As anyone who has participated in a death spiral will tell you — they are stressful and traumatic to be in the middle of. Slower death spirals might take years to play out. There are some death spirals — however — that are in a class of their own. These spirals can destroy whole systems of value in under a week. Let’s have a chat about the Turbo Death Spiral.
*The usual “This is not financial advice” disclaimer at the bottom of the article.
What is a Death Spiral?
For me, the hyper-evolutionary nature (ie they mutate and die at an incredible rate) of protocols in crypto is incredibly entertaining. There is always a lot to learn. There is always a lot to be wrong about. We are experimenting with complex machinery.
Successes are hard to learn from, as often the successes are not easy to replicate in other contexts — or just haven’t failed yet. Systemic failures, however, are a wellspring of learning opportunities.
Here we are looking at a really particular failure state called a “death spiral”. You might have heard this term in association with the UST/LUNA collapse. In general, a death spiral can be any self-enforcing vicious loop that ultimately kills a system. In crypto, this seems to take a more particular form that looks something like this:
To put the picture into words — a death spiral in this context is a series of events by which a token’s value gets hammered, the system that depends on the token breaks down, the system then acts against the best interests of the token holders, and the token holders sell off to avoid the system destroying their wealth. Then the cycle repeats. Ultimately, this cycle ends up in the protocol being dead and the token holders traumatized. It’s a negative-sum scenario that very few will benefit from.
What is Endogenous Value Tokenomics?
I use the term Endogenous Value Tokenomics (EVT) to refer to a specific kind of system design phenomenon, in which the price of the system’s native token plays an active role in some function of the system itself. Most crypto projects employ EVT implicitly to some extent. Examples of this might be:
- Most Proof of Stake blockchains require its token to be expensive enough that running a 51% attack on the blockchain would not result in a profitable theft of assets.
- Governance tokens require participation to be expensive enough that no one player could maliciously subvert the protocol’s (and other holder’s) long-term interests by accumulating a large enough stake.
- Any yield farming program that pays out in the protocol’s native (governance?) token, as they depend on the token being valuable in order to attract participants. This was the whole DeFi summer situation.
There are other projects that employ EVT explicitly. These projects feature some aspects of spending the projects’ tokens in absence of (but denominated in) dollars/other tokens. Some ways this might happen are:
- Algorithmic stablecoin designs that use a complementary “share token”, that captures the volatility of the associated stable asset. The only example off the top of my head that hasn’t imploded (So far? I really can’t see the future.) is FXS’s role in the creation and destruction of the FRAX stablecoin. Dead examples include TITAN’s role in stabilizing IRON, and of course — LUNA’s role in stabilizing UST
- Non-native-token-denominated rewards and compensation programs, that are paid out in the native token. Examples of this include 1inch’s Gas Refund Program which refunds the ETH cost of gas in 1inch tokens of equal value.
- Protocols that take on some sort of liabilities that are covered by a sell-off of their native token. Examples of this would include Aave’s Safety Module and Bancor’s Impermanent Loss Insurance.
- Protocols that algorithmically exchange a (discounted) dollar value in their own native token for other assets. The most common example I can think of is the bond mechanism introduced by Olympus DAO.
Tokenomics that employ EVT generally work well in markets where everyone is buying your token. In fact — they might get superpowers because of all of the buy-pressure. EVT-based tokenomics are generally very good at harnessing positive price action to bring value to the system. In a bear market, however — where everyone is trying to sell your token… EVT can rapidly flip into a liability. This is where structural issues arising from EVT can be felt in practice.
EVT on its own is completely fine. Not all examples I named inherently introduce structural issues. Some applications of EVT can be trivially turned off, so the downsides are limited. That being said — certain ways of harnessing EVT can create the pre-conditions for death spirals to occur. If your system (as a whole) can properly function while losing 90% value in a very short period of time — there don’t seem to be significant structural issues when it comes to initiating a death spiral. If the system completely breaks down if the native token loses value — big oof.
The Turbo Death Spiral Checklist
Any system that employs EVT can viably feature a self-reinforcing feedback loop that can cause long-term value loss — especially if done in excess. There are some “supporting factors”, however, that can turn a slow-bleed loss of value into a wealth destruction vortex of epic proportions. This is what I’m calling a “Turbo Death Spiral” in this context. Unchecked, system-driven, rapid value destruction. Based on a couple of observations we can narrow this down to a neat 4-step checklist.
Step 1: Does your system’s ability to function depend on your token’s price?
