If you don’t know already, my private key associated with this account wallet was compromised a week ago by the team over at Shadow Edges.

https://twitter.com/0xArhat/status/1693525868084383961?s=20

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However, this blog on crvUSD will provide simpler explanations and diagrams, making it easier for everyone to grasp the concept.

Table of Contents

1. crvUSD: What is it?

   1. What problem is Curve Finance trying to solve with crvUSD?

2. crvUSD vs. UST

3. Comparing Stablecoin Mechanisms- Curve Finance, MakerDAO & Compound

4. How to decide what kind of stablecoin to invest in?

5. crvUSD Design

   1. LLAMMA

   2. PegKeeper Mechanism

      1. How it works?

      2. How does crvUSD maintain its peg?

      3. How do soft liquidations happen?

   3. Automatic Stabilizer and Monetary Policy Mechanisms.

6. Risks & Benefits to crvUSD

crvUSD: What is it?

Curve Finance’s crvUSD is probably one of the most anticipated stablecoin launches. Ever since the Terra-LUNA debacle, the skepticism around stablecoins still lingers.

Curve Finance’s CrvUSD is a crypto-backed over collateralized stablecoin that is soft-pegged to the US dollar, similar to MakerDAO’s DAI.

Users can mint crvUSD by depositing collateral in a collateralized debt position (CDP), a smart contract that locks up the collateral and issues the stablecoin. Users can also burn crvUSD to get back their collateral, minus some fees.

CrvUSD uses a novel algorithm called the Lending-Liquidating AMM Algorithm (LLAMMA), designed to manage the collateralization risks of the stablecoin.

The problem that Curve Finance is trying to solve with crvUSD is the lack of a stable and decentralized alternative to fiat currencies in the DeFi space.

• Centralized stablecoins, such as USDT, USDC, or BUSD, are backed by fiat reserves that are held by centralized entities. These entities can censor transactions, freeze accounts, or (can) manipulate the supply of stablecoins. They also face regulatory uncertainty and compliance issues in different jurisdictions.

• Decentralized stablecoins like DAI or FRAX are backed by crypto assets deposited into smart contracts. These assets are subject to market fluctuations and volatility, which can affect the stability and security of the stablecoins. They also require liquidations, which are events where the collateral backing a stablecoin becomes insufficient to support its value, and thus has to be sold off quickly to avoid under-collateralization. Liquidations can be costly and disruptive for users, as they may lose their collateral or incur high fees.

• Algorithmic stablecoins are not backed by any collateral but rely on algorithms that adjust the supply and demand of the stablecoins using incentives and penalties. These algorithms are complex and experimental and may only sometimes work as intended. They also face governance attacks, market manipulation, or coordination failures.

CrvUSD aims to solve these problems by offering a decentralized, over-collateralized stablecoin that is soft-pegged to the US dollar and built on Curve Finance.

CrvUSD uses a novel algorithm called LLAMMA. LLAMMA combines the functions of lending, borrowing, and liquidating in an AMM system and adjusts the amount of collateral backing each stablecoin in real time based on market conditions. This avoids the need for liquidations, which are costly and disruptive events where the collateral backing a stablecoin becomes insufficient to support its value.

CrvUSD benefits from the existing liquidity and user base of Curve Finance. Curve has a specialized AMM that uses low-degree polynomial curves to determine the prices and availability of the tokens, which allows for low fees and slippage, as well as high capital efficiency and liquidity. CrvUSD can leverage Curve Finance’s pools, fees, rewards, and governance system to enhance its utility and adoption.

CrvUSD also complements Curve Finance’s native token, CRV, which is used for governance and rewards on Curve Finance. CRV holders can lock their tokens into veCRV, which gives them voting rights, a share of trading fees, and boosted liquidity mining rewards on Curve Finance. CrvUSD will also generate fees and reward values for CRV holders and increase CRV's demand and v.

crvUSD is not an algorithmic stablecoin similar to Terra’s UST.

CrvUSD and UST have some key differences in their design and mechanism.

• CrvUSD is over-collateralized with crypto assets, meaning users must deposit more value in crypto than they can mint in crvUSD.  UST was under-collateralized with Luna, Terra’s native token, meaning users only had to burn $1 worth of Luna to mint 1 UST.

• CrvUSD uses a novel algorithm called LLAMMA, which continuously liquidates and sells the deposited collateral to maintain a healthy collateral ratio and avoid under-collateralization. UST used a seigniorage model, which adjusts the supply of Luna and UST to maintain the peg.

• CrvUSD is built on Ethereum, the most popular and widely used blockchain for DeFi applications. UST was built on Terra, a blockchain specializing in stablecoins and payment solutions.

• CrvUSD benefits from the existing liquidity and user base of Curve Finance. UST benefited from integrating various Terra applications, such as Anchor Protocol, Mirror Protocol, and Chai.

Now that we have an idea of what crvUSD as a stablecoin is, I’ll be analyzing crvUSD as a Stablecoin mechanism as compared to MakerDAO & Compound.

But MakerDAO & Compound aren’t stablecoins. Why are you comparing crvUSD with them?

Although not stablecoins themselves, MakerDAO and Compound serve as stablecoin mechanisms. These platforms enable users to mint and borrow stablecoins by providing collateral.

For instance, MakerDAO lets users mint DAI, a decentralized stablecoin pegged to the US dollar, by depositing ETH or other assets as collateral. Similarly, Compound allows users to borrow USDC and other stablecoins by depositing ETH or other assets as collateral.

CrvUSD is also a stablecoin mechanism, but it differs from MakerDAO and Compound. It is a native collateralized-debt-position (CDP) stablecoin based on Curve Finance’s Lending-Liquidating AMM Algorithm (LLAMMA).

It allows users to mint crvUSD, a decentralized stablecoin pegged to the US dollar, by depositing ETH or other assets as collateral. It also enables users to liquidate undercollateralized positions by swapping collateral for crvUSD.

Existing stablecoin mechanisms, such as MakerDAO and Compound, allow users to access stablecoins by depositing crypto assets as collateral.

However, they use fixed parameters for the interest rate and the liquidation ratio that are often conservative and inefficient.

For example, MakerDAO uses a stability fee and a collateralization ratio determined by the Maker DAO governance. In contrast, Compound uses a market-based interest rate and a collateral factor determined by supply and demand.

MakerDAO uses a stability fee and a collateralization ratio determined by the Maker DAO governance. The stability fee is a fixed interest rate that borrowers must pay on their borrowed DAI, while the collateralization ratio determines how much collateral a user must deposit to borrow DAI. These fixed parameters can be conservative and may not adjust quickly enough to market conditions.

Compound uses a market-based interest rate and a collateral factor determined by supply and demand. The interest rate is based on the supply and demand of each asset in the Compound protocol, while the collateral factor determines how much of each asset can be used as collateral. However, these parameters are still fixed and may need to adjust more quickly to market conditions.

So, how would you, as a retail investor, decide which stablecoin is better for you to invest in?

Which metric do you think is the most important for a stablecoin mechanism?

I don’t think there is a definitive answer, but here’s what I’m thinking:

• If you are a borrower who wants to leverage your collateral and maximize your return on investment, you may care more about the capital efficiency and the liquidation risk of the stablecoin mechanism.

• If you are a lender who wants to earn interest by supplying collateral or stablecoins to the pool, you may care more about the interest rate and the security of the stablecoin mechanism.

• If you are a trader who wants to swap between different stablecoins or other assets, you may care more about the scalability and the interoperability of the stablecoin mechanism.

• If you are a governance token holder who wants to have a say in the direction and development of the stablecoin mechanism, you may care more about the governance model and the incentives of the stablecoin mechanism.

Let's dive into crvUSD’s design and discover how this stablecoin mechanism works.

The design of crvUSD, as described by Michael Egorov in his Curve stablecoin design paper, is based on several key concepts:

• Lending-Liquidating AMM Algorithm (LLAMMA),

• PegKeeper, and

• Automatic Stabilizer and Monetary Policy Mechanisms.

So, What is LLAMA?

crvUSD follows the Lending Liquidating AMM Algorithm much different from what we saw with Terra's UST, which followed a Seigniorage algorithm.

LLAMMA is a novel algorithm to manage the collateralization risks of the stablecoin. LLAMMA stands for Lending-Liquidating AMM, which combines lending, borrowing, and liquidating functions in an automated market maker (AMM) system.

The main idea behind LLAMMA is to adjust the pool leverage of the collateral backing each stablecoin in real time based on market conditions.

This means that the supply and demand of the stablecoin and the collateral are always in sync, and liquidations are less needed.

Liquidations are events where the collateral backing a stablecoin becomes insufficient to support its value and thus has to be sold off quickly to avoid under-collateralization. Liquidations can be costly and disruptive for users, as they may lose their collateral or incur high fees.

