Solidly Deep Dive Pt.1: Economics, Inflation, Rebasing, Sustainability

Published in

Equalizer Exchange

19 min readMar 7, 2023

Intro

In this series, I’ll explore the Solidly ve model in-depth and review the core underlying principles of this new primitive. In addition to high-level principled thinking, I will include practical examples and some appropriate modeling to demonstrate how the model operates under different conditions.

Future parts in this series will include:

Solidly ve vs. Curve vs. Uniswap
Core Metrics

In this first part, I will explore the Solidly ve model from an economics lens, which makes sense as a micro-economy is going on, complete with monetary policy, inflation, and capital investment.

TLDR:

Inflation is required in Solidly DEXs to keep the economy moving.

Inflation is not bad and has many positive effects in this model.

Token Emissions $ will always be greater than revenues; this does not mean it’s unsustainable.

Viewing TOKEN Emissions as a “cost” to the system is the wrong framework because all TOKEN emissions are prepaid before mintage.

Rebasing or “anti-dilution” is more of a marketing buzzword than anything, and it does not add any value to the system and, over time, ruins the flywheel.

There is a substantial market opportunity for decentralized exchanges, which means even though initial inflation rates might be high, they can be matched with revenue growth.

Over the long term, Solidly economics are sustainable as inflation rates taper to zero.

Solidly DEX’s provide a huge opportunity to build new products on top. Furthering the value proposition of TOKEN and strengthening the flywheel.

Solidly Economics

To kick off this discussion, we must first briefly cover the economics of the Solidly ve system, i.e. the incentives structures that keep the flywheel spinning.

There are four major players in this economy:

Traders: Traders conduct swaps from token A to token B from the liquidity pools. Traders pay fees for the swap. (revenue #1)

Liquidity Providers: stake their idle tokens into a liquidity pool to receive TOKEN emissions. In exchange for the TOKEN emissions, all trading fees earned through swaps are sent to the veTOKEN voters who voted for that specific liquidity pool.

Protocols: Projects need liquidity so users can buy their tokens. To incentivize liquidity providers, projects can bribe gauges to incentivize veTOKEN voters to vote for their LP pair. (revenue #2). Protocols are also highly incentivized to acquire their own veTOKEN to direct emissions as a long-term solution to their liquidity requirements so that they won’t have to keep bribing gauges into perpetuity.

veTOKEN Voters: voters govern TOKEN emissions by voting on gauges weekly. And they are incentivized to vote for the most economical pool to maximize their revenues as they collect the fees + bribes from the pools they vote on.

Now, we can see that two revenue sources are coming to veTOKEN in the form of fees + bribes, and in turn, TOKEN emissions are going out to LPs. That is, in a nutshell, the flywheel; the more revenue coming into veTOKEN, the more attractive it is as an investment, which sustains the emissions rewards to LPs, which enables trading volume that generates fees.

The economy grows in this cycle of drawing in liquidity, and that liquidity will generate more and more fees. Often described as a liquidity “vacuum,” we can see just how effective this model is through recent TVL charts:

We know that nothing can go straight up and that while effective at the growth stage, I want to evaluate the model’s sustainability long term. We’ll do exactly that later in this article. First, let’s explore some underlying mechanics and principles behind this economy, starting with emissions.

Emissions

Emissions are a vital part of this system; because the Solidly model incentivizes LPs through emissions, there will be TOKEN inflation regardless of how you frame it. Typically these models start with high emissions to bootstrap the project and then taper off to a tail-end schedule. In any event, if token emissions seize, LPs can no longer be incentivized, and the economy halts, so this is a necessary part of the flywheel.

So as a starting point, we must first acknowledge and accept that inflation will happen. Although inflation is a scary word, especially now in times of high macro inflation, I hope to make a case for why it works and how we should think about it from an economic perspective. Inflation is a feature, not a bug.

Firstly, when you break down the math, it is typical that the $ value of emissions of TOKEN is greater than the total revenue received in return. Here is a comparison of the 3 top projects by revenue (Velodrome, Thena, and Equalizer):

Expressed as a ratio of $1 of revenue per $1 of emission:

For every $1 of emission, these projects get between $0.26 — $0.41 in revenue back.

This is where many people hit a mental block regarding the Solidly or Curve model. They see this dynamic of TOKEN emissions as a project cost and analyze this in an income statement where emissions (cost) > revenue.

If this is the case, are Solidly exchanges simply unsustainable ponzi farms, which will eventually trend towards 0 as emissions outpace revenues? This is a fair question; looking from this limited and frankly incomplete lens, it’s easy to see why this would be a concern.

