Greetings community,
I’ve been thinking about Bonds lately and the role they will play with ShadeSwap. Fundamentally, the current model of LP rewards is quite simply not cost effective in relation to bootstrapping long term sustainability, and I feel that Bonds are actually a more efficient means by which we can sustainably build out compounding growth that is owned and not rented.
Before I make the petition for bonds to be the primary mechanic bootstrapping ShadeSwap (as opposed to LP emissions), let us first define terminology to make this claim as easy to understand as possible.
Disclaimer: the following terms below will be used for educational purposes due to the terms being helpful for transmitting concepts, and in no manner represent actual underlying definitions of Shade Protocol mechanics and definitions.
Equity: decentralized ownership of a protocol - decentralized governance collectively can determine where long term revenue and rewards are directed too (please see above disclaimer)
Asset: tokens that hold value
Service: the act of helping or doing work for someone
Inventory: assets that a business holds for the ultimate goal of resale, production, or utilisation.
Let’s start with the problem of DEXs:
DEX “Z” provides a trading service by creating a liquid market of digital assets that can be traded between. Z is obsessed with deepening liquidity because the deeper the liquidity, the better the service that is provided to users (deeper liquidity means less slippage and less volatility).
In order for Z to be sustainable into perpetuity:
trading fees >inventory expenses
That is to say, revenue (trading fees from trades) from providing the service must be greater than the cost of providing the service (cost of emissions & development). In order to attract sufficient liquidity, Z feels the urgency to emit rewards at those who can bring liquidity to Z such that users will trade on Z versus alternative options.
In DeFi, LP providers are happy to provide the service for the DEX assuming the following assumption holds:
(LP rewards on DEX + trading fees) / risk) >alternative yield options
But what is Z giving to LP providers in return for their service of renting liquidity to the DEX? Z is emitting equity at liquidity providers in exchange for a service that the LP provider is giving Z.
Think about the significance of this in relationship to a fictional real world example:
Bob runs a racing track. Bob has a problem: he has no race cars for people to use. Zach has race cars - he agrees that Bob can use his race cars on a daily basis, but instead of paying a fixed amount of assets to Zach for providing the race cars, Bob instead has to pay equity to Zach. Zach is earning not only a claim on the underlying assets and revenue of the racing track, he also has the ability to sell his equity whenever he’d like to anyone else at any time. Finally, Zach has no fixed obligations to the race track. He can take his race cars away to the next highest bidder whenever he’d like: damaging the service that Bob is providing and reducing the number of customers that will use the race track.
I’d like to reiterate the absurdity of what DEXs are doing: they are emitting equity at individuals that are providing a temporary service - and what is even more absurd is that the revenue captured from the service provided by LP providers does not outpace the value emitted at LP providers. This is fundamentally not sustainable.
But Carter, this DEX model clearly is operating under a “loss leader” assumption, once there is enough liquidity, trading fees, and proof that Z is safe then surely this equation starts to turn around? I would agree with you except that LP providers can pull their liquidity whenever they would like based on their risk/reward profile and projections of alternatives. Under the Z model, liquidity that is present on a DEX today is not a promise that it will be there tomorrow.
So what is the alternative? Simply put, stop emitting equity for a service that is not permanent and is not creating value accrual that outpaces the expense. Instead, emit equity for assets that the protocol will own into perpetuity. This is conceptually what Shade Bonds unlock: the sale of SHD for assets that ShadeSwap can use, forever.
This is significantly more sustainable: if depth of liquidity is the service that ShadeSwap is providing, and the deeper the liquidity the better the service, than we should aim to create the following feedback loop:
- Acquire assets
- Liquidity provide the assets
- Fees are generated from the service provided
- Use revenue from use of the service to acquire more assets
- Liquidity provide the assets acquired by revenue (service just got BETTER because liquidity is now deeper)
With an extremely patient approach to building out a DEX (say a decade long vision) as long as the DEX is able to continue to grow, this feedback loop should create a compounding effect where the service is always improving, and the nominal number of assets being used to create liquidity that is traded across should never decrease.
How do you kick-start the above loop? Simply put, by trading one valuable resource (SHD) for another desired asset (SCRT, ATOM) using Shade Bonds. A shout-out to DRO here, they are attempting to jumpstart the above loop using revenue from derivatives, which is another fascinating way of kickstarting the above feedback loop. Shade Protocol plans to use its various DeFi primitives (derivatives, lend, stablecoin) to all help contribute to the above feedback loop.
So, we swap out bonds for LP emissions - what does this tangibly look like? First, let’s briefly return to LP rewards.
What a user might do with their LP rewards:
- Sell 100% of LP rewards
- Stake LP rewards
- Some combination
If we assume a user will sell 100% of LP rewards, then by the same logic we should assume that all SHD acquired by a user from bonds will 100% be sold on the open market. In the previous model of Z, DEXs have been okay with this assumption. They didn’t have a choice really, they had to be okay with that trade-off. Well, with bonds we have to be okay with that assumption too. They might sell all of the SHD tokens acquired from bonds, but we end up with permanent assets vs a rented service, so all around we are pretty content with the trade.
Osmosis is an interesting case study on LP providers and how much they sell versus stake. 45% of 300M emissions in Y1 went to LP rewards. 25% went to staking. What was the net result? The staking ratio of Osmosis is ~35%, with the staking/LP ratio being 0.55 (you could think of this that for every $0.55 of rewards for staking, there is $1 worth of LP rewards).
