While there is little doubt in our minds that 0x is one of the best projects out there, with a strong team building genuine, open-architecture solutions to wean us off custodial exchanges (one of the persisting ironic elements of our industry’s structure), it is our view that the token model has room for improvement; it is currently an underutilized tool that can be wielded to drive stronger network effects and bring liquidity to the platform while accruing greater value to the token itself. Given 0x have a working product and a developing ecosystem of relayers, we feel that they are in an excellent position to capitalize on a leading market position.
Some general thoughts on tokens, and their implications for DEXs
The reality is that in a lot of cases ERC20 tokens have been created primarily as a fundraising mechanism, and in some cases their functional purpose within the application was an afterthought. In other cases, projects settled for a token design that was simple, low risk and passed a basic smell-test of value accrual. Token models should be calibrated to drive adoption and network participation through native incentive structures, while accruing value to the token itself. We believe that driving adoption of the protocol/product and value accrual should be the primary functions of token models, and that concerns around friction and token distribution are important but secondary considerations.
Most crypto projects are built on open source code, and thus the cost of replicating a competitor’s technology is marginal. As a result, the competitive dynamics amongst substitutable products within the space will likely revolve around their respective go-to-market strategies and the strength of the token in retaining users through native incentive systems. Token economics should be a key pillar within most crypto go-to-market strategies, as they can be a formidable tool in driving adoption. We also see a dynamic arising where the network effects generated by strong token models will have an ability to erode a competitor’s first mover advantage, as well as add to the defensibility of a project’s incumbency within a particular vertical. Given the emerging industry structure surrounding cryptocurrencies, it is likely that technological differentiation will not be sustainable, and technology leaders should prepare themselves for disruptive competitors coming to market with aggressive tokenized incentive schemes.
The exchange business is the most mature and competitive segment of the crypto economy. Customer loyalty to individual exchanges has proven to be fickle, with market share shifting drastically on several occasions over the last 3 years. For centralized exchanges, the competitive implications of exchange tokens are more obvious; tokens can be used to foster customer loyalty not only through fee discounts, but by offering value add products, services and privileges to loyal token holders (access to ICOs, voting power on exchange listings etc). These initiatives should add to customer stickiness and solidify the position of market leaders in the centralized exchange space. The key shortcomings of DEXs versus centralized exchanges today revolve around liquidity and UX; this informs us as to what the priorities should be when DEXs design their token.
The ZRX token
0x’s current token model sees ZRX denominated fees paid on ‘shared liquidity’ or ‘open order book’ orders only (ie when one relayer is allowed to fill an order on another relayer’s order book). This is a highly transactional use case that sees relayers earning revenue in ZRX. This model suffers from the commonly discussed ‘velocity problem’ and will likely see relayers selling ZRX tokens earned due to uncertainty around the ability for the token to accrue and retain value. In the future, relayers will have some incentive to retain tokens in order to maintain a stake in the protocol’s governance.
In our view, a revised token model for 0x should have the following attributes:
- Consistently accrues value to the token
- Incentivizes market making/brings liquidity to the platform
- Incentivizes liquidity sharing to promote the realization of network effects
- Decentralizes governance over the protocol
- Maintains sufficient economic independence of relayers to define their own commercial relationships
- Maintains the neutrality and openness of the protocol
- Minimises friction.
We believe that the healthiest and most defensible protocols will have successfully rallied their various participants around their native token. One of the most powerful elements of crypto network effects is the engagement encouraged amongst network participants who own that network’s native token; if participants become apathetic with respect to the token, the network loses community zeal which will likely become a competitive disadvantage over the long term. I will propose two new elements that could be added to the ZRX token model that encourages 0x participants to think in terms of the network’s health as a whole. Overall, a slight change in perspective is needed.
The first element of our proposed model is a simple token burn. This could be structured like so:
- A ZRX denominated fee of x% is paid to a burn address on every open order book trade
- The fee level is set as a part of on-chain protocol governance
The idea is not to eliminate relayer fee revenue by burning all fees, but rather to allocate a portion of current fee revenue to be burned (ie 5 basis points of total trade size). This portion can be set by ZRX holders, giving relayers a greater incentive to hold tokens. This fee burn addresses one of the key problems faced by the protocol today, being the lack of built-in incentives for liquidity sharing. Currently relayers face an opportunity cost whenever another relayer’s order is filled on their books (as they receive no fees for this fill), and a fee burn would create a small incentive to rebroadcast other relayers’ orders and grow overall network volume in order to drive capital gains of the ZRX token. The system does not preclude explicit, trusted fee sharing between relayers using systems such as Aqueduct (created by the ERC dEX team). Gas inefficiencies could be addressed by only applying the burn to trades of a certain minimum value.
Creating a token burn also gives the protocol firepower to re-issue some of these previously burned tokens in order to incentivise behavior that adds value to the network. This is the crux of the second element of our proposed model.
Opt-in incentive system for market makers
This system is designed to drive greater liquidity to the network by rewarding market makers with either fee discounts and/or by paying them fees in ZRX. This could be structured like so:
- Market makers opt into the system by staking an amount of ZRX tokens (e.g. $10,000 worth with a staking period of 10 days). The amount of tokens staked defines the total fee obligation that can be incurred over the staking period.