However, LLAMMA does not eliminate liquidations entirely. It only reduces their frequency and severity by burning some stablecoins from the pool reserve when the collateral value drops and minting some stablecoins to the pool reserve when the collateral value rises. This way, the pool leverage is constantly adjusted to maintain a healthy pool collateralization ratio.

However, suppose the collateral value drops too fast or too much. In that case, LLAMMA may still need to partially liquidate some users’ positions by selling some of their collateral to buy back stablecoins and repay their loans until their collateral ratios reach the minimum threshold again. Users can also avoid liquidation by repaying some of their stablecoins loans or adding more collateral.

At the same time, LLAMMA uses a price oracle to monitor the market value of the collateral and crvUSD. when the value of the collateral drops, LLAMMA converts some of the collateral into crvUSD to maintain stability and prevent liquidation. Conversely, when the value of the collateral rises, LLAMMA converts some of the crvUSD back into collateral to maintain stability. This process is automated and continuous, with LLAMMA adjusting the ratio of collateral to crvUSD based on market conditions in order to maintain stability.

By doing so, LLAMMA ensures that the collateral ratio of crvUSD stays above a certain threshold, which is determined by a risk parameter that governance can adjust.

The collateral ratio is the ratio between the total value of the collateral and the total value of crvUSD. -- A higher collateral ratio means that crvUSD is more secure and stable but also more expensive to mint. -- A lower collateral ratio means that crvUSD is cheaper to mint but also more risky and volatile.

LLAMMA is designed to provide a scalable and efficient solution for creating a decentralized stablecoin that can be used in various DeFi applications. By replacing liquidations with a continuous process of selling and buying collateral, LLAMMA aims to reduce the volatility and complexity of managing a stablecoin system.

CrvUSD improves upon existing stablecoin mechanisms by using a dynamic interest rate and liquidation ratio that adjust to market conditions.

Dynamic interest rate* incentivizes users to deposit or withdraw their funds based on market demand, which helps maintain stability and avoid liquidations as much as possible. The mechanism works by adjusting the interest rate for borrowing crvUSD (the stablecoin) based on the supply and demand of crvUSD and the collateral.*

LLAMMA also uses it to respond to market conditions and adjust quickly based on real-time data. This helps ensure that users are always incentivized appropriately based on market demand, which helps maintain stability and avoid liquidations as much as possible.

The LLAMMA converts between collateral (such as sfrxETH) and crvUSD in a continuous liquidation/de-liquidation process, but it does not directly adjust the dynamic interest rate or liquidation ratio.

LLAMMA also introduces the feature of PRICE BANDS

In LLAMMA, price bands are used to determine the appropriate allocation of collateral between crvUSD and volatile crypto assets.

When a user deposits collateral and borrows a stablecoin, the LLAMMA smart contract calculates the bands where to locate the collateral. The bands are determined based on the current market conditions and can adjust in real-time as market conditions change.

Suppose the LLAMMA system has three bands for borrowing crvUSD against ETH collateral:

• Band 1: 150% to 170% Collateralization Ratio (CR) - Low risk

• Band 2: 130% to 150% CR - Medium risk

• Band 3: 110% to 130% CR - High risk

If a user borrows crvUSD with ETH as collateral, they must first choose the collateralization ratio within one of these bands. This ratio determines the debt they can take and the amount of crvUSD they can borrow against their ETH collateral.

When the price of ETH changes, it converts into crvUSD if it falls below a certain band. For example, if ETH falls below the lower limit of Band 1 (150%), some of the ETH will be automatically converted into crvUSD until the required collateralization ratio is maintained. This process continues until all of the ETH has been converted into crvUSD or until the price bounces back up above a certain threshold.

By using price bands in this way, LLAMMA can ensure that there is always enough crvUSD available to cover any potential losses due to market volatility while allowing for more efficient use of collateral.

The lower band and upper band ranges are critical components for maintaining the stability of a stablecoin, such as crvUSD. These two bands represent a range within which the stablecoin's price should ideally stay.

1. Lower Band: If the price of the stablecoin falls below the lower band, LLAMMA will convert some of that collateral into more crvUSD to maintain stability.

2. Upper Band: If the price of the stablecoin rises above the upper band, LLAMMA will convert some of those stablecoins back into more collateral.

In this diagram: LB represents the lower band, while UB represents the upper band.

• If the price drifts towards LB, the PegKeeper increases the liquidation ratio (LiqRatio↑) and decreases the borrow rate (BorrowRate↓). This aims to reduce the stablecoin supply and bring the price back to the target value.

• If the price drifts towards UB, the PegKeeper decreases the liquidation ratio (LiqRatio↓) and increases the borrow rate (BorrowRate↑). This aims to increase the stablecoin supply and reduce the price, bringing it back to its target value.

The bands serve as a reference for the PegKeeper mechanism to adjust key parameters and maintain stability in the stablecoin's price.

For Example,

Let's say a user deposits 100 ETH as collateral and borrows 10,000 crvUSD. The LLAMMA smart contract calculates the bands where to locate the collateral based on market conditions.

Suppose the LLAMMA system has 3 bands for borrowing crvUSD against ETH collateral:

• Band 1: ETH price between $1900 and $2100

• Band 2: ETH price between $1700 and $1900

• Band 3: ETH price below $1700

If the price of ETH is currently $2000, then all of the user's collateral will be in Band 1. If the price of ETH drops to $1800, then some of the collateral will be converted into crvUSD to maintain the required collateralization ratio.

Specifically, enough ETH will be converted into crvUSD to cover any potential losses if the price were to drop further.

If the price of ETH drops further to $1500, then more of the collateral will be converted into crvUSD. This process continues until all the collateral has been converted into crvUSD or until the price bounces back up above a certain threshold.

By using bands this way, LLAMMA can ensure that there is always enough crvUSD available to cover any potential losses due to market volatility while allowing for more efficient use of collateral.

These bands are used to maintain a healthy collateralization ratio and avoid under-collateralization without relying on traditional liquidations.

However, suppose the price of the collateral drops too quickly and falls outside of the designated band. In that case, this can trigger a soft liquidation or an external liquidation if coverage is too close to dangerous limits.

This helps ensure that there is always enough collateral backing each stablecoin to maintain stability and avoid under-collateralization.

Capital efficiency measures how many stablecoins a user can mint with a given amount of collateral. A higher capital efficiency means that the user can borrow more stablecoins with less collateral, which increases their leverage and return on investment.

Liquidation risk is the probability that a user’s position will be liquidated due to a drop in the collateral value or a rise in the interest rate. A lower liquidation risk means the user can avoid losing collateral and paying a liquidation penalty.

So, How does crvUSD maintain its peg?

Due to market volatility, the price of crvUSD may deviate from its target value, and while crvUSD does maintain its peg, it does so through a combination of different mechanisms.

The primary mechanism for maintaining the peg is the PegKeeper algorithm, which adjusts the interest rate and liquidation ratio based on the supply and demand of crvUSD to keep its value stable relative to the USD. This helps to balance the supply and demand of crvUSD and ensure that its value is backed by sufficient collateral.

Collateralization is also an essential mechanism for maintaining the peg. Users who want to mint crvUSD must first deposit collateral (such as ETH) into a smart contract as security. The amount of collateral required depends on the current liquidation ratio, which the PegKeeper algorithm sets. This ensures there is always enough collateral backing crvUSD to maintain its value.

Finally, soft liquidation is used as a last-resort mechanism to maintain the peg. If a user's position becomes undercollateralized (i.e., their collateral value drops below a certain threshold), their position will be partially liquidated in a way that minimizes losses for both the user and the system. This helps to prevent sudden drops in collateral value from destabilizing the system and causing crvUSD to lose its peg.

1. When collateral falls below a certain threshold, the soft liquidation mechanism starts.

2. Instead of forcibly liquidating the collateral, other users are incentivized to repay the debt at a discount.

3. The user partially repays the debt and receives a portion of the collateral at a discounted rate.

4. The process helps maintain stability and reduce the harsh impact of forced liquidations on the market.

This soft liquidation process ensures a more gentle approach to dealing with under-collateralized positions in the crvUSD stablecoin system and minimizes the risk of severe market disruptions.

• Collateralization involves locking crypto assets in an LLAMMA pool to mint crvUSD. The collateral assets guarantee the value of crvUSD and act as a buffer against price volatility. The collateral ratio is the ratio between the collateral's value and the crvUSD debt's value. A higher collateral ratio means that the crvUSD is more secure and stable, while a lower collateral ratio implies that the crvUSD is more risky and volatile.

• Interest rate adjustment changes the interest rate that users have to pay on their crvUSD debt based on the supply and demand of crvUSD. The interest rate affects the incentive for users to mint or burn crvUSD. A higher interest rate means that users must pay more for borrowing crvUSD, which discourages minting and encourages burning. A lower interest rate means that users must pay less for borrowing crvUSD, which encourages minting and discourages burning.