But we know from experience that this isn’t true. Curve, which is by all accounts an inferior ve model (only 50% fees to veCRV, not integrated stack with Convex taking a cut, etc.), has not inflated to zero. In fact, its price has held up relatively well in the broader markets. Despite a savage prolonged bear with 90% price drops across all alts and TVL wiped out.

As you can see, the price of CRV has roughly tracked with the broader crypto markets (chart shows CRV vs. total crypto market cap), with some periods of over and underperforming. Not quite the chart of an infinitely inflating ponzi farm token, is it?

And although the TVL has gone from 25B to now ~5B in the last year through all of the dramatic blow-ups, the price of CRV has held up fairly well during this time. Never quite entering the downward death spiral that would theoretically happen if the flywheel is interrupted. (lower TVL > lower volume > lower APY > lower CRV price > lower TVL).

So how is this possible during the whole time their emissions > revenues? Even during the secular declines, where one would think this model would start to break down.

As the vote escrow is a novel and relatively complex primitive, we must investigate the matter of emissions/inflation in a different framework. I’ll also add that the Solidly model is much stronger and more cohesive than Curve and one that I expect to perform far better than Curve. I am using Curve as an example because they are the first ve model and are most mature along its emission schedule.

The emission TOKEN $ value is always greater than the revenues because the emission TOKEN has value BEYOND just strictly the revenue accrual.

1. governance value to direct emissions

2. value as an LP pair

3. future growth pricing

4. speculative trading

5. other use cases built on top (such as crvUSD as an example)

These factors will carry a premium value over the strict 1:1 revenue accrued. For this reason, the TOKEN emissions $ value will be greater than the revenue. This dynamic makes the economy tick and allows the Solidly ve model to be an effective marketplace for projects to source on-chain liquidity.

Because the value of TOKEN emissions is greater than the revenue, this is what allows for effective protocol bribing. Where $1 of bribes > $1 of LP incentives.

There’s some further discussion on whether this is sustainable, which we will explore later, but first, let’s also talk about why framing the TOKEN emissions as a “cost” is the wrong approach.

The reason TOKEN emissions are not a “cost” is that they are already prepaid before they are emitted.

The gauge weight voting directs TOKEN emission, and to vote, one must (1) buy more TOKEN and lock for veTOKEN or (2) bribe veTOKEN holders to vote. Either way, TOKEN is paid to get emitted.

As projects prepay every TOKEN as a cost of liquidity, it is more accurate to look at TOKEN emission as a cost of projects to maintain on-chain liquidity, not necessarily a cost to veTOKEN itself. Projects must continually re-invest to support this liquidity by buying and locking more TOKEN.

In a simple emissions > revenue equation, the money for buying TOKEN and the time value of locking into veTOKEN aren’t considered. For example, 70%+ of emitted EQUAL is currently locked, most permanently. Thus this forms an integral part of veTOKEN economics that should not be ignored.

So to re-iterate, apart from the bribes and fees, projects prepay TOKEN emission by buying & locking more TOKEN. This is their cost of on-chain liquidity, and as we will explore further in the inflation section, they must continue to add to their position over time.

Summary:

TOKENs must be emitted to sustain the Solidly economy. Therefore, there will be inflation.

TOKEN emissions $ value is greater than the revenue because of added use cases of the TOKEN other than strict revenue accrual. This dynamic allows the model to be an effective place to pay for on-chain liquidity.

TOKEN emissions are not a cost to veTOKEN holders; they are a cost to projects maintaining on-chain liquidity, as all emitted TOKENs are prepaid.

Because TOKEN emission is not strictly a cost, we must look deeper than a simple emissions > revenue equation.

Inflation

In crypto specifically, inflation is generally portrayed as something evil in nature. Economically speaking, it is both necessary (as explained before) and not evil. It is also a vital part of the game theory that enables the Solidly model to work so well.

For starters, inflation is a gradual process of wealth redistribution. In deflation: if every dollar were worth more than it was 1 year ago, that would be great, right? Everyone is making money by doing nothing. But then, people are not incentivized to work hard, capital stops being productive, and wealth is concentrated at the top. This is bad for the economy as new entrants have no opportunity to acquire capital, with existing capital remaining idle and not put to work to grow the economy.

On the other hand, inflation drives consumption, and people have to work to earn more money. In this process, capital wealth is continually channeled to the most productive people, businesses, and investments, eventually increasing aggregate demand (economic growth).

