ve(3,3) model explained
Dexes, by definition, provide exchange services through automated software. The decentralization element eliminates the human factor from financial interactions making them more efficient.
But the road doesn’t stop there: there’s an ongoing debate over how to make Dexes even more efficient. A debate that revolves around different design models generally involves math and game theory.
One of those models is ve(3,3).
What is ve(3,3)
ve(3,3) is the name given to an approach to decentralized exchanges that attempts to optimize incentives for the different actors involved in them. Its most emblematic parent is Solidly, currently the third most forked protocol, above Aave and Uniswap V3, and the magic ingredient of the success of platforms like Velodrome, responsible for one-third of Optimism’s TVL.
Let’s trace the origins of ve(3,3).
The name consists of two references to prior innovations.
ve comes from “vote escrowed.” It was an innovation introduced by Curve, the leading stableswap DEX, when the protocol tried to add more value to their governance token. Curve encouraged CRV holders to lock their tokens in exchange for veCRV (vote escrowed CRV), which provided two benefits to its holders:
- veCRV holders would see their rewards increased.
- veCRV holders would hold voting power over what pools the protocol would incentivize through emissions.
- At the same time, CRV introduced the concept of “bribes.” Protocols could pay veCRV holders to direct their votes toward the pools of their choice.
During 2020, DeFi experienced a boom that was called “DeFi Summer”: protocols discovered that by creating a native protocol token and using it to incentivize liquidity providers they could attract liquidity to their platforms (sometimes virtually snatch it from competitors). But these native tokens had a short-lived appeal: they promised governance power to their holders, but they didn’t really accrue value. Investors who held on to them, did so in the hopes that some day governance tokens would accrue value from transaction fees. But so far, experiments in this direction have failed. Uniswap is the best example: the leading Dex has been dragging its feet through the fee switch activation, which would funnel fee revenue to UNI holders, because of regulatory concerns and worries that the fee switch would make Uniswap less attractive to liquidity providers.
The “(3,3)” part is a meme that references game theory. It was introduced by OlympusDAO, the DeFi version of a one-hit wonder in music that shone brightly for a brief period of time until it burned out. Without going into detail, the expression (3,3) illustrates the best possible outcome of a game-theoretical scenario where users can sell, bond, or stake their assets.
How does ve(3,3) work
Therefore, ve(3,3) is a design model for Dexes where game theory is applied to coordinate users into achieving the best possible outcome for all of them through vote-escrowing token staking. All the participants in the Dex navigate an incentive design system that locks, distributes, and delays rewards in a way that guarantees the ongoing participation of actors and, therefore, the project's sustainability.
There might be different recipes for ve(3,3), but the ingredients are usually the same and generally work as depicted in this chart.
The participants involved in a dex are:
- Liquidity providers. These are investors who pool their tokens, often in pairs, in a liquidity pool, in exchange for some kind of benefit
- Traders access that liquidity pool to perform swaps and pay a fee.
- Governance token holders have a say over protocol configuration through their votes.
- Protocols are also parties interested in the correct functioning of Dexes because these exchanges are the tools required to guarantee that their token is liquid.
Going through ve(3,3) model can be tricky. So, to give it an artificial sense or chronological order, we can follow the sequence of each user-type journey.
Traders do their usual: approach liquidity pools to trade tokens and pay their fees. Nothing special here for them.
Liquidity providers add liquidity to pools. In most Dexes, LPs are incentivized through swap fees paid by traders. In ve(3,3) models, liquidity providers are incentivized by token emissions instead of getting a cut (or the totality) of the fees charged to traders. For example, a Velodrome liquidity provider adding funds to an ETH-USDC pool would be paid in VELO instead of the ETH-USDC pair.
The size of the token emissions received by LPs is decided through a governance decision, where only users who have vote-escrowed the protocol’s token (veTOKEN) can vote.
veTOKEN holders. Holders of the native protocol token can choose to stake them in exchange for vote-escrowed tokens. veTOKENs usually have an escrow period (from days to years), that establishes the conversion rate. For example, a protocol might decide that tokens escrowed for 4 whole years can be exchanged at the end of the year on a 1 to 1 basis with the plain token (1 TOKEN = 1 veTOKEN), while tokens escrowed for 1 year will only be converted to one-fourth of the veTOKENS (1 TOKEN = 0.25veTOKEN).
veTOKEN holders are incentivized through two mechanisms.
- veTOKEN holders receive the trading fees paid by traders interacting with liquidity pools.
- veTOKEN holders can also be bribed by protocols that want to direct their votes toward a certain pool. More on this, below
Protocols. Decentralized protocols are interested in achieving the highest levels of liquidity for their tokens and are willing to spend their budgets on promoting that. ve(3,3) dexes allow protocols to buy votes from veTOKEN holders to direct their votes towards a certain pool.
If Carbono was a protocol, and CARB its token, they could choose to bribe veCRV holders with CARB to encourage them to direct emissions to, for example, the CARB-USDC pool. This would incentivize liquidity providers to deposit funds in that pool and increase CARB’s liquidity.
ve(3,3) model improves the tokenomics design of Dex’s native tokens. They add a monetary utility to governance tokens by accruing value through fees and bribes, incentivizing the reduction of the supply by adding a locking feature and incentivizing longer period locks. Making those tokens more valuable makes them a much more attractive reward for liquidity providers, who are paid through token emissions instead of fees. Protocols, in the meantime, only have to redirect their bribes toward a different type of actor through carefully designed interfaces that allow for detailed planning. These coordinated forces are dubbed “the flywheel effect” of ve(3,3)