• Soft liquidation converts collateral into stablecoins using a special-purpose AMM when the collateral ratio falls below a certain threshold. Soft liquidation reduces the crvUSD debt and increases the collateral ratio, which restores the stability and security of crvUSD. Soft liquidation also avoids abrupt and forceful liquidation events that could cause market shocks or losses for users.

What is the PegKeeper Mechanism?

The PegKeeper is a concept used in the design of LLAMMA to help maintain the peg between the stablecoin and its target price. When the price of the stablecoin deviates from its target price, the PegKeeper can take action to bring it back in line.

It is a single smart contract responsible for minting and burning crvUSD tokens in response to changes in demand.

and how does it help maintain the peg between the stablecoin and its target price?

When the price of crvUSD rises above $1, the PegKeeper mints new crvUSD tokens and deposits them into a Curve pool between the stablecoin and a redeemable reference coin or LP token. Specifically, when the price of the stablecoin rises above its target price (i.e., when ps > 1), an asymmetric deposit forms a peg-keeping reserve into a stableswap Curve pool between the stablecoin and a redeemable reference coin or LP token. Once ps > 1, the PegKeeper contract is allowed to mint uncollateralized stablecoin and deposit it to the stableswap pool single-sided in such a way that the final price after this is still no less than 1.

Conversely, when the price of crvUSD falls below $1, the PegKeeper withdraws existing crvUSD tokens from the Curve pool and burns them. Conversely, when the price of the stablecoin falls below its target price (i.e., when ps < 1), the PegKeeper is allowed to withdraw (asymmetrically) and burn the stablecoin. This helps reduce supply and increase demand for the stablecoin, which can help bring its price back up toward its target.

ELI5

Imagine you have a piggy bank where you keep your money. You want to make sure that you always have the same amount of money in your piggy bank, but sometimes you accidentally spend some of it, or someone gives you extra money.

The PegKeeper is like a helper who watches your piggy bank and makes sure that you always have the right amount of money in it.

If you accidentally spend too much money and don't have enough left in your piggy bank, the PegKeeper will give you some extra money to put back in.

And if someone gives you too much money and your piggy bank has more than it should, the PegKeeper will take some of the extra money out.

The goal is to make sure that your piggy bank always has the right amount of money in it, just like how LLAMMA stablecoins aim to keep their price close to their target value with the help of the PegKeeper!

In PegKeeper’s design, Automatic Stabilizer and Monetary Policy mechanisms also play crucial roles in maintaining the stablecoin's value and ensuring its long-term stability.

Let’s explore each in detail.

Automatic Stabilizer

This mechanism is the interaction between the LLAMMA and PegKeeper.

The Automatic Stabilizer's primary goal is to maintain the crvUSD's intended peg value, and it does so with the help of LLAMMA's asymmetrical conversions between collateral and crvUSD.

As the collateral price rises, more deposits are converted to collateral, and when it falls, the deposits are converted back to crvUSD.adjustment mechanism ensures that the stablecoin's value remains stable without requiring any manual intervention.

This automatic adjustment mechanism ensures that the crvUSD’s value remains stable without requiring any manual intervention.

Monetary Policy

The Monetary Policy mechanism helps manage crvUSD's supply, issuance, and other aspects to ensure long-term stability and value.

For example, when crvUSD's price is greater than the 1:1 peg (e.g., due to increased demand), the PegKeeper mints uncollateralized stablecoin and deposits it into the stableswap pool, maintaining the price at no less than 1.

In contrast, when the crvUSD price is below the peg, the PegKeeper withdraws asymmetrically from the stableswap pool and burns the stablecoin to appreciate its price. This dynamic Monetary Policy helps maintain the crvUSD peg while managing its supply in a responsive and efficient manner.

This diagram showcases how the PegKeeper interacts with the Stableswap Pool when the crvUSD price goes above or below the intended peg.

When the crvUSD price is greater than 1, the PegKeeper mints uncollateralized stablecoin and deposits it into the Stableswap Pool, which prevents the price from going below 1.

Conversely, when the crvUSD price is below 1, the PegKeeper withdraws asymmetrically from the Stableswap Pool and burns the stablecoin, appreciating its price and moving it closer to the intended peg.

Together, Automatic Stabilizer & Monetary Policy work like this:

In this diagram:

1. If the crvUSD price (ps) is greater than 1, the PegKeeper mints uncollateralized stablecoin and deposits it into the stableswap pool. This helps maintain the price no less than 1.

2. If the crvUSD price (ps) is less than 1, the PegKeeper withdraws asymmetrically and burns the stablecoin. This helps appreciate the price.

3. A "slow" mechanism is also used for stabilization through the varying borrow rate (r), which changes as the crvUSD price (ps) changes, ensuring that the rate remains within a stable range.

So this is how crvUSD maintains its peg

crvUSD also carries higher risk due to its reliance on liquidity pools and the PegKeeper mechanism for maintaining price stability.

crvUSD is tied to the US dollar through liquidity pools and the PegKeeper mechanism, but this approach is riskier than other stablecoins that use traditional collateralization methods.

One of the main risks associated with crvUSD is liquidity risk. Since crvUSD relies on liquidity pools to maintain its peg, any disruptions in these pools can lead to price instability.

For example, if there is a sudden increase in demand for crvUSD and the liquidity pool cannot keep up with this demand, the price of crvUSD may rise above its peg. Conversely, if there is a sudden decrease in demand for crvUSD and the liquidity pool has excess supply, the price of crvUSD may fall below its peg.

Another risk associated with crvUSD is smart contract risk. Since crvUSD is implemented as a smart contract on the Ethereum blockchain, any vulnerabilities or bugs in this smart contract could potentially be exploited by attackers. This could lead to loss of funds or other security issues.

Regarding LLAMMA, one of the main risks associated with this algorithm is market risk. Since LLAMMA relies on converting collateral into stablecoins based on market conditions, any sudden changes in market conditions can lead to significant losses for users who have deposited collateral into the system.

Additionally, there is also some risk associated with external liquidations. If a user's collateral falls below a certain threshold and LLAMMA cannot convert it into stablecoins quickly enough to maintain stability, an external liquidation may occur. This could result in significant losses for the user whose collateral was liquidated.

Overall, while both crvUSD and LLAMMA have been designed to minimize risks as much as possible, there are still some inherent risks associated with using these systems that users should be aware of before depositing funds into them.

Although, crvUSD can offer several benefits:

• Providing more liquidity and stability to the Curve ecosystem, as crvUSD can be used as a base currency for swapping and lending other stablecoins.

• Reducing the reliance on centralized stablecoins, such as USDC and USDT, which are currently exposed to regulatory and security risks.

• Increasing the utility and value of CRV, the native token of Curve Finance, as CRV holders can participate in the governance and risk management of crvUSD.

• Creating new opportunities for arbitrage and yield farming, as users can exploit price differences and interest rates between crvUSD and other stablecoins.

As CrvUSD is still in its early stages of development and testing, and Curve Finance plans to launch it on the mainnet soon, let’s hope all goes well.

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If you find this deep dive analysis useful, please consider donating to 0x34ddd9223D9DDb6B56F640824Af6FCC31e1deBF4 and/or by minting an NFT for this & other blog posts by me.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

16. Voting Mechanisms & Incentives For Governance in DAOs

17. Uniswap's Fee Switch Dilemma

18. MakerDAO’s Endgame

19. LSD in Crisis: Can They Bounce Back After Shapella?

The Luban hard fork will incorporate three BEPs:

• BEP-126: Introduce Fast Finality Mechanism.

• BEP-174: Introduce BSC Extension Protocol.

• BEP-221: Introduce BSC Fee Market.

BEP-126

BEP-126 introduces a Fast Finality Mechanism to the Binance Smart Chain (BSC) network. It aims to reduce the confirmation time and improve the user experience of BSC transactions by introducing a voting mechanism among validators.

According to the proposal, the Fast Finality Mechanism works as follows:

• The validators form a committee that votes on each block using a BLS-based multi-signature scheme.

• The committee size is dynamically adjusted according to the number of active validators and the network latency.

• The committee members broadcast their votes to each other through a peer-to-peer (P2P) channel.

• The votes are aggregated into a signature that attests the validity of the block.

• The signature is attached to the block header and propagated to the network.

• The block is considered fast finalized if it has a valid signature from more than two-thirds of the committee members.

• The fast finalized blocks can be used as cross-chain communication and data-sharing checkpoints.

BEP-174

BEP-174 introduces a new governance proposal type to manage the set of whitelisted Relayers. A Relayer is a service that facilitates cross-chain communication and data sharing among different blockchains by relaying messages and transactions between them.