This is the process of wealth creation; not only does the investor make money, but so do all involved market participants.

In this way, wealth is “decentralized,” and new entrants into the economy have an opportunity to make money and get their fair share. This allows the economy to grow and for everyone to benefit. Whereas in a deflationary environment where everyone is hoarding their money, they would not have that same opportunity.

Economists universally agree upon this net positive effect of inflation. That predictable and responsible inflation can help economies grow. Even under a gold standard, there is a steady and constant supply inflation rate of ~2.5% per year.

Now, many separate issues are going on when it relates to modern monetary policy the western world is experiencing today. The increase in M1 money supply has been anything but gradual and predictable, the uneven distribution of new mintage (Cantillon Effect), the disconnected and inaccurate measurement of inflation, etc.

The matter of inflation in the macro economy is far outside the scope of this writing. What I am trying to get across is that we need to look at inflation from a balanced lens and remove some negative preconceived notions to evaluate inflationary tokenomics fairly.

As it relates to tokenomics, inflation is a gradual process of governance redistribution, favoring those more loyal and committed to the community over time. Projects that aim to be truly decentralized need inflation for this reason. And we don’t see Bitcoiners complain that every year they have less % of the total supply than the year prior. This is the nature of decentralized primitives.

In our case with the Solidly model, loyalty is expressed in the consistent accumulation of TOKEN and the locking of veTOKEN. This allows projects to sustain on-chain liquidity at an effective cost and keeps the flywheel spinning.

Inflation:

Decentralizes voting power and allows new participants (projects) to enter the economy and get their fair share of voting through bribes or veTOKEN accrual.
Create aggregate demand for TOKEN by incentivizing projects to continually accumulate more veTOKEN to maintain their emissions share.
Ensures that veTOKEN voters will utilize their capital (votes) on strictly the most productive pools. Failure to do so will mean they are economic losers.
Sustains the Solidly flywheel through adequate compensation to liquidity providers.

Inflation is not always the evil it’s made out to be; in the right circumstances, it is a valuable tool to incentivize the economy to move in the right direction and decentralize wealth. So long as inflation is created fairly and the supply is predictable, it is healthy for the economy.

During the bootstrap stages of the Solidly projects, TOKENs emit at a faster rate to bootstrap the project and get TOKENs in the hands of as many people and projects as possible; in the long term, these emissions taper off pretty hard as the model moves to a more mature state.

This is also not unlike other emission models like Bitcoin, for example. In Bitcoins case, emissions are high to bootstrap use and, over time, taper off for long tail security; in the Solidly ve model, emissions do the same for liquidity. All emissions are created and distributed fairly in both cases, allowing new participants to enter. This is the essence of decentralization.

If you notice, the supply curves for EQUAL and Bitcoin are quite similar, with high initial inflation followed by prolonged tapering.

Of course, Bitcoin and EQUAL are very different assets with different use cases, the point being that inflation is an intended and essential mechanism. And we should not dismiss this inflation as inherently negative.

Rebasing (anti-dilution)

So now let’s talk about rebasing for veTOKEN holders.

The intent of rebasing is to ensure that veTOKEN holders were not diluted on their % share of holdings and that for every TOKEN emitted, veTOKEN holders would grow their stack in lock-step. Best of both worlds as it allows for the required inflation while protecting holders; sounds great, right?

Unfortunately, rebasing, or “anti-dilution,” is NOT healthy for the economy. Although it sounds nice to protect investors from dilution, when you break down the underlying mechanics and math, over the long term rebasing to veTOKEN holders breaks the flywheel. Similar to the token emission vs revenue discussion, we have to dig deeper than the surface to find out the truth.

Current forks have taken a variety of approaches to rebasing:

Solidly v2 = 100% rebasing

Thena, Velodrome, Velocimeter, Equilibre, SolidLizard= 30% rebasing

Equalizer, Sterling, Satin = 0% rebasing

In effect, rebasing tries to remove or reduce inflation from the veTOKEN holders. But as we discussed in the inflation chapter, inflation is needed in the system to incentivize all actors to behave in the interest of growing the economy.

For starters, if veTOKEN voters are guaranteed not to be diluted, they no longer have to vote for economic gauges (unproductive capital issue). This creates an extension of the batman/superman problem in the original Solidly model. Where veTOKEN voters can direct emissions to uneconomical pools and exploit the flywheel at no cost or limited cost to themselves. With rebase protection, a project doing this could continue this into perpetuity, effectively ruining the economy over time.

In a model with no rebasing, veTOKEN voters are disincentivized from such toxic behaviors because while they can still vote for uneconomical pools, their voting power will diminish over time. And suppose they want to maintain their emissions to their unproductive pools. In that case, they will have to add capital back into the system through bribes or additional TOKEN accumulation and locking.

This isn’t to say that under an inflationary model, projects are necessarily doomed to continue re-investing. If their LP pool is productive (generating lots of trade fees), they will get votes even without bribes or project-owned veTOKEN.

It aligns the interests of all participants toward the long-term health of the economy. If your pool is not economically viable, then projects must invest in that incentivization. Under a rebasing model, projects can make a one-time investment and incentivize their pool into perpetuity, even when it is not productive to the economy.

Can you imagine a scenario in which the large Curve / Convex players such as Frax and Yearn just secured their share early on and never re-invested a dime into the system? As it currently exists, the system would have failed a long time ago.

With rebasing, veTOKENs will greatly concentrate on the earliest and largest entrants as time passes. Making it difficult and eventually straight-up uneconomical for new actors to join in.

This is where I will relate back to our discussion on the effects of inflation to promote healthy economic behaviors. With rebasing, inflation is effectively removed from veTOKEN voters, and all of the positive outcomes of inflation are reversed:

Centralizes voting power and doesn’t allows new participants (projects) to enter the economy and get their fair share of voting through bribes or veTOKEN accrual.
Removes aggregate demand for TOKEN by eliminating the need for projects to continually accumulate more veTOKEN to maintain their emissions share.
It does not incentivize veTOKEN voters to utilize their capital (votes) on strictly the most productive and economical pools.
Does not sustain the Solidly flywheel through adequate compensation to liquidity providers because of the reduction in aggregate demand for TOKEN.

To back this up, I want to run a few completely hypothetical scenarios to show the long-term effects of rebasing on the Solidly economy.

These three scenarios will all operate under the same specifications, the only difference being rebasing to veTOKEN holders.

Initial Supply: 500,000 TOKEN

TOKEN price: $10 (constant)

Emissions: 50,000 / epoch reducing 0.5% per week

Lock Rate: 70% (constant)

Revenue: $50,000 / epoch increasing with the rate of inflation (token emissions)

You’ll notice in each of these scenarios that in EPOCH 1, the APYs are the same across the board at 68%; however, as we project out over 2 years (104 EPOCHs), there is a divergence with the rebasing scenarios underperforming the 0% rebasing scenario in terms of veTOKEN APY.

Scenario 1: 0% Rebasing:

In this scenario, because the revenues grow in lock-step with the new emissions, real APY is maintained at a constant 68%.

The total supply ends at just over 4,500,000.

Scenario 2: 30% Rebasing

With 30% rebasing, real APYs start at 68% on EPOCH 1; however, even with the same revenue growth as scenario 1, APYs diminish to ~57% at the end of the 104 weeks.

The total supply ends at just ~5,400,000. You can also see that the total supply is larger because of the effect rebasing has on the locked veTOKEN part of the supply.

Scenario 3: 100% Rebasing

With 100% rebasing, real APYs also start at 68% but diminish to 42% by the end of the same period.

Total supply ends at just over ~7,300,000.

Results:

Comparing the veTOKEN real APYs, you can see that rebasing negatively correlates with APYs. The more rebasing, the lower the APYs. With the baseline scenario at 68% and 100% rebasing at 42%.

This means the 100% rebasing project needs to grow revenue 38% faster than no rebasing to maintain the same rewards to veTOKEN voters.

This happens because rebasing adds MORE inflation to the system, not less. Despite being touted as “anti-dilution,” it has had the opposite effect over time.

Returning to our emissions discussion, the TOKEN emission to LP is required to sustain LP incentives. This is the bare minimum necessary inflation to keep the engine running. What rebasing does is add more inflation to the locked veTOKEN supply as well. Over time reducing the economic value of locking TOKEN.

Specifically, it pushes the cost of inflation away from veTOKEN voters onto new TOKEN buyers. But by doing so, it breaks the flywheel that is based on a high-value proposition to TOKEN.

Some will argue that I should include the value of the rebasing veTOKEN to the APY, but this is disingenuous. That APY added from rebasing is just paper gains; it adds no value to the economic system. Further, with smaller real APYs, the secondary market for veTOKEN will reflect a lower trade price. So you can’t even realize that APY into real profits.

Further, for a new project looking to acquire a sizable share of the votes at any point in the future, it will be much harder with rebasing as the earliest participants will have highly concentrated holdings. This makes the exchange susceptible to new competition from other DEX’s, which can grab market share through new projects if it’s not economical for them to join at a later stage. In conclusion, rebasing has the effect of adding more inflation to the system than necessary, not less. And over time, this increase to the total supply makes liquid TOKEN a worse value proposition, which detracts from the flywheel that propels the Solidly economy.

In conclusion, believe the newer generation of forks, such as EQUAL, STR, and SATIN, have better tokenomics for long-term sustainability with no rebasing.

That said, VELO and THE models with 30% rebasing can still work. The factor that cannot be easily distilled is the effect of this rebase on buyer psychology. It may be the case that introducing a small rebase can encourage buying and locking of TOKEN, which helps the flywheel, but in the long run, they will need to generate more revenue over time to be competitive. Strictly speaking, they are suboptimal models to 0% rebasing.

Sustainability

The last piece of this discussion is sustainability. Because inflation is necessary for the system, the revenue growth would have to either match or exceed the inflation rate to be a good long-term investment.

Is constantly increasing growth possible?

First, because TOKEN emissions taper off into a tail-end emission schedule, growth requirements will also taper off. What is initially 200% annual inflation in the first year will eventually become 10% in year 4. And with that, revenue growth expectations for year 4 would only have to meet or exceed 10% for an investment to sustain APY to the investor.

I believe this is very sustainable. Because DEXs are the heart blood of DeFi, their revenue growth should broadly reflect the overall growth in the market. From what we know, the growth has been up only so far, and still, less than 0.1% of the internet operates on the blockchain:

Keep in mind this chart is in log scale, so growths have been in the many 1000%s of percent per year. Would you bet this chart continues to go up? I do.

I am confident that crypto adoption will continue rapidly into the future as adoption picks up. And with this, DEX revenue potentials will follow as UX improves and more transactions move away from CEXs.

Further, even within the existing crypto markets, DEXs still only account for between 5–15% of trade volumes. So even without accounting for any future growth, there is a huge growth opportunity to realize within the space.

Using the same numbers from scenario 1, here is a graph of annual revenue growth requirements to sustain APY on veTOKEN, assuming no further reinvestment is made (that you are “diluted” ):

What starts as high in the first year asymptotically approaches 0% as emissions decrease over time. This fast growth in the first year is the bootstrapping mechanism as Solidly DEXs gains market share over existing competitors. In a more mature stage, growth will slow down while maintaining great returns to investors.

This is also similar to my expectations of growth for overall crypto markets, heavily front-loaded adoption, and as the space matures, it will slow down. Similar to any new technology adoption curve:

In fact, I bet that the growth of DEX revenues will far exceed the requirements to sustain APY by many hundreds and thousands of percent over the next few years as the world is onboarded to the new global financial infrastructure.

And in this way, the diminishing inflation of Solidly DEXs will be far outpaced by the revenue growth. And my thesis’s basis is that they represent a great investment opportunity at this early stage.

And with responsible monetary policy, it will continue to be sustainable far into the future. I specifically like what Velodrome is doing by introducing their VELO FED to dictate monetary policy into the future. To ensure sustainable growth and protect investors. I would be interested to see more Solidly DEXs consider such a policy in the future.

And a secondary path to sustainability exists:

Maybe most importantly, these Solidly DEXs create an amazing opportunity to build on top of. Because of the large TVL captured, many innovative features can be built on top to increase revenue to veTOKEN and further promote sustainability. This is what Curve is doing with crvUSD.

Building more value capture and revenue accrual to TOKEN beyond just the DEX is underrated and overlooked. Even a 10% revenue accrual bonus over the long term will dramatically improve the value proposition of TOKEN. And because the flywheel is already so strong, improving the TOKEN value proposition any more means even stronger TVL capture.

You can even use this platform to create deflationary effects on TOKEN. Truly creating a sustainable flywheel. The potential is nearly unlimited.

Conclusion:

Inflation is required in Solidly DEXs to keep the economy moving

Inflation is not a bad thing, specifically in this economic model

Token Emissions $ will always be greater than revenues; this does not mean it’s not sustainable

Viewing TOKEN Emissions as a “cost” to the system is the wrong framework because all TOKEN emissions are prepaid

Rebasing or “anti-dilution” is more of a marketing buzzword than anything. It does not add any value to the system and, over time, deteriorates the Solidly flywheel.

There is a strong market opportunity for decentralized exchanges, which means even though initial inflation rates might be high, they can be matched and exceeded with revenue growth.