Vote Escrow, Bribing and DeFi Flywheels
Vote Escrow, Bribing and DeFi Flywheels
The power behind veJOE
Liquidity providers are essential for every decentralised exchange, without them there are no tokens to trade and no volume to get revenue from. It is industry standard to charge a small fee (usually 0.01%-0.3%) on every DEX trade and re-distribute it to LP holders. The fees by themselves, however, are quite often not enough to compensate for the risks (e.g., impermanent loss) they take.
This is where token emissions come in, with projects incentivising liquidity by issuing their native token to liquidity providers. This approach is efficient in the short term but comes with its own set of problems. The biggest of them is an increase in sell pressure and token inflation - mercenary capital comes in, “farms” rewards, sells them on the market and moves on once the yield dries up. Incentives are misaligned between token holders, who are interested in the longevity of the DEX, and some of the liquidity providers, who are just chasing the best yields.
Vote escrow (”ve”) tokenomics aim to fix this. They were first introduced by Curve in August 2020 and since then have been adopted by various other protocols including Trader Joe. The exact implementations will vary, but underlying principles stay the same - users are encouraged to “vote lock” their tokens to gain time-weighted governance rights, and yield boosting power.
Vote-locked tokens can’t be sold/transferred until the lock expires (Curve model) or without losing all voting power (Platypus/Trader Joe model). This ensures that token holders can’t just jump ship whenever they want and are interested in the protocol’s longevity.
Gauges and Tokens
Curve not only pioneered the ve model but was also the first protocol to introduce emission gauges. Each liquidity pool has its own gauge and each gauge has a weight associated with it, which defines what portion of CRV (Curve’s native token) emissions the pool receives. The weights are voted on every week by veCRV holders through the on-chain governance mechanism.
Stablecoin protocols are interested in having the deepest possible liquidity on Curve and therefore want the weight for their pool to be as high as possible to attract liquidity providers. The most basic way to achieve this would be to accumulate vote-escrowed tokens and vote for their pool’s gauge themselves.
This, however, would require a significant capital allocation from each protocol and expose them to a price movement of tokens they don’t necessarily want to hold. The users who don’t necessarily want to vote but are interested in boosting yields for their LP positions would also need to take big risks by buying and holding the exchange’s native token.
Convexes and Vectors
That’s where all the “geometrical” protocols come in. They vary in their design and do not always have a math-sounding name, but are similar in the sense that they aim to accumulate large amounts of ve tokens in their treasuries and then use them to benefit all protocol participants (i.e., to boost yields for everyone willing to farm through them).
Convex is a DAO building on top of Curve that was able to accumulate more than 50% of all veCRV. In a similar fashion, Vector holds the majority stake in veJOE. This dominant position allows these protocols to offer incredible yield boosts to their users but also offers a unique governance opportunity, as they de-facto have immense control over underlying exchanges, which comes in handy when it comes to governance and voting.
Bribing and Governance
DEXes are building blocks of DeFi and liquidity is their lifeblood. Those who control the flow of liquidity have the most power, so instead of accumulating governance tokens themselves protocols can pay a small one-time fee (i.e., “bribe”) to existing holders to vote to direct emissions to their gauge.
With Convex-like protocols controlling huge shares of governance power for underlying DEXes, it actually becomes more enticing to bribe those protocols and their holders directly.
Bribing is beneficial for both DeFi projects interested in increasing liquidity for their pairs and users looking to be bribed. For example, on Convex each dollar spent on bribes results in more than 1$ worth of emissions. Governance token holders on the other hand gain a source of yield that’s external from the decentralised exchange itself and exposure to other projects in the ecosystem.
Flywheels and Utility
Once you have the three ingredients - a DEX with clever tokenomics, protocols that are willing to build on top of it and working governance (e.g., gauges) - you can start assembling the DeFi “flywheel”.
Similar to how these mechanical devices serve to accumulate kinetic energy in real life, DeFi flywheels acquire value for the tokens involved. The DEX ecosystem theoretically becomes complete and self-sustaining:
Exchange leaks some value through token emissions to liquidity providers
This value is re-captured by “convexes” and demand for yield boosting
Gauges and bribes ensure that external protocols participate and provide further utility to the token
Sustainability and Conclusion
Building working flywheels takes time and effort. You need to make sure they don’t go too fast or too slow and you must oil them so there isn’t any unnecessary friction.
Avalanche has only really started on its journey of engineering such a system, but have made an amazing progress. There are three protocols with ve tokenomics including Trader Joe and even more projects competing for control over them.
The perpetuum mobile of Avalanche DeFi is being built right in front of everyone’s eyes and when it’s done it will be glorious.