According to the proposal, the new governance proposal type works as follows:

• The validators can submit a proposal to add or remove a Relayer from the whitelist.

• The proposal must include the Relayer’s address, name, and description.

• The proposal must also specify the amount of BNB that will be locked as collateral by the Relayer.

• The validators will vote on the proposal within a certain period of time.

• If the proposal passes, the Relayer will be added or removed from the whitelist accordingly.

• If the Relayer is added to the whitelist, it must lock the specified amount of BNB as collateral before it can start relaying messages and transactions.

• If the Relayer is removed from the whitelist, it will lose its collateral, and the network will reject its relayed messages and transactions.

BEP-221

BEP-221 introduces a new pre-compiled contract to authorize the CometBFT blocks. CometBFT is a light block validation protocol that the BSC Extension Protocol uses to verify the block headers of other blockchains.

According to the proposal, the new pre-compiled contract works as follows:

• The contract takes the block header and the signature of a CometBFT block as inputs.

• The contract verifies the validity of the signature using the public keys of the validators who signed the block.

• The contract checks if the signature has enough quorum (more than two-thirds of the validators) to authorize the block.

• The contract returns true if the signature is valid and has enough quorum and false otherwise

The hard fork is expected to bring more innovation and efficiency to the BSC ecosystem and make it more competitive.

The Shapella upgrade of Ethereum, implemented on April 12, brought various changes, resulting in enhanced security and efficiency of Ethereum 2.0.

A week after Shapella, we saw no heavy withdrawals. Instead, more ETH was going into the staking protocols.

https://twitter.com/0xArhat/status/1648401739031216129?s=20

However, most liquid staking tokens have underperformed compared to ETH, implying a decrease in value relative to the native asset, despite the upgrade being weeks old.

LSTs such as stETH, cbETH, ankrETH, and rETH have suffered a decrease in value ranging from 5% to 15% compared to ETH over the past few weeks.

Data Analysis

The upgrade reduced the inflation rate of ETH by burning a portion of the transaction fees.

stETH has the highest price ratio and the lowest yield among the four LSTs, which reflects its popularity and liquidity in the market. stETH’s highest price ratio among the four LSTs demonstrates its popularity and liquidity in the market. stETH has also seen its discount to ETH widen from 0.1% to 0.36% in the five weeks after the upgrade.

It has also lost around 3.29% of its peg against ETH. You can read why cbETH has lost its value and market share in the tweet below.

https://twitter.com/0xArhat/status/1659241594346946560?s=20

cbETH has the lowest price ratio and the highest yield among the four LSTs, which reflects its lower demand and higher risk due to its custodial nature.

ankrETH and rETH have similar price ratios and yields, but rETH has been more volatile due to its recent exploit that resulted in a loss of $31 million.

rETH has seen its premium to ETH shrink by almost 7%, while ankrETH has seen its discount to ETH fluctuate and shrink a whopping 11% in the same period.

All four LSTs have seen their price ratios and yields decline since the Shapella upgrade, indicating a loss of value and attractiveness compared to ETH.

Some possible factors that contributed to the decline in LSTs’ value compared to ETH

There are 4 main factors:

Reduced inflation: The Shapella upgrade introduced a new mechanism for burning ETH fees, which reduced the inflation rate of ETH from 4.5% to 1.8% per year. And at the time of writing this, it is around 0.806%. This made ETH more scarce and valuable and reduced the attractiveness of LSTs as a yield-generating instrument.

Increased demand: The upgrade also increased the demand for ETH as a deflationary asset and a store of value, especially among institutional investors and long-term holders. This increased the opportunity cost of staking ETH and reduced the supply of LSTs in the market.

Technical issues: Some LSTs faced technical and security risks that affected their trustworthiness and usability. For example, stETH suffered a solvency crisis in June 2022 when whales withdrew stETH from the liquidity pool and caused a price dislocation. rETH experienced an exploit in December 2022 that resulted in a loss of $31 million and a temporary halt of its service.

Regulatory uncertainty: The regulatory environment for staking services is still unclear and evolving and could challenge how LSTs are operated and taxed. For example, some jurisdictions may consider LSTs as securities or derivatives, which could impose stricter rules and requirements on LST providers and users.

How does inflation affect LSTs?

Inflation affects LSTs in two main ways:

• It affects the value of LSTs relative to ETH. If ETH has a higher inflation rate than LSTs, then LSTs become more valuable and trade at a premium to ETH. On the other hand, if ETH has a lower inflation rate than LSTs, then LSTs become less valuable and trade at a discount to ETH.

• It affects the yield of LSTs relative to ETH. If ETH has a higher inflation rate than LSTs, then LSTs offer a higher yield and attract more demand from income-seeking users. However, if ETH has a lower inflation rate than LSTs, then LSTs provide a lower yield and attract less demand from income-seeking users.

But why did LSTs initially have an upsurge? What can we expect now?

The initial upsurge in liquid staking demand can be attributed to the growth and acceptance of proof-of-stake (PoS) networks, particularly Ethereum 2.0.

Users must stake their native tokens to secure and validate the network, which involves locking up tokens for extended periods and incurring liquidity and opportunity costs.

However, liquid staking offers solutions to these challenges by enabling users to earn rewards and access liquidity without locking up their tokens.

Liquid staking has many advantages and opportunities for users who want to participate in PoS networks and benefit from the growing crypto ecosystem.

• Users can increase their liquidity and capital efficiency by accessing their funds at any time and using them for other purposes.

• This will also enhance their yield and return by earning rewards from staking and other high-interest rate platforms.

• Diversifying their portfolio and hedging against market fluctuations or network failures can also help to reduce risk and volatility.

• Staking tokens enables more users to contribute towards the validation and governance of PoS networks, thereby supporting network security and decentralization.

By extending the scope of alternative options, the sector could experience substantial growth as it offers a more comprehensive range of choices and features for various users and platforms. Currently, in the liquid staking space, multiple options are emerging and evolving, including:

aTokens vs. cTokens

There are different ways to represent the interest earned by LSTs, such as the aToken and cToken models.

• The aToken model utilizes a unit increase method, whereby the number of aTokens increases as more assets are added to the pool from interest payments.

• On the other hand, the cToken model uses an exchange rate increase method, where the exchange rate between the cToken and the underlying asset increases as more assets are added to the pool from interest payments.

Custodial vs. Non-custodial tokens

There are varying forms of custody and security for LSTs, including custodial and non-custodial tokens.

• Custodial tokens are provided by a centralized entity that manages and possesses the underlying assets on behalf of the users.

• On the other hand, non-custodial tokens are issued by a decentralized protocol that empowers users to maintain complete control and ownership of their underlying assets.

Thoughts

It's clear that LSTs are here to stay and are not limited to the Ethereum ecosystem.

Despite the uncertain future, ETH is currently a safer and more attractive option than stETH, cbETH, rETH, and ankrETH.

It's essential to do your own research, but there's hope for a bull run in the near future.

Thank you for reading through, and subscribe below for regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

16. Voting Mechanisms & Incentives For Governance in DAOs

17. Uniswap's Fee Switch Dilemma

18. MakerDAO’s Endgame

Endgame consists of 14 Maker Improvement Proposals (MIPs), each designed to create rules and frameworks for the new governance structure. The first MIP voted on by the community was the Maker Constitution, also known as MIP101.

These are the 14 proposals that make up the entire Endgame.

Phases of Endgame

The five phases of Endgame are a roadmap proposed by MakerDAO co-founder Rune Christensen to decentralize governance and improve innovation at MakerDAO, the decentralized protocol behind the stablecoin DAI and the governance token MKR.

Let’s explore each in detail.

Phase 1 will involve the following changes:

• A complete rebrand to unify the DAI and Maker brands and create a new identity for the MakerDAO ecosystem.

• The introduction of two new tokens with updated features: NewStable and NewGovToken.

• NewStable is an ERC20 wrapper with the same features as DAI but with additional benefits such as flash minting, interest-bearing, and complete 1:1 conversion to DAI.

• NewGovToken is a new version of MKR but with a higher supply and a deflationary mechanism that burns LP tokens for NewStable against NewGovToken using protocol surplus.

• The preservation of Dai and MKR in their current form, but with a governance backend that operates through a secure bridge to Ethereum.

The purpose of Phase 1 is to improve the scalability and efficiency of the Maker Protocol by upgrading its architecture and deploying AI tools to optimize various processes.

Phase 2 will involve the following changes:

• The launch of six SubDAOs, smaller DAOs that will have their governance tokens and determine charities to donate to through community votes.

• The introduction of NewStable farms, which are liquidity pools that allow users to stake their NewStable tokens and earn rewards in the form of SubDAO tokens.

