Osmosis
DACM Special Situations Snapshot
Summary
- Cosmos is a decentralised network of independent and parallel blockchains, powered by an open source technology stack. The Cosmos ecosystem is one of the largest, by user and applications, in crypto;
- DACM has been a long-term Cosmos (ATOM) holder and participant in the validator set. DACM also continues to review and build positions in other Cosmos-enabled Appchains, particularly those which are uniquely specialised and leveraging IBC for distinctive products and user experiences;
- Osmosis is the leading DEX-chain and most used zone in the Cosmos network and expanding into other DEX models and DeFi verticals. It has built a unique and strategic positions position within the Cosmos ecosystem;
- There are a number of apps planning to launch on Osmosis and the potential of interfluid staking and interchain activity give the potential for Total Value Locked (“TVL”) increase materially — a strong historical relationship exists between OSMO (Osmosis’ governance and gas token) and the TVL secured by Osmosis and we would expect any material changes in TVL to be a valuation driver in the short-term; and
- DACM has high conviction that cross-chain operations will become as ubiquitous as swaps have become on centralised exchange venues. There is a very large opportunity for the ‘middleware layers’ who are facilitators, such as Osmosis.
Look into the Cosmos
The Cosmos universe is premised on the classical economic principles of trade specialisation and differentiation, as well as a priority of chain sovereignty. Billing itself as the “Internet of Blockchains” Cosmos has a key mandate to make seamless communication between every blockchain in existence possible. More practically, Cosmos is a decentralised network of independent and parallel blockchains, powered by an open source technology stack consisting of BFT consensus algorithms such as Tendermint’s PoS and PoA Consensus, Cosmos’ SDK development kit and the IBC Protocol.
The Inter-Blockchain Communication (IBC) protocol is a general communication standard devised to enable every necessary flavor of interoperability. IBC can be applied to everything from simple asset transfers, to cross-Zone data availability proofs, to slashing validators on remote Zones (i.e., fully shared security). An apt analogy for IBC may be that of the discovery of shipbuilding…
“Imagine every blockchain right now as a small tribe living on an island in a vast archipelago. So what IBC enables is the discovery of shipbuilding, which allows these tribes to travel between each other. So it’s really big, it’s huge for community building… the moment a blockchain flips IBC on, people can start traveling back and forth and participate in cross-island trade of various goods that each island is specialized in creating.” — Peng Zhong, Tendermint CEO commenting on IBC
The rationale behind IBC is that in order to support the transaction throughput, application diversity, cost efficiency, and fault tolerance required to facilitate wide deployment of distributed ledger applications, execution and storage must be split across many independent ledgers which can run concurrently, upgrade independently, and each specialise in different ways.
However, whilst we’re all here for the tech, there are valid concerns that the Cosmos Hub ($ATOM) has been weaker than other Layer 1 protocols at accruing value to its token. When combined with the incredible growth in the wider Cosmos ecosystem, it is becoming increasingly attractive to invest additionally in the wider galaxy of IBC enabled chains.
DACM has therefore reasoned that as long-term ATOM holders and participant in the validator set it makes sense for us to also continue to build positions in other Cosmos-enabled Appchains, particularly those which are uniquely specialised and leveraging IBC for distinctive products and user experiences.
Osmosis — The Financial Hub
Osmosis, in its current form is the leading DEX-chain and most used zone in the Cosmos network. It has built a unique strategic position as the key liquidity provider across the Cosmos ecosystem. Osmosis aims to expand the use cases for AMMs within the Cosmos ecosystem beyond traditional token swaps (which it already does very well). Custom-curve AMMs, dynamic adjustments of swap fees, and multi-token liquidity pools are all customisable, creating a new design space for applications such as decentralised token fundraisers, interchain staking, and options markets. For context, most major AMMs limit the degree to which a pool can be customised — Uniswap only allows the creation of a two-token pool of equal ratio with pre-determined swap fees.
Osmosis can therefore be viewed as an expression of the thesis that DeFi will become increasingly complex and specialized. Different assets will require differently structured pools. You wouldn’t use a bulldozer to commute through the city in the same way you wouldn’t use a family-style sedan for landscaping. As the market continues to grow and participant’s sophistication follows, the need for liquidity pools to react to market conditions will become apparent. A pool may decide to adjust fees based on factors such as block times, slippage, transaction fees, or market volatility. Ultimately, the goal is to expand the addressable market for AMMs and bonding curves beyond the current status-quo of token swaps.
A great example of Osmosis’ versatility is its deployment into music-oriented fan token marketplace — Sinfonia. Using OsmoJS, custom front ends can be created which leverage the powerful back end and functionality of Osmosis for niche user experiences. This is a classic example of DeFi composability or ‘money legos’ where Osmosis acts as the baseplate for others to build on. We expect to see many more of these types of integrations as both Osmosis expands its capability, crypto use-cases increase, and developers realise the attractiveness of a DEX-as-a-Service.
Osmo Token and Value Accrual
At its core OSMO is Osmosis’ gas and governance token enabling the holder to vote on protocol parameters such as upgrades, liquidity rewards, and swap fees. Governance has proven to be critical to the Osmosis community given in its current high-growth state, the DAO has voted on over 250 proposals, with an average turnout of 50–70% of staked OSMO voting.