Some Osmosis data
This is very interesting data as (45% LP rewards + 25% staking rewards) / 2 = 35% staking ratio! That is to say, roughly speaking the staking ratio will be a meeting-in-the-middle of LP providers taking a percentage of rewards and putting it towards the staking opportunity. This is a simplification of a number of variables, but as a general rule makes sense. Some rules Shade Bonds should take away from this rough data:
- The higher the staking rewards in relation to Shade Bonds emissions, the more that Shade Bond purchasers will stake their acquired SHD vs selling it
This is where SHD protocol has an interesting conceptual advantage over other staking protocols. In traditional staking schemas, staking is essentially a scarcity mechanic where users that are staking get paid rewards for absorbing volatility by not being able to sell their equity immediately.
With Shade Protocol, SHD staking collateral provides a service: arbitrage + scarcity + liquidity provision (via SHD ←→ Silk bounded conversion minting). As such, having a high staking ratio in relation to Shade Bonds is not a disadvantage as the service being provided by SHD stakers is quite compelling. This follows one of the original principles of Shade Protocol:
“In order to realise the rewards of SHD staking, you must take on some level of risk to help stabilise the underlying protocol.”
Now onto the asset acquisition participant: I call this “Asset Providers” i.e. “AP” instead of LP “Liquidity Provider”. An AP participating in “Bond Mining” (the process of continually rotating through bond opportunities in a profitable fashion) has a different set of risks compared to an LP provider. Let us examine them:
- If an AP provider deposits assets in Shade Bond, and the price of SHD decreases beyond the discount rate then the AP provider is net negative
- AP provider must absorb the cost of slippage when they receive their SHD, as they need to retrade SHD back to the demanded asset by the new set of issued Shade Bonds. This process of continual rotation is what I call “Bond Mining”.
- Vesting length
So how can we reduce risk for the AP here?
- Deeper the discount, the less risk the AP is taking on
- Have a deep liquidity for bond miners rotating through bonds, the deeper the liquidity on, say, an ATOM/SHD pair, the less risk the bond miner is taking. Note that this feels like a pretty intuitive risk that gets resolved as the protocol will immediately turn around and deepen the exit liquidity that the bond miner is rotating through.
- ATOM → Deposit in SHD Bond
- User receives SHD at end of vesting period
- Sell SHD for ATOM
- ATOM → Deposit in SHD Bond (but with a grown position due to discount)
- Short vesting lengths
Now to inverse the perspective, when the protocol reduces AP risk how does this increase protocol risk?
- Deeper the discount, the worse trade that is being made by the protocol (I’m giving you equity at a cheaper rate than what it is actually worth)
- No real additional risk here, the opportunity cost here is that the liquidity used on the DEX by the protocol can’t be used in other Shade primitives
- The shorter the vesting length, the quicker bond miners can negatively impact SHD price, but note we have already accepted the fact that 100% of SHD may be sold - as this is the same assumption that LP emissions assumes. Obviously you want to reduce the risk of SHD being market sold directly, and this brings us back to our above point about having SHD staking emissions be quite high
Osmosis daily LP emissions in Y1 (in relation to Y1 emissions) is ~0.037% of rewards per day. Osmosis daily staking emissions in Y1 (in relation to Y1 emissions) is ~0.021% of rewards per day. I would posit that SHD protocol should mirror these numbers but instead swap out LP rewards for daily bond emissions.
This would look like the following: ~902k SHD earmarked for Y1 staking & LP rewards. We want to mirror the 0.55 stake/LP ratio initially which would put us at the following:
Staking: 9.75% down from 12.36%
AP / LP: 17.61% up from 15%
SHD originally had a staking/LP ratio planned at .824 → this ratio puts a higher emphasis on rewarding those providing the service of scarcity + locked rented liquidity + arbitrage + ownership of tokens in comparison to AP providing. I would posit that the currently planned ratio suffers from the same issue we are trying to avoid with DEX Z, which is overvaluing rented services. Grant it, staking is a unique component of any protocol as it is the feedback mechanism that rewards tokenholders for being….tokenholders. But hopefully we can all collectively understand the wisdom behind not overemphasising on the value of staking out of the gates in relation to where emissions can be directed towards permanent stability in the form of services built on top of protocol owned assets and liquidity that eventually is kickback to stakers.
Some questions at large I have on my mind:
- If we know X amount of SHD is earmarked on a daily basis, do we keep deepening the discount until someone APs the bond until max-out?
- That is to say, do we have a floor value of issuing bonds at?
- The role of Silk bonds
- Minting bonds vs using existing SHD assets on the treasury
- The split of emissions between renting LP vs bond miners
In summary, I would posit that ShadeSwap should be built out with a ten year vision in mind. This means patience with emissions, and making sure emissions are maximising long term sustainability & ROI. I would posit that protocol owned assets are the best emission trade. Bob should be selling equity in return for the business permanently owning Zach’s race cars as opposed to selling equity for the temporary service of Zach providing race cars.
If we bootstrap the DEX properly, we will eventually hit a level of protocol owned assets where revenue from the protocol can continue to deepen liquidity via protocol asset purchases (perhaps in the form of a bond sale using a non-SHD asset) instead of token emissions in the form of SHD. That is what true sustainability looks like. Note, LP rental is in essence, a user attraction mechanism - and should be thought of as such.
If done properly, the service provided by ShadeSwap will only continue to improve. Things like UI/UX is of course a moat, but sustainable tokenomics that create compounding growth are the greatest moat of them all.
-Carter Woetzel