• The activation of the Smart Burn Engine will accumulate and burn LP tokens for NewStable against NewGovToken using protocol surplus, creating deflationary pressure on NewGovToken.

• The creation of a Purpose System, which will enable token allocations to SubDAOs based on their social impact and alignment with MakerDAO’s vision.

The six subDAOs are categorized under these two:

• FacilitatorDAO: Responsible for facilitating the governance process and ensuring all parties follow the Maker Constitution.

• AllocatorDAO: Responsible for allocating funds to various projects and initiatives that support the MakerDAO vision and mission.

While there’s very little information about what these 6 subDAOs will be, each SubDAO will have its own governance token that can be earned by staking NewStable tokens in the corresponding NewStable farm.

The SubDAO tokens will also have voting rights and influence over the SubDAO’s decisions and actions. The SubDAOs will operate independently or in conjunction with the main DAO, depending on the situation and the purpose.

The purpose of Phase 2 is to enhance the governance mechanism of MakerDAO by creating a more diverse and resilient ecosystem of SubDAOs that can operate independently or in conjunction with the main DAO.

Phase 3 will involve the following changes:

• The launch of several internal AI tools to optimize governance tasks such as monitoring, data siloing, risk assessment, and voting.

• The creation of The Purpose Fund will promote and fund free, open-source AI models and tools for socially impactful industries and projects.

• Integrating real-world assets (RWA), such as real estate and stocks as collateral types for the Maker Protocol, expands its use case and adoption.

• The development of Alignment Artifacts, which are AI-generated summaries of governance proposals that help users understand the pros and cons of each option.

The purpose of Phase 3 is to leverage the power of AI to enhance the efficiency, resilience, and participation of the MakerDAO ecosystem. It will also support open-source AI development and social impact projects that use NewStable or NewGovToken to create positive change in the world.

Phase 4 will involve the following changes:

• The development of an incentive program for ecosystem participants called the Governance Participation Incentive (GPI).

• The GPI will involve gamification and rewards to incentivize interactions on the MakerDAO platform, such as voting, delegating, staking, and providing feedback.

• The GPI will use the Sagittarius Lockstake Engine (SLE), incentivizing users to lock up NewGovTokens and delegate voting power.

• The SLE will also enable users to earn NewStable income or SubDAO tokens as rewards for their participation in securing the governance process.

The purpose of Phase 4 is to increase user engagement and participation in governance by creating a positive feedback loop and aligning incentives. It will also foster a more diverse and active community that can contribute to the MakerDAO vision and mission.

Phase 5 will involve the following changes:

• The creation of a proprietary blockchain currently referred to as NewChain.

• NewChain will host all backend logic for SubDAO tokenomics and MakerDAO governance security.

• NewChain will be bridged to Ethereum, meaning NewStable, NewGovToken, Dai, and MKR will continue functioning normally on Ethereum.

• NewChain will be protected by a governance backend that operates through a secure, state-of-the-art bridge.

NewChain is a proprietary blockchain that MakerDAO plans to create in Phase 5 of Endgame, the final stage of its roadmap to decentralize governance and improve innovation. According to the official forum post, NewChain will have the following features:

• NewChain will host all backend logic for SubDAO tokenomics and MakerDAO governance security.

• NewChain will be bridged to Ethereum, meaning NewStable, NewGovToken, DAI, and MKR will continue functioning normally on Ethereum.

• NewChain will be protected by a governance backend that operates through a secure, state-of-the-art bridge.

• NewChain will enable greater scalability and innovation for the MakerDAO ecosystem by optimizing performance and security.

The purpose of Phase 5 is to finalize the Endgame governance and tokenomics of MakerDAO and SubDAOs by creating a dedicated blockchain that can optimize performance and security. It will also enable greater scalability and innovation for the MakerDAO ecosystem.

Questions Raised By the Community

1. Isn’t transitioning Dai to a NewStable token going to fragment liquidity and give up the vast amount of integrations and brand power Dai has accomplished? That’s a valid concern, but the transition will not fragment liquidity or give up the integrations and brand power of DAI:

   • Dai will remain the undisturbed OG stablecoin with no flashy features, and the complete 1:1 conversion to NewStable will always bootstrap its liquidity.

   • NewStable will be an ERC20 wrapper with the same features as DAI but with additional benefits such as flash minting, interest-bearing, and complete 1:1 conversion to DAI.

   • NewStable will be compatible with all existing DAI integrations and protocols and enable new use cases.

   Therefore, the transition will not harm the existing ecosystem of DAI but rather enhance it and expand it with new features and incentives.

2. Why will USA IPs and VPN users be geo-blocked from accessing all forms of farming and yield opportunities of NewStable and NewGovToken? The US has a complex and uncertain legal and regulatory environment for crypto and DeFi projects, especially for DAOs and stablecoins. Because of the legal and regulatory risks involved, the US authorities:

   • have shown a hostile and aggressive attitude towards crypto and DeFi projects, such as launching investigations, lawsuits, and enforcement actions.

   • have the power and jurisdiction to seize assets, freeze accounts, impose sanctions, and extradite individuals involved in crypto and DeFi projects.

   • have the influence and leverage to pressure other countries and entities to comply with their demands and policies.

   Therefore, US-based entities and addresses are excluded from the Endgame to protect the MakerDAO ecosystem and community from potential legal and regulatory threats. This is a precautionary measure to ensure the security and sustainability of the project.

3. How will the AI tools be developed and deployed, and what are the ethical and security implications of using AI for governance? The AI tools for governance will be developed and deployed in Phase 3 of Endgame, the third stage of MakerDAO’s roadmap to decentralize governance and improve innovation. The AI tools will:

   • be used to optimize governance tasks such as monitoring, data siloing, risk assessment, and voting.

   • include Alignment Artifacts, which are AI-generated summaries of governance proposals that help users understand the pros and cons of each option.

   • also include AI Oracles, which are AI models that provide reliable and unbiased data feeds for the Maker Protocol and SubDAOs.

   • be developed by MakerDAO’s Innovation DAO (MID), one of the six SubDAOs launched in Phase 2 of Endgame.

   • be funded by The Purpose Fund, which will promote and fund free, open-source AI models and tools for socially impactful industries and projects.

   The ethical and security implications of using AI for governance are complex and challenging. Some of the implications are that the AI tools may:

   • introduce new risks and vulnerabilities, such as hacking, manipulation, bias, or errors.

   • raise ethical and legal questions, such as accountability, transparency, privacy, or consent.

   • affect the human agency and autonomy of the users and stakeholders, such as reducing their involvement, influence, or trust.

   Therefore, developing and deploying AI tools for governance will require careful design, testing, and evaluation to ensure their quality, reliability, and security. Clear and consistent ethical principles and guidelines will also be needed to ensure fairness, accountability, and transparency. It will also require constant feedback and communication with the users and stakeholders to ensure their satisfaction, participation, and empowerment.

4. How will Endgame affect the tokenomics and value proposition of MKR and DAI? Endgame will affect MKR and DAI's tokenomics and value proposition in several ways. According to the official forum post by Rune Christensen and other sources, some of the effects are:

   • MKR will be replaced by a new version of MKR, called NewGovToken, which will have a higher supply and a deflationary mechanism that burns LP tokens for NewStable against NewGovToken using protocol surplus.

   • NewGovToken will be the governance token of MakerDAO and SubDAOs and will have voting rights and influence over the decisions and actions of the ecosystem.

   • NewGovToken will also be used as collateral to generate more NewStable tokens, creating a positive feedback loop and increasing the demand and value of NewGovToken.

   • NewStable will be compatible with all existing integrations and protocols that use DAI and enable new use cases.

   • NewStable will also be used to stake in NewStable farms, which are liquidity pools that allow users to earn rewards in the form of SubDAO tokens.

   Therefore, Endgame will enhance the tokenomics and value proposition of MKR and Dai by upgrading their features and functions, creating new incentives and opportunities, and expanding their use case and adoption. It will also preserve their existing ecosystem and brand power while preparing them for the future direction of MakerDAO.DAI integrations and protocols

MakerDAOs Endgame is an ongoing discussion, and I’ll keep updating this blog as and when new updates have been released.

Thank you for reading through, and subscribe below for regular post updates.

If you enjoyed reading this, consider sharing this on Twitter.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

16. Voting Mechanisms & Incentives For Governance in DAOs

17. Uniswap's Fee Switch Dilemma

The fee switch was introduced with Uniswap V3 in March 2021 and can be activated by Uniswap governance, but it hasn’t happened still.

Uniswap charges a 0.3% swap fee for every trade on its platform. The entirety of that fee is given to liquidity providers (LPs), who supply tokens to the pools and enable trading.

The fee switch feature allows Uniswap governance to redirect 0.05% of the 0.3% swap fee to a different destination, such as the Uniswap treasury, a development fund, a liquidity mining program, or a charity.

