sees none of it. Uniswap has never charged, and plans never to distribute fees.

Use of the Uniswap protocol is completely uncorrelated with the value of its token.

Because they didn’t capture value initially, Uniswap can’t capture value from the utility it creates.

Value capture comes from the strategic inclusion of tokenomic mechanisms – ways a token is used in a protocol.

Value captured through tokenomic mechanisms (e.g. staking, collateralization, buyback-and-burn) varies.

Value captured by a protocol can be modeled, and mechanisms compared based on value capture and economic security.

Economic Security

Economic security is the third principle of tokenomics.

Economic security is distinct from technical security – technical security comes from an absence of bugs in the code; economic security entails a lack of vulnerabilities in the incentives.

Vulnerabilities in the incentives enabled three major exploits in 2022 – the collapse of Terra, the Mango Markets exploit, and the Aave liquidity exploit were all economic, rather than technical security issues.

Conclusion

There are tradeoffs between each of these principle, and successful protocols maximize the aggregate of the three.

Tokenomics is challenging to get right, especially because of the associated technical complexity of writing smart contracts.

It’s helpful to have a framework when designing the tokenomics of your protocol.

The demand-side tokenomics framework is what Eat Sleep Crypto uses to teach tokenomics to developers in the Tokenomics For Founders 6-week intensive course.

Space is limited, so apply now to be a part of the next cohort.