From a value accrual perspective, there is one metric that clearly matters the most in the short to medium term. TVL. The total value locked on the chain has a direct link to the value of the token due to the principles of security economics. Given a certain TVL, it is possible to ascribe a cost-of-attack value to the token given its role in validating the network. In a Tendermint Proof-of-Stake chain such as Osmosis, consensus is reached when more than 2/3rds of validators agree. Therefore, a bad actor could attack the network if they were able to accrue 2/3rds of the networks stake. At a high level, the argument becomes that the value of the tokens securing the network (commonly, the circulating market capitalisation) must approximately be valued at 1.5x of the TVL.
Let’s see how this holds up in the case of Osmosis:
Clearly there is a correlation. Hence, we consider the value accrual of OSMO to come down to its ability to attract TVL (i.e., liquidity) plus a speculative premium. At DACM we believe our ability to look for catalysts which might increase TVL is far better than our ability to predict the animal spirits which may impact the speculative premium. Therefore, the rest of this piece will be dedicated to catalysts that may bring additional liquidity to the Osmosis protocol.
Catalyst 1: Mars (and other Terra Refugees)
Tragic for many, but with a silver lining for Osmosis, the collapse of Terra has presented an opportunity to bring some very strong teams over to the Osmoverse. One to focus on is the Mars Protocol. Mars Protocol was a Delphi-darling launched on Terra who has now shifted focus towards becoming the credit protocol for all of the Cosmos. Mars tactically plans to launch their first outpost on-top of Osmosis — a homebase with many synergies.
A minimum requirement of any DeFi hub is a lending platform able to satisfy the degeneracy of leveraged traders. But additional to this, through integration with trading logic of the Osmosis AMM, Mars will be able to offer advanced features such as staged liquidations, efficient cross-margining, and the use of Osmosis LP shares as collateral. Combine this functionality with any potential airdrop or liquidity incentives, and there’s a chance we will see TVL increase materially.
Mars is just one of many protocols looking to transition to Osmosis. Apollo DAO and Void are two more examples out of many. We are expecting to see a vibrant ecosystem building on top of Osmosis in the near future which will all contribute to the functionality and the value secured by the protocol.
Catalyst 2: Interfluid Staking
Providing AMM liquidity for a Proof-of-Stake (PoS) asset is not always an obvious choice for a savvy investor. For example, a Cosmos Hub token-holder can choose between providing liquidity alongside the Osmosis token for c. 23% APY (and risk impermanent loss) OR stake into a validator and earn c. 18% APY. Osmosis’ work on interfluid staking presents an alternative solution to the hodlers looking to enhance their yields.
In simple terms, Sunny and the team at Osmosis plan to offer the option to both be an LP and participate in securing the network. This is possible thanks to Cosmos’ IBC. Interfluid staking will allow token-holders to ‘double-dip’ their tokens to earn yields. This is best visualised below:
This could be a material catalyst for Osmosis TVL. Returning to the Cosmos Hub example, currently ~2/3rds of the liquid token supply is staked in validators, or ~$2.2bn, which could be made available to pair with other assets in Osmosis LP positions. Vice versa, the ~$40m of ATOM paired in the ATOM/OSMO LP pool currently could be used to enhance the security of the Cosmos Hub. Everybody wins.
With the Cosmos Hub receiving a lot of hype with the upcoming release of interchain security, we feel that Osmosis will also play a part in the future of shared security via interfluid staking. It will make sense for a protocol to derive a layer of its security from Osmosis as this will also improve token liquidity — in a fairly sticky way. It will be interesting to see how protocols act to incentivize this and/or play with the ideas of ‘DeFi 2.0’ and protocol-owned-liquidity.
Catalyst 3: Interchain Offering
DACM has written before about our conviction in rising demand for blockspace over the medium-term, particularly in our Synapse piece earlier this year. Osmosis’ work with Axelar presents another composability angle — with the goal for Osmosis to become a ‘cross-chain backend’. Both teams have a deep focus on UX, which when combined with the security of IBC, should create a fierce competitor in the bridging space.
We are believers that one day cross-chain operations will become as ubiquitous as swaps have become on centralised exchange venues. Hence, there is a very large opportunity for the ‘middleware layers’ who are facilitators. The Block track TVL of Ethereum Layer 1 bridges and report that as of 16/08/2022, there is c. $16bn of capital dedicated to Ethereum-centred cross-chain flow.
We would expect a significant amount of liquidity to flow into Osmosis if they are able to actualize this vision of becoming a leader in cross-chain swaps and beyond.
Conclusion
The Cosmos vision is slowly but surely coming to fruition. IBC and the Cosmos SDK has created a design space for Osmosis to expand on the concepts of a decentralised exchange and AMMs in both an intellectually and commercially fascinating way. From an investor’s perspective, it is hard not to be excited about the catalysts expanded upon above — each with a clear link to potential; token value accrual. DACM views its investment in Osmosis as a strategic investment in the Cosmos ecosystem and is excited to continue growing out its presence and contribution; since investing DACM Infrastructure has spun up the 11th largest (and growing) validator. Overall, look for Osmosis to continue to build UX forward, cutting-edge DEX tools alongside a flourishing IBC-enabled ecosystem — all the while creating value for their own sovereign Appchain.