This means LPs would receive 0.25% of the swap fee instead of 0.3%.

The fee switch feature creates a revenue stream for the Uniswap protocol and its governance, which can fund development, innovation, and community initiatives. The feature also gives UNI token holders more influence and stake in the protocol’s success.

However, the fee switch feature also has some trade-offs and challenges. For example, reducing the fees for LPs could reduce their incentives to provide liquidity and affect the competitiveness of Uniswap with other exchanges. Additionally, activating the fee switch could have regulatory and tax implications for the protocol and its users.

Let’s dive deep

Uniswap has three options for activating the fee switch:

Option 1: Protocol-Wide Fee Switch

• This option involves turning on the fee switch for all pools on Uniswap and redirecting 0.05% of the 0.3% swap fee to the Uniswap treasury, which UNI token holders control.

• This generates the most revenue for the protocol and its governance, which could be used to fund development, innovation, and community initiatives.

• However, it would also reduce the fees for all LPs, which could reduce their incentives to provide liquidity and affect the competitiveness of Uniswap with other exchanges.

Option 2: Pool-Specific Fee Switch

• This option involves turning on the fee switch for selected pools based on specific criteria, such as volume, liquidity, or volatility, and redirecting 0.05% of the swap fee to the Uniswap treasury.

• This fee switch would generate less revenue for the protocol and its governance than option 1, but it would also reduce the fees for fewer LPs, which could mitigate some of the adverse effects on liquidity and competitiveness.

• However, this would also introduce complexity and subjectivity in selecting the pools and criteria for activating the fee switch, as well as potential arbitrage opportunities and gaming behavior by LPs and traders.

Option 3: Alternative Fee Destinations

• This option involves turning on the fee switch for selected pools and redirecting 0.05% of the swap fee to a different destination, such as a development fund, a liquidity mining program, or a charity.

• This fee switch would generate no revenue for the protocol and its governance, but it would also reduce the fees for fewer LPs than option 1. Moreover, this switch could create positive externalities and network effects for Uniswap by supporting development and community initiatives aligned with Uniswap’s vision and values.

• However, this would also introduce complexity and subjectivity in selecting the pools and destinations for activating the fee switch and potential coordination and governance challenges in managing and distributing the funds.

There are Benefits to Each of Them…

… And Also, Some Trade-offs:

The main trade-offs are between the following:

Maximizing revenue for the protocol

• The more fees the protocol collects, the more resources it has to fund development and community initiatives that could enhance Uniswap’s functionality, security, and user experience.

• The fee switch feature allows Uniswap governance to redirect a portion of the fees generated by the exchange to the Uniswap treasury, which UNI token holders control.

• The fee switch feature also aligns the interests of UNI token holders with the protocol’s success, as they would receive a share of the fees generated by the exchange.

Incentivizing liquidity providers

• The more fees LPs receive, the more incentives they have to provide liquidity and earn passive income.

• LPs also face risks such as impermanent loss and price volatility when they provide liquidity, so they must be compensated accordingly.

• The fee switch feature reduces the fees that LPs receive by redirecting a portion of them to a different destination, such as the Uniswap treasury or an alternative destination.

• This could reduce LPs’ incentives to provide liquidity and affect their profitability.

Maintaining competitiveness with other exchanges

• The more competitive Uniswap is with other exchanges, both centralized and decentralized, the more volume and liquidity it can generate.

• Uniswap’s competitiveness depends on fees, slippage, speed, security, and user experience.

• The fee switch feature could affect Uniswap’s competitiveness by increasing the effective fee for traders who swap tokens on its platform.

• This could make Uniswap less attractive than other exchanges offering lower fees or better services.

For Example

If Uniswap governance decides to maximize revenue for the protocol by turning on the fee switch for all pools and redirecting 0.05% of the swap fee to the Uniswap treasury, this could reduce the incentives for LPs to provide liquidity and affect Uniswap’s competitiveness with other exchanges that offer lower fees or better services.

Conversely, if Uniswap governance decides to incentivize liquidity providers by turning off the fee switch for all pools and giving 0.3% of the swap fee to LPs, this could reduce the revenue for the protocol and its governance and limit their ability to fund development, innovation, and community initiatives that could enhance Uniswap’s functionality, security, and user experience.

Therefore, Uniswap governance needs to carefully weigh the costs and benefits of each option and decide on the best balance for the protocol’s long-term growth and sustainability.

What’s the Current Status of the Fee Switch?

The fee switch feature was introduced in Uniswap V3, launched in March 2021.

However, the fee switch feature still needs to be implemented or activated. It can only be done via a governance vote by UNI holders, which has yet to happen. There have been some proposals and discussions in the Uniswap governance forum about turning on the fee switch for some pools, such as ETH-stablecoin pairs, but they have yet to reach a consensus or a formal vote.

Therefore, the fee switch feature is still a theoretical possibility yet to be tested or deployed on Uniswap. However, it remains to be seen if and when Uniswap governance will decide to activate the fee switch and its impact on the Uniswap protocol and stakeholders.

The community reaction to the fee switch feature is mixed and diverse.

Some UNI holders favor turning on the fee switch, as they see it as a way to generate revenue for the protocol and its governance, which could be used to fund development and community initiatives. They also see it as a way to align their interests with the protocol’s success, as they would receive a share of the fees generated by the exchange.

• More revenue for the protocol would increase the value and utility of UNI tokens, representing a claim on the fees generated by the exchange.

• Some feel that the fee switch feature would align their interests with the protocol’s success, as they would receive a share of the fees generated by the exchange. This would create a positive feedback loop, as UNI holders would have more incentives to support and promote Uniswap, increasing its volumes, liquidity, market share, and fees and revenue benefit UNI holders.

Some LPs oppose turning on the fee switch, seeing it as a way to reduce their fees and incentives to provide liquidity. They see it as a way to harm Uniswap’s competitiveness with other exchanges that offer lower fees or better services. They also question the need and rationale for turning on the fee switch, arguing that Uniswap is already successful and profitable without it.

• The fee switch feature would redirect 0.05% of the 0.3% swap fee to a different destination, reducing their incentives to provide liquidity, especially if they face impermanent loss and price volatility when they deposit tokens to the pools.

• The fee switch feature could affect Uniswap’s competitiveness by reducing the fees and incentives for LPs making Uniswap less attractive than other exchanges offering lower fees or better services, such as faster execution, higher security, or more features.

• Some also question the need and rationale for turning on the fee switch, as they argue that Uniswap is already successful and profitable without it. They also argue that Uniswap does not need to fund development and community initiatives, as it already has a strong team, a loyal community, and a proven product.

Some users are indifferent or neutral about turning on the fee switch, as they see it as having little or no impact on their experience or the costs of using Uniswap.

Final Thoughts

Turning on the fee switch feature is a complex and important decision that requires careful consideration and deliberation by Uniswap governance.

As the Uniswap ecosystem grows and its needs evolve, the community can adjust the fee switch mechanism through governance decisions. This adaptability empowers token holders to balance the need for growth, sustainability, and alignment with the broader goals of the platform to ensure its long-term success. As a result, it’ll become easier to balance trade-offs.

Indeed, a well-implemented fee switch can help the platform grow and strengthen its position in the DeFi landscape. By encouraging more projects to launch on Uniswap and attracting additional liquidity, the platform can support high-performing pools and pave the way for new and innovative initiatives within the DeFi space.

This strategic positioning would ultimately contribute to Uniswap's long-term success and its reputation as a go-to platform within the DeFi community.

Adjusting the fee switch mechanism over time through governance decisions can help maintain balance and alignment with the platform's broader goals, ensuring sustained growth and development of the ecosystem.

Thank you for reading through, and subscribe below for regular post updates.

If you enjoyed reading this, consider sharing this on Twitter.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

16. Voting Mechanisms & Incentives For Governance in DAOs

Earlier this year, I explored the concept of Governance & Growth in Modern Society, where I identified two different societies emerging in modern economies.

• On the one hand, we have a global society of consumers with unprecedented mobility and access to information.

• On the other hand, we have organizations with digital sovereignty (DAOs) approaching to take power from the hands of corporations.

In that research thesis, I explored how organizations, especially DAOs, can scale and what motives (profit or growth principle) drive them to scale and operate at a higher level.

This research thesis focuses more on how governance is enabled in DAOs through

• Voting incentives,

• Pricing Mechanisms & Prediction Markets, and

• Oracles for data-driven decisions

Further, this research delves deeper into analyzing & optimizing interactions between DAO participants through game theory. This is done by exploring the idea of Voting mechanisms & rewards. Also, I examined case studies of MakerDAO, Augur, Gitcoin Grants, Decred & Tezos.

Table of Contents

• The Concept of Voting Incentives

  • Types of IDPs

  • How does the community view voting incentives?

