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Blockbytes > Blog > Article > Series > Modeling DeFi III: Incentives
Series

Modeling DeFi III: Incentives

kickflip
Last updated: 2022/10/17 at 9:30 PM
kickflip Published August 3, 2022
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Small Business Concept - Savings and Loan Related

Modeling DeFi Analyzing Incentives

Hello everyone! Kickflip is back with Modeling DeFi III. This time he’s using his modeling skills to answer Bebis’ question, “Is Your Favourite Protocol Really Profitable.” While this article stands on its own, I highly recommend you read Kickflip’s previous articles, which model DeFi lending and the profitability of compounding. Well, dear reader, continue and discover new insights that will supercharge your evaluation of DeFi incentive structures.  

Contents
Modeling DeFi Analyzing IncentivesIs Your Favourite Protocol Really Profitable?The SpreadsheetThe ModelThe ResultThe RealityThank you

Is Your Favourite Protocol Really Profitable?

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 yet, I strongly recommend you do. 

In the article\’s conclusion, Bebis provides a tool for analyzing 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 to inject more detail into Bebis’s argument and shed some more light on incentives. It may help to have the spreadsheet open to follow along as you read. 

Long-term profitability is not as simple as deducting overhead from revenue because token emissions play a massive part in sustainability. 

In my first two articles, I introduced a concept called parameter sensitivity. Parameter sensitivity refers to the effects a slight 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 require massive resource commitments, and 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 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 particular pool can only offer a high yield when 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 and target APRs between 10 and 25%, but we will isolate an investment size of 100k to demonstrate the effect of variable TVL. The following equation governs the relationship:

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 color gradients when discussing outputs.

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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 an entire 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 analyze from the image, but you can perhaps interpolate a bit from the color. And at the top left, a 100k investment can provide the smallest yield to the highest capital for the smallest amount of time.

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 the value of the investment in dollars. That is why it is essential 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 asset\’s value. So, the yield and sustainability of that position adjust accordingly.

Therefore, the goal is to generate value from quality, 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 helpful (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,

kickflip

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TAGGED: DeFi, Incentives, Modeling

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