This is a question about the possibility of a death spiral — as this is the only question you need to answer to know if a death spiral is possible. If this token’s price would go down by 90% overnight — would your system still work as intended?
If the answer is yes: congratulations, no price-driven death spiral in sight.
If the answer is “the system would collapse or someone would need to step in” — welcome to death spiral territory.
Step 2: Can your system mint an unchecked amount of tokens in response to some event?
The worst offenders when it comes to EVT are structures that will work counter to the interests of its token holder’s short-term interests in order to save the system. This is generally in the form of printing a large new supply that will be predictably liquidated on the open market.
Step 2 is a question about damage — what is the largest loss in value from system-induced damage that you can expect? If the answer is “as much as it takes” as in the case of stablecoin re-pegs at the expense of share tokens… we have a problem.
Tokenomics models with no checks on how many tokens can be created (ie tokenomics with no maximum supply imposed) implicitly have no checks on the amount the holders can be diluted by. This is a dangerous arrangement. The amount of downside you can experience is functionally 100% of the value of your holdings. If a sudden >99% dilution event can happen on paper, it can happen.
Step 3: Can this large influx of supply be anticipated ahead of time?
Step 3 is a question about timing — can you point to a specific moment in time that the system would automatically inflate itself by a predictable value that isn’t denominated in the token itself? It doesn’t have to be a timestamp. If you can even anticipate that “it will be over the course of a week”, this is enough information.
If you can anticipate when everyone is getting heavily diluted — you now have all the steps needed to trigger a full-on bank run. Why would anyone hold a token they know will predictably lose value? Why not sell off and buy back in after the loss has occurred?
If there is no way to anticipate everyone getting heavily diluted — the situation is a bit more nuanced. If damage can’t be anticipated, there is no explicit reason to sell off your tokens now instead of in 2 weeks. It also means you can get completely wrecked in the time it takes for an Australian black swan to blink. But hey — if your answer to Step 2 was yes, this is what you signed up for. Might want to research setting up a stop loss.
Step 4: Is there a highly liquid market in which your token can be shorted?
Okay so if you have been following along and checking boxes for Step 1, Step 2, and Step 3: we have assessed that (1) as a consequence of some bad (price) event, (2) the system’s token supply will expand by an unchecked amount (3) at some approximate time in the near future.
The final question is about whether someone could significantly profit from making the situation worse. This is almost certainly true if your token is listed on most major exchanges.
This is something I think many looking at tokenomics designs don’t immediately realize — but if a system directly interacts with its native token’s price — it can open up some (extremely unhealthy) opportunities for intelligent traders to profit from the interaction.
Thanks to Steps 1–3, we have basically defined a trade — more specifically a short. This is the maneuver where you borrow more of an asset and immediately sell it off. The expectation here is that buying it back later will be cheap and you will pocket the difference as profit. If this can be done for a high-confidence profit, it will be done.
You can anticipate the system to flood the market with new supply. You can also anticipate that the situation will likely be worse if the price goes even lower. As far as game theory goes — this is likely one of the safest short positions you could take on a market, as the short position itself already worsens the situation and causes knock-on effects. If the market ends up completely flooded with new supply — the whole buying-back part at the end will not be a challenge.
If you have answered Step 4 in the affirmative — we have entered turbo death spiral territory. I hope you brought some water and sunscreen because this is about as Mad Max as crypto can get.
Next up: A couple of case studies 👀
We have the checklist. Let’s apply it to a few historical examples and see what we can learn from them. Expect to see them published here in the upcoming weeks. Look forward to seeing the mechanisms of Terra and Bancor being discussed in detail.
After that, we’ll round it out with an article discussing how to address the design challenges around EVT. How do we avoid death spiral scenarios and still provide price-derived value/stability to (eco)systems? We’ll take a look at a couple of examples of these mechanisms as well as do some theory-crafting.
Obviously, I don’t have all the answers, but I hope this writing can get more people interested in creating something beautiful. Disagree with this checklist? Feel free to @ me on Twitter or something.
Acknowledgments
I’d like to thank my co-founder Stenver, the legendary CryptoAnalyst, and the fabled Roman-emperor-turned-cryto-BUIDLer Marcus Aurelius for their feedback and comments prior to publishing. Figuring out appropriate tone and structure is always a bit of a challenge and I appreciate the recommendations.
Thanks to all the readers! I hope this was informative. Tell a friend if so. Stay tuned for case studies and further learning. 👍
* Disclaimer
I’m not a financial advisor and this is not financial advice. Consult a professional investment advisor before making any investment decisions. I’m just a dude on the internet that likes writing walls of text.