• Pricing Mechanisms & Prediction Markets for decision making

• Role of Oracles in Decision Making

• Analyzing and Optimizing the Interactions Between Participants in Governance of a DAO

  • How to analyze interactions b/w participants

  • How to optimize interactions b/w participants

• Laying the Rules for Interactions

• Categorizing Voting Mechanisms

  • How to incentivize participation?

  • How to implement different voting mechanisms?

• Impact of Various Voting Mechanisms on Voting Rewards

• Case Study of MakerDAO, Augur, Decred & Tezos.

• Conclusion

The Concept of Voting Incentives

Vote incentives involve Independent Distribution Partners (IDPs) that provide users with financial incentives for participating in governance by voting on their held governance tokens.

Independent Distribution Partners (IDPs) are platforms or entities that work on encouraging and facilitating voting participation among token holders. Their primary goal is to increase voter turnout by providing incentives, rewards, or other mechanisms that motivate users to engage in the governance process of decentralized projects or organizations.

IDPs can take various forms or operate in different ways, such as:

Third-party platforms: External platforms can integrate with a decentralized project's governance system, offering participants an easy and user-friendly way to vote on proposals and receive rewards for participation.

• Tally: A decentralized governance platform that facilitates easy voting and proposal creation for multiple DeFi projects, including MakerDAO, Bancor, Synthetix, and more.

  • Tally connects with various web3 wallets, allowing users to manage their voting activities across different protocols from one place.

  • Each protocol may determine incentives for participation but can include rewards in the form of governance tokens.

• Aragon: An Ethereum-based platform that helps users create and manage decentralized organizations.

  • It provides a suite of tools for DAOs, including governance, proposal creation, and voting modules.

  • Aragon integrates with multiple projects to enable seamless decentralized governance. Depending on each DAO's governance tokenomics, users may receive rewards or incentives for participating in voting activities.

• DAOstack: A decentralized platform for the creation and management of DAOs. It offers a modular and extensible framework for governance, including tools for proposal creation, voting, and delegation.

  • DAOstack integrates with several Ethereum-based projects, allowing participants to engage in voting and decision-making activities.

  • As with other platforms, incentives for voters are determined by each specific DAO's rules and token economics.

Native ecosystem integrations: The IDPs can be built into the native governance ecosystem of a project, providing a seamless experience for token holders and making it more convenient to participate in the voting process.

• By integrating IDPs directly into a project's native ecosystem, developers foster a more cohesive environment where token holders can easily access and engage with the governance process.

• This approach elevates the user experience and encourages greater participation from the community, ultimately benefiting the project’s decentralized decision-making process.

• Additionally, native integrations can facilitate a more secure and trustless voting system, as they often leverage the project's existing smart contracts and security measures.

Collaborative organizations or networks: These IDPs can be groups or consortia of companies or projects that work together to support and promote the adoption of blockchain-based governance systems and enhance voter participation through incentives.

• In this setup, multiple organizations join forces to create a more democratic and decentralized decision-making process.

• These collaborative arrangements can pool resources, share knowledge, and develop mutually beneficial incentive programs to encourage active participation in voting initiatives.

• The collaborative nature of these networks enables projects to learn from one another and continuously improve their governance structures while striving to create a more engaged and active community.

While IDPs can be essential in fostering broader engagement in decentralized governance, their implementation should be carefully considered to avoid issues related to vote-buying or manipulation. Some of the ways this can be done:

• designing appropriate incentive structures,

• maintaining transparent decision-making processes, and

• minimizing the undue influence on voting outcomes.

The main goal of this approach is to improve voter turnout and engagement in decentralized ecosystems, fostering more robust and active participation in governance.

Some questions I will answer in this research:

1. What are the types of Vote Incentives that might be available to stakeholders?

2. What are the pros and cons of each type of vote incentive?

3. What are the strategies for improving voting quality on a decentralized protocol?

4. What is the potential impact and advantage of implementing vote incentives for community-driven organizations?

5. What are the best practices for executing and using vote incentives?

6. Is there a sample voting system that could be implemented on a blockchain?

The idea of vote incentives can be seen as both positive and negative.

Positively, it results in more users requiring less incentive value to be incentivized to participate. Negatively, it may result in a system that can't be counted on for correct voting results.

Let’s see how Vote Incentives can be seen as both positive and negative features with these 4 reasons

#1: Democratization Tool

Some, including me, believe vote incentives promote democracy within decentralized systems by encouraging more people to vote. IDPs help to facilitate the process by incentivizing users to cast their votes, which can lead to a broader distribution of power, greater diversity of opinions, and ultimately more representative decision-making.

As a democratization tool, vote incentives are considered by some to be a valuable mechanism in promoting more inclusive and diverse decision-making within decentralized systems. The involvement of Independent Distribution Partners (IDPs) in facilitating the process is crucial to this viewpoint. By offering users rewards for voting, IDPs encourage a broader range of people to vote on governance tokens.

This increased participation results in several positive outcomes:

• Wider distribution of power: With more people voting, the power dynamics within decentralized systems shift, allowing for a more equitable distribution of influence over decision-making processes.

• Greater diversity of opinions: Encouraging a broader range of people to vote leads to various perspectives being heard and considered, enhancing the quality of decisions and supporting more innovative solutions.

• More representative decision-making: As more people participate in voting, the resulting decisions better reflect the community's collective interest, improving overall governance and promoting long-term sustainability within the decentralized ecosystem.

Voting incentives, when utilized effectively, can be a powerful tool to further democratic principles within decentralized systems, fostering healthier governance and more equitable outcomes.

#2: Vote-Buying

On the other hand, some critics argue that offering financial incentives for voting might encourage vote-buying, which could distort the governance process. In this scenario, IDPs may attract users with the promise of monetary compensation, potentially leading to biased voting behavior and manipulation of the results. This would ultimately compromise the fairness and legitimacy of the governance decisions.

Vote-buying, as a potential downside of vote incentives, is a critical concern that must be acknowledged when discussing using financial incentives in decentralized systems.

Critics argue that the use of Independent Distribution Partners (IDPs) and financial incentives may result in issues such as:

• Distorting the governance process: Monetary incentives shift users' focus from making informed decisions based on their beliefs and values to making decisions driven by the promise of financial gain, thus leading to biased voting behavior.

• Role of IDPs: In this perspective, Independent Distribution Partners, by offering financial rewards, unintentionally attract users who prioritize monetary compensation rather than genuine interest or understanding of the issues being voted upon.

• Manipulation of results: Vote-buying could result in power being concentrated among those who can offer the most incentives, leading to an imbalance in the governance process and increased vulnerability to manipulation.

• Compromising fairness and legitimacy: The potential for vote-buying raises questions about the integrity of governance decisions made using incentives. When financial rewards rather than well-considered perspectives primarily influence decisions, the overall fairness and legitimacy of the governance process may be compromised.

• Biased voting behavior: When financial incentives are offered, users might be more likely to vote based on monetary gain rather than considering the underlying proposals' merits. This could lead to a skewed decision-making process that no longer accurately reflects the preferences of the broader community.

• Manipulation of results: With monetary compensation in play, powerful entities might attempt to sway decisions in their favor by colluding with IDPs or exploiting vulnerabilities in the system. This could severely undermine the integrity of the voting process.

• Compromised fairness and legitimacy: If vote-buying becomes prevalent within a decentralized system, it erodes trust in the outcomes, as these decisions would not arise from an impartial assessment of the proposals but rather be influenced by financial gains.

In light of these concerns, careful consideration must be given to implementing vote incentives in decentralized systems to ensure they do not endanger fairness and legitimacy instead of contributing positively to the overall governance process.

As a potentially negative aspect, vote incentives promote vote-buying, negatively affecting the decentralized systems' governance process.

Acknowledging these concerns, exploring ways to balance the potential benefits of vote incentives while minimizing the risks associated with vote-buying behaviors and ensuring the integrity of decentralized governance processes is essential.

There is a fine line between fostering democracy within decentralized systems and engaging in vote-buying behavior that undermines good governance.

#3: Pricing Mechanisms

Pricing mechanisms are crucial in determining resource allocation and consumer behavior in various markets.

I want to explore two case studies— Film exclusivity windows and Rake in Poker—to illustrate the impact of pricing mechanisms and underscore the need for more efficient pricing systems.

Let's examine these examples in more detail:

• Film exclusivity windows: These windows refer to the period during which a film is exclusively available in a particular platform or format (e.g., theaters) before being released to other channels (e.g., streaming services or home video).

  • This mechanism maximizes revenue by segmenting the market and capitalizing on consumer willingness to pay for early access.

  • However, this can also lead to inefficiencies, such as piracy due to limited accessibility, suboptimal release timeframes that fail to utilize demand, and potentially alienating some consumer segments.