- Once tokens are staked, the maker is no longer required to pay fees upfront. Fee obligations incurred during the staking period must be monitored (address watching?), and will be payable at the end of the staking period.
- Under an on-chain governance mechanism, ZRX holders vote to include particular assets in the incentive system, and define a fee discount and rebate level for each. The idea is that fees will be discounted for makers providing further liquidity for already liquid assets, and that fee rebates may be paid for makers providing liquidity for illiquid assets. This drives liquidity to where it is most needed. It would probably be ideal to apply a formula to define the discount/rebate level based on the total volume contribution by the individual market makers (example in the charts below).
- At the end of the staking period, a fee discount and rebate is applied to the total fee obligations incurred, and subsequent fees owed to the protocol (burn) and relayers are deducted from the stake and paid out based on the relayer’s respective volume share (ie relayer fee * 1 — applicable discount). Fee burn and relayer fees can be paid out in one transaction every 10 days to increase gas efficiency.
- If net positive fee rebates are payable to the market maker, the tokens are sourced from the pool of previously burned tokens, meaning rebates will never result in new ZRX tokens being issued (maintaining the deflationary expectation introduced by the token burn). In most cases, the rebates earned would net out against fees owed.
To clarify, market making on relatively liquid pairs would simply reduce trading fees that would otherwise be paid if the maker had not opted into the system. The system would only reward market makers with ZRX tokens (ie giving them net fee revenue from such trading activity) when they are supplying liquidity to relatively illiquid markets. The greater the volume contribution of a particular market maker, the greater the discount/rebate.
Rewarding market makers with a token is not unique to this system, and has already been implemented in Ethfinex’s Nectar token. There has also been an attempt to abstract away this incentive system and introduce it, along with a new token in the Hydro Protocol, which is a layer that sits above 0x. Indeed, it seems that another risk of not implementing such a system within 0x itself is that a similar system will be implemented extra-protocol, reducing the relevance of the ZRX token. This system obviously introduces several engineering complexities and unanswered problems that need solving, however these are some of the most worthwhile problems to solve.
A strength of this model is that it increases the functional purpose of the ZRX token but does not add friction to the average trader. The incentive system is opt-in and only really concerns professional market makers, who can handle the extra friction (and are being adequately compensated for it).
Why not leave this up to relayers?
An obvious rebuttal to this proposal is that this kind of incentive scheme falls within the wheelhouse of the relayer, and such a system is encroaching on their ability to define their own business relationships. There are a few reasons why a protocol level incentive system is attractive; this system drives liquidity neutrally to all relayers, giving smaller relayers more liquidity, possibly enabling a richer ecosystem overall. If there are no protocol level incentives, then a small number of the largest, best resourced relayers will likely win the vast majority of the market over time (more money to spend on customer acquisition, bringing more liquidity, bringing more customers and so on). Moreover, if the system is effective in driving liquidity to 0x, then relayers can focus their efforts on product development and user acquisition, rather than bootstrapping liquidity. In any case, the system is opt-in, and relayers that don’t wish to participate don’t have to.
There is also an argument to be made that relying on protocol-level incentive systems increases the ‘legal’ decentralization of the project. In a recent speech by SEC Director of Corporate Finance William Hinman, he noted that the level of reliance that token holders have on the entrepreneurial efforts of the token’s proprietor is a key factor in determining whether a digital asset is sufficiently decentralized to no longer be considered a security. Thus if the 0x team are tasked with driving liquidity to the platform by developing extra-protocol arrangements, the token holder is relying on their entrepreneurial efforts, however, if protocol-level mechanisms are doing the lion’s share of the work, and value-accretion factors such as the token burn are being set by on-chain governance, then the key drivers of the token’s value are decentralized.
A point on governance, incentives and forks
It is fair to say that the 0x team’s current focus with respect to the ZRX token is around governance, which is a good place to start. People often consider governance mechanisms as a defensive measure against hard forks, and there is also a view that governance rights can accrue value to a token (such as ZRX). I struggle with these concepts, as any governance decision that is valuable enough to an individual stakeholder (or genus of stakeholders) to justify significant value accrual to the governance token will likely be significant enough to justify a hard fork. Picture a scenario where 40% of 0x relayers support proposal x, and 60% support proposal y. The governance value model suggests that each side will acquire tokens in order to influence the result (up to the point that it is economically rational). However, should the supporters of proposal y acquire sufficient voting rights and succeed in having their proposal adopted, then the marginalized relayers could simply sell their tokens, fork and take all their liquidity to a new protocol, leaving the ‘victorious’ group holding a token that probably just lost 40% of its value. They could even short ZRX before announcing their intention to move off the protocol.
Making the ZRX token a desirable asset will be more effective in preventing hard forks and maintaining network participants’ commitment to the protocol. Creating a vested interest in the long term prospects of a protocol token will increase the incentive for disagreeing parties to find a compromise. The network effects and incentives generated by end users owning significant stakes in the token will increase their loyalty to the protocol, and reduce the competitive viability of any fork.
Consider these ideas food for thought. I hope they inspire some discussion and that members of the community can iterate on them or develop their own, stronger incentive models. We are supporters of the 0x team and relayers, and encourage them to consider these and other ideas around furthering the economic integration of the ZRX token and protocol-level incentives for driving liquidity to the platform and sharing liquidity amongst relayers.