Modelling DeFi, Part 3 — Analysing Incentives

Foreword

This is the third part of my Modelling DeFi series, which was originally published on Blockbytes. I have decided to republish it on Medium to aggregate my writing, for my own personal record. You may see some grammatical differences but the core content will remain the same.

Is Your Favourite Protocol Really Profitable?

Back in May, Justin Bebis wrote an article with the same title, which presented some arguments against using traditional indicators (like FDV and TVL) for evaluating long-term investment opportunities. If you have not read it, then I strongly recommend that you do.

In the conclusion of the article, Bebis provides a tool for analysing incentives, this spreadsheet.

If you are like me, after reading it, it took you a while to understand what was being presented. I will construct a graphical representation of this spreadsheet with the hopes of injecting some more detail into Bebis’ argument and shedding some more light on incentives. It may help to have the spreadsheet open to follow along as you read.

In essence, long term profitability is not as simple as deducting overhead from revenue, because token emissions play a huge part in sustainability.

In my first two articles, I introduced a concept called parameter sensitivity. Parameter sensitivity refers to the effects that a small change in an independent variable may have on the dependent variable. It is the crux of modeling and simulation, because changing variables in the real world may not only require massive resource commitments, but the consequences might also be dire. This is why ‘sweeping’ through parameters is such a powerful tool. It can help to identify sensitivity and direction, without real-world consequences, in support of business operations.

The Spreadsheet

The spreadsheet that Justin proposes compares term and yield combinations to ‘investment size’, to determine a principal that the protocol can support. ‘Investment size’ refers to the dollar amount of emissions that a protocol provides as incentives. One way that many readers might be familiar with this concept is through providing liquidity. A certain amount of emissions going to a certain pool can only provide high yield for the time that the TVL remains low. You have all seen it before. A new protocol launches and yields are massive, but as TVL grows, the investment required to maintain the TVL is impossible, so yield collapses, and the protocol dies.

The Model

Visualising the numbers on a spreadsheet can be hard, so I’ve put together a model to help demonstrate the effects.

The variables we want to look at are term, yield, investment size (think emissions), and principal (think TVL). Term and yield are logical x- and y- axes, and in this case I will use principal as z- axis. The reason for this is that it is much easier to see TVLs fluctuate in DeFi than the value of the emissions investment from a protocol. TVL is a more openly tracked and advertised metric.

Following suit from Justin’s spreadsheet, we will look at term lengths between 90 and 365 days, target APRs between 10 and 25%, but we will isolate an investment size of 100k in order to demonstrate the effect of variable TVL. The relationship is governed by the following equation:

Principal($) = InvestmentSize($)/APR/Term(yrs)

The Result

Having three variables, I have opted to use another surface plot. It is nice seeing the contour and colour gradients when discussing outputs.

Let’s start by looking at the four corners of the plot. At the bottom right, if you want to offer a target APR of 25% for a full year, a 100k investment of emissions can support less than 0.5mil in capital. Moving up the image, the same yield for a quarter of the time is sustainable for just over 1mil in capital. The bottom left vertex is hard to analyse from the image, but you can perhaps interpolate a bit from the colour. And at the top left, a 100k investment can provide the smallest yield for the smallest amount of time to the highest capital.

I challenge you to take a few minutes and think about how the market moves around this surface. Choose a corner you are comfortable with, and think about what happens when TVL grows or diminishes. How do yield and term adjust accordingly? What do you think would happen with a larger investment?

The Reality

Protocols emit a number of tokens, not a value of tokens. We have looked at investment in dollar terms but the truth is that the market ultimately determines what the investment is in dollars. That is why it is important to consider the market value of emissions. When everyone enters a position that displays a massive yield, the TVL goes up, but the investment does not. In fact, it quickly goes down as the emissions are diluted and the market determines the value of the asset. So, the yield and sustainability of that position adjust accordingly.

The goal therefore, is to generate value from quality, and not quantity, of emissions. Otherwise, your protocol may not be sustainable.

Protocols like Spookyswap, LiquidDriver, and BeethovenX, have been implementing strategies to bring value to their emissions, to keep their investments high, so they can continue to offer yield opportunities as their TVLs grow and over the long term. There are many more protocols doing the same, and many that are not. Farming, buy-backs, and bribes, are all strategies worth researching, but I’ll leave that up to you.

Thank you

I hope you learned something from this write-up. As usual, please reach out and let me know if this piece was useful (or if you think I made any mistakes). I’d also like to hear from you if there are any concepts you would like to explore further.

Ta ra,

[yuvi]