• Rake in poker: Rake refers to the commission fee that poker rooms and casinos charge players for participating in poker games. While rake enables these establishments to operate profitably, it can also have negative consequences.

  • For example, high rake rates might deter more casual players, leading to a less diverse player pool and limiting growth potential.

  • Additionally, competing pricing models, like time-based rakes, can result in inefficient allocation of resources as players might make suboptimal decisions based on time constraints.

Pricing mechanisms significantly impact resource allocation and consumer behavior, sometimes leading to inefficient outcomes. But how do we decide on appropriate alternatives?

By evaluating the effectiveness of existing pricing models, which is through Oracles.

#4: Oracles

There is a need for a certain level of centralization or trust in Oracle systems that supply crucial data to the decentralized platforms.

Augur, for instance, relies on a decentralized network of oracles to report and verify real-world event outcomes, which determine the payout of prediction market bets.

Oracle solutions often require some degree of trust in the data sender, which may present potential security risks, inaccuracies, or manipulations. This contradicts the inherent nature of decentralized systems, which typically seek to minimize trust in any single party or authority.

One possible solution to this challenge lies in using trust-minimization technologies like Arbitrum. Arbitrum is an off-chain scaling solution that offers a protocol for running smart contracts with minimal trust requirements between the parties involved. It achieves this by enabling the execution of contracts off-chain while maintaining the same security and dispute resolution capability as on-chain solutions.

Arbitrum can improve the current limitations faced by decentralized oracle systems by reducing the reliance on trusted parties and enhancing data reliability, ultimately leading to the more secure and efficient operation of blockchain-based prediction markets. In this context, exploring and implementing trust-minimization solutions like Arbitrum may pave the way for more robust and resilient decentralized oracle systems that better serve users' needs and maintain the decentralization ideals at their core.

Why are Prediction Markets Important for Voting Incentives?

Prediction markets provide an effective mechanism for aggregating information, fostering collective intelligence, and incentivizing informed decision-making.

Prediction markets play a critical role in incentivizing well-informed voting, utilizing the collective knowledge of participants, enabling real-time decision-making, and building trust in DAO governance. These features make them a valuable tool for enhancing voting incentives and achieving better decision outcomes in DAOs.

Why are oracles important for voting incentives in DAO governance? Oracles are important for voting incentives in DAO governance since they provide the interface between off-chain data sources and on-chain smart contracts, enabling effective integration of external information in decision-making. In the context of DAO governance, oracles play a crucial role by:

• Data-driven decision-making: Oracles provide accurate, up-to-date, and reliable off-chain data that feeds into voting decisions made by the DAO members. This helps to create a more informed and data-driven voting process, improving the quality of governance decisions.

• Facilitating conditional outcomes: In some scenarios, DAO governance decisions might be based on external events or conditions not native to the blockchain. Oracles reduce this dependency by fetching the required external data and reliably feeding it into the DAO’s voting mechanisms, allowing for more versatile and adaptable DAO governance.

• Enhancing transparency and trust: Reliable oracles contribute to the trust in the DAO governance process since members can verify the accuracy and reliability of off-chain data used in decision-making. This trust drives more active participation and engagement from the DAO members, enabling better-informed voting.

• Enabling automation and efficiency: Oracles can trigger specific actions or changes in DAO governance based on predefined conditions, automating certain aspects of the governance process. This can lead to higher efficiency, responsiveness, and adaptability within the DAO ecosystem.

• Encouraging innovation and diversity: By providing access to off-chain data and information, oracles enable various voting incentives and mechanisms, allowing DAOs to experiment with and adopt innovative governance models tailored to their specific needs and goals.

Today and in the coming future, Oracles will play a vital role in the governance process of DAOs.

By leveraging oracles, DAOs can create more effective governance models that incentivize well-informed voting and improve overall decision outcomes.

Now that we have discussed the good and bad of voting incentives, it’s time to put a framework of how to operationalize Voting Incentives.

Analyze and Optimize the interactions between participants in the governance of a DAO through game theory.

Analyzing and optimizing the interactions between participants in DAO governance through game theory involves identifying key actors, their objectives, available strategies, and the rules governing interactions.

By understanding the incentives and potential outcomes of different strategies, it is possible to design a governance mechanism that encourages optimal behavior and maximizes the overall utility for the participants.

How to Analyze Interactions b/w Participants.

In a DAO, the key actors typically include

• token holders,

• proposers,

• developers, and

• oracles.

Each stakeholder has different objectives and priorities, influencing how they interact with the governance process.

After identifying critical actors in a DAO, we can further analyze their objectives, priorities, and impact on the governance process.

Understanding the objectives and priorities of these key stakeholders allows the DAO to design appropriate incentive mechanisms and governance structures that optimize cooperation, decision-making, and overall utility for all stakeholders.

By addressing each stakeholder’s concerns and priorities, the DAO can create an environment that fosters collaboration and drives the organization toward its goals.

Once we have identified the individual objective and priorities, we can then structure the shared objectives of the entire DAO:

1. Maximize overall value and growth of the DAO: All actors share a common goal in promoting the growth, adoption, and value proposition of the DAO to ensure its long-term success and sustainability.

2. Ensure smooth functioning of the DAO: Stakeholders collectively desire an effective governance process that supports decision-making, encourages cooperation, and maintains the overall stability of the organization.

3. Work towards the organization's mission: All participants in the DAO governance process aim to align their actions and decisions with the organization's overarching mission and long-term goals.

By clearly defining each key stakeholder’s individual and shared objectives, DAO governance can consider these motivations when designing the appropriate incentive structures and governance mechanisms to optimize cooperation and decision-making across stakeholders.

Once we have done that, each stakeholder may have different strategies available based on their roles and capabilities within the governance structure. These strategies can include voting on proposals, submitting proposals, influencing other participants through discussion, and abstaining from voting.

In DeFi protocols and DAOs, various actors can access different strategies based on their roles and capabilities. These strategies can help actors participate and engage effectively within the governance structure.

Let's consider the key actors that we have previously discussed to outline the strategies available for each:

By understanding and leveraging these strategies based on their roles, actors in a DAO or DeFi protocol can work together to influence the governance process, address common goals, and ensure the platform's long-term success.

This involves outlining the mechanisms governing voting, communication, and other participant interactions.

Now, Let’s Discuss the Rules of Interactions

In the context of DAOs and DeFi protocols, the rules of interaction outline the core mechanisms governing voting, communication, and other interactions between participants.

These rules are crucial for creating an effective and transparent governance process, and they allow the platform to function smoothly while ensuring stakeholder involvement.

Here are the primary rules of interaction:

These rules and guidelines are essential for creating an effective, transparent governance process, enabling the platform to function smoothly and ensuring stakeholder involvement.

Let’s discuss each category in detail:

Voting Mechanisms:

• One Token, One Vote: In most DAOs and DeFi protocols, voting power is typically determined by the number of governance tokens a participant holds. This can translate to a "one token, one vote" system, where the user's voting influence is proportional to their token holdings.

• Quorum Requirements: To avoid decision-making with low community involvement, a minimum quorum—a specific percentage of total tokens or eligible voters—may be required for a vote to be valid. The quorum ensures a broad consensus for proposed changes.

• Proposal Approval Thresholds: DAOs and DeFi platforms may have predefined approval thresholds to be met for a proposal to be considered approved. This prevents a minority from dominating decisions and ensures fairness.

Communication Channels:

• Public Forums: To encourage open discussion, many DeFi protocols and DAOs utilize public forums or discussion boards where participants can share their views, opinions, and proposals. This can include platforms like Discourse, GitHub, or dedicated community forums.

• Community Calls or Meetings: Regular community calls or meetings can be organized to gather feedback, discuss pressing issues, or address technical details that may be more challenging to handle in text-based communication.

• Social Media Engagement: Engaging community members on social media platforms such as Twitter, Telegram, or Discord can help maintain an active dialogue, increase awareness of governance matters, and broaden user participation.

Proposal Submission and Evaluation:

• Structured Proposal Process: To maintain the DAO and ensure a thorough evaluation, a structured process for proposal submission may be in place. This can include drafting the proposal, submitting it to a public forum for discussion, and allowing changes or amendments before the final vote.

• Proposal Evaluation Criteria: To ensure objective evaluation, there may be specific criteria for evaluating proposals, such as their impact on the platform's security, usability, efficiency, or alignment with the platform's long-term vision.

• Voting Timelines: Voting periods can be predefined, allowing participants ample time to review proposals, engage in discussions, or make decisions.

Overall, these rules of interaction are meant to provide a framework for facilitating productive communication, informed decision-making, and transparent governance in DAOs and DeFi protocols.

By incorporating and adhering to these guidelines, the community can foster a cooperative environment, allowing the platform to evolve and adapt to its users' needