Breaking down Olympus DAO using DeFi bonding primitives

This is the second part of the three-part posting series on DeFi bonding.

Special thanks to Kevin.J for providing the inspiration for improving Olympus DAO, and Oscar.K, Richard.N, Harvey.J, Kevin.J, Praveen.S, Zena.P, Gongpil.C and Jamie.J for useful discussion to identify the DeFi bonding primitives.

In the previous posting, we explained why Olympus DAO worked by examining their building blocks and how they are interconnected to achieve protocol-owned liquidity (POL). In this posting, we will generalize the building blocks of Olympus DAO into a concept called DeFi bonding primitives: three primitives that can be used to build a similar system to Olympus DAO’s bonding system.

What is a DeFi bonding system?

A traditional bond is a loan agreement between the bonder and the bond issuer. Like a loan, the bonder earns periodic interest and can claim the principal amount after the specified date, also known as the maturity date. Typically, organizations use bonds to raise large capital that exceeds what an average bank can provide. The primary motivation behind it is for organizations to use the raised capital to invest in a new product or service that can generate enough profit to periodically pay the interest and pay back the principal amount by the maturity date.

Like bonds, Olympus DAO’s “bonding” is a way to raise large capital, but it is different in at least three ways:

1. The denomination is flexible for “bonding” while it is not so flexible for traditional bonds. For example, you can “bond” a large amount like 1,000 DAI or a small amount like 0.0005 DAI. This flexibility allows even small investors to participate, increasing the decentralization of the capital and improving capital efficiency for investors.
2. The deposit and the payout for “bonding” are in different currencies (they are the same for traditional bonds). The deposit for “bonding” can be paid using stable tokens, Ethereum, or LP tokens, while the payout is always in OHM.
3. The payout on “bonding” is always guaranteed. Traditional bonds can become worthless at the end of their maturity date if the bond issuer cannot pay back the principal loan. But, “bonding” always ensures that the promised principal (in OHM) is paid. This is one of the advantages of using the smart contract because contractual terms are always enforced.

It is clear that traditional bonds and “bonding” are fundamentally different, but “bonding” has become such a familiar word for the DeFi community that we cannot just abandon it. To differentiate between the two terms, we propose using “DeFi bonding system” to refer to various “bonding” schemes in DeFi space.

Fig.1. DeFi bonding primitives: bonding, swapping, locking mechanics working together to promote the stability of the native token

Let’s formally define what a DeFi bonding system is: A DeFi bonding system is a general bootstrapping system that couples three DeFi bonding primitives — bonding mechanic, swapping mechanic, and locking mechanic — into a single system that promotes stability of the native token.

For example, Olympus DAO’s “bonding” system is a type of DeFi bonding system that uses

1. “Bonding” is the bonding mechanic that brings new capital to the treasury in exchange for minting new OHMs.
2. SushiSwap & UniswapV2 are the swapping mechanics that allow a decentralized way to swap between ERC20 tokens for OHMs.
3. Auto-staking is the locking mechanic that ties “bonding” and SushiSwap & UniswapV2 together to produce a single system to maximize the liquidity owned by the protocol.

Now that DeFi bonding primitives are defined let’s examine what choices we can make and look at how they are interconnected to form a single system.

Bonding mechanic

Like Initial Coin Offering (ICO) & Initial Discord Offering (IDO), the bonding mechanic is a way to raise capital for the project. But, unlike them, where the capital raising is restricted to the beginning, it offers a continuous way to raise the capital.

The bonding mechanic works like this: when a user bonds, they deposit crypto assets to the treasury, a smart contract that holds the bonding deposit. The treasury then mints native tokens based on the deposit’s worth and the minting rate. After the vesting period for bonding is finished, the treasury gives native tokens to the user based on the bonding price, the market price for one native token that is usually discounted at the time of bonding.

Below lists the defining characteristics of the bonding mechanic:

1. Bonding type: This represents the token type that the user deposits to the treasury for bonding. The bonding type can be divided into stable tokens (tokens that are pegged to a stable currency such as DAI, USDC, USDT, etc), widely used utility tokens (Ethereum), and unstable tokens. The native token should not be offered as a bonding type, because bonding the native token is the same as recycling an existing capital, thus it does not inject new capital into the system.
2. Bonding evaluation: When bonding occurs, the treasury should mint the native tokens based on the deposit value. The bonding evaluation is used to determine the deposit’s worth based on the perceived capital injection effect on the system. Stable coins like USDC, are easy to evaluate because they are pegged to a stable currency. But, unstable tokens, including some LP tokens, are harder to evaluate because their price can constantly fluctuate. One way to evaluate the unstable token is by reflecting only a fixed percentage of the unstable token’s market value. Since only the partial value is reflected, it reduces the risk that the treasury asset used for backing drops below the minting rate.
3. Minting rate: Once the deposit’s worth is evaluated, the treasury can mint the native tokens based on the minting rate. The minting rate is usually fixed to some constant, but depending on the goal of the DeFi bonding system, this can be adjusted to create a less inflationary system. Olympus DAO’s treasury adopts 1 OHM per 1 DAI constant minting rate, meaning for every 1 DAI worth of deposit, 1 OHM is minted.
4. Bonding price & discount rate: The bonding price for the native token is discounted to incentivize users to bond rather than buying the native token from the open market. Since the native tokens are minted only when bonding occurs, the discount rate can be used to control the bonding rate. For example, if the treasury has too many native tokens, the discount rate can be reduced to decrease the number of users from bonding. On the other hand, if the treasury does not have too many native tokens, the discount rate can be increased to encourage users to bond.
5. Vesting period: The vesting period is one of the most important design choices that need to be made for the DeFi bonding system. It defines the amount of time the bonder needs to wait before the payout is given. When a user bonds, although the bonding price is discounted when compared to the market price, they can profit from the discount only if the market price of the native token rises or stays the same.
6. Capital utilization by the treasury: This defines how the treasury utilizes the capital raised from bonding. Lending, providing liquidity, and buying back native tokens are some examples of how the treasury can utilize its capital to increase its capital which increases the value of the native token.

The bonding mechanic provides a way to continuously raise capital while protecting the interest of the existing users. While the bonding price is usually cheaper than the market price to attract new investment, it rewards the bonder for taking the risk that the price can drop during the vesting period. After the vesting period, if the market price drops below the bonding price, the bonder is effectively paying more for the native token than they would have if they bought it from the open market, but the existing users benefit from the higher price paid by the bonder. On the other hand, if the price rises, both the bonder and the existing users benefit. When the bonding occurs, the treasury can mint native tokens with the help of the bonding evaluation function. The bonding evaluation function ensures that the minting is based on the deposit’s worth. This means that unstable tokens are evaluated to be worth less to account for a possible sudden price drop, whereas stable tokens that are pegged to a fixed value, are valued at their face value.

Swapping mechanic

Unlike traditional bonds where the payout is in stable currency, payout for bonding mechanic is in native tokens. This means that user needs a capital efficient way to cash out their native tokens if they want to utilize it for other purpose. The swapping mechanic defines the way to exchange native tokens for other crypto assets or vice versa. Currently, there are at least six types of swapping mechanics that can be utilized in a DeFi bonding system:

1. Constant product market maker (Uniswap, SushiSwap, PancakeSwap, etc.)
2. Constant sum & constant product market maker (Curve)
3. Constant mean market maker (Balancer)
4. NFT trading exchange
5. Order book based DEX
6. Centralized exchange

Although any of the listed options can be used for swapping tokens, the swapping mechanic that will have the best synergy with the rest of the DeFi bonding system should be chosen. For example, Olympus DAO chose to integrate SushiSwap & UniswapV2 into their bonding mechanic. This meant that users can deposit SushiSwap & UniswapV2 LP tokens for bonding. The evaluation of those LP tokens for bonding is trivial because every LP tokens -for that specific liquidity pool- represents the same liquidity. Also, the decentralized nature of SushiSwap allows users to easily exchange the native tokens with other crypto assets without KYC and the signup process required for centralized exchanges. The only negative point about SushiSwap is that the liquidity is spread equally across the price curve making OHM’s price susceptible to higher price slippage and the underutilization of the capital in the liquidity pool.

Among the six swapping mechanics, the centralized exchange is the most unconventional choice for a DeFi bonding system given that it is not decentralized. But, it can be good if there is a way to integrate its unique aspects, such as KYC (Know your customer), compliance with local law, and regulations. The exact formulation is not within the scope of this posting, but we want people to start thinking about DeFi bonding systems that are different from Olympus DAO’s bonding system.

In the next post, we will discuss a way to utilize UniswapV3, an upgraded version of SushiSwap & UniswapV2, as a swapping mechanic in the new proposed DeFi bonding system. In this new DeFi bonding system, UniswapV3’s new feature called concentrated liquidity, which allows for lower price slippage and a more efficient way to utilize the capital by allowing users to choose the range for providing the liquidity, will be integrated into the bonding mechanic.

Locking mechanic

Before discussing what a locking mechanic is, we first need to explain the story behind how the locking mechanic came to be. The story starts with ICO, i.e., initial coin offering. ICO was one of the first decentralized fundraising methods for a project by accepting cryptocurrencies directly from users. In return, the project sent native tokens to those users and they could hold onto those tokens in hope that the price will go up as the project matured. But in reality, many were only interested in making money in a short time and were not interested in the project’s future. This increased the price volatility for new tokens and made them realize that holding on to the token is an ineffective way to utilize the capital when they could sell their token when the price is high and buy when the price is low.

To incentivize and reward users to hold on to their tokens for a longer period, the staking mechanic was introduced. The staking mechanic worked like the traditional savings account: users earn periodic staking reward in the form of native tokens for locking up their tokens. But, unlike the traditional savings account that adjusted the interest rate to achieve sustainable economic growth, the staking reward amount was usually fixed to a schedule and not related to the project’s progress. This meant that native tokens were minted just to give out as a staking reward causing value dilution as the time passed.

The staking mechanic introduced by Olympus DAO solves the aforementioned problem by changing how the staking rewards are minted. Instead of simply minting tokens when staking rewards need to be distributed, they are minted only when bonding occurs. In other words, new tokens are minted only when new capital is injected into the treasury, thus distributing staking rewards caused less value dilution than before. Extending this idea to extreme, Olympus DAO provided a high staking reward rate (APY) to encourage users to lock up their tokens and not to provide liquidity. Thus, number of OHM in the open market, including the liquidity pool are consistently lower than staked OHM, which helped with stabilizing OHM’s high price.

The locking mechanic in the DeFi bonding system is a generalized form of Olympus DAO’s staking. Instead of focusing on providing an incentive for locking the native tokens, the locking mechanic considers locking other assets related to the native token such as the liquidity provider token. Other than that, it is similar to Olympus DAO’s staking in that the native tokens are backed via the bonding mechanic, and promotes stability for native tokens outside of the staking system.

Conclusion

In this posting, the building blocks of Olympus DAO that made it successful are generalized to three DeFi bonding primitives: bonding mechanic, swapping mechanic, and locking mechanic. The bonding mechanic is used to raise capital and mint native tokens based on the injected capital. The swapping mechanic provides a way to swap native tokens with other crypto assets or vice versa and is integrated with the bonding and locking mechanics to bring a positive synergy to a DeFi bonding system. Finally, the locking mechanic rewards users who stake their native tokens or assets related to the native tokens for promoting stability (price, liquidity pool, etc).

Stay subscribed for the next medium post that will discuss a new DeFi-bonding system built by customizing the DeFi bonding primitives with the goal to maximize the liquidity owned by the user, referred as user owned liquidity (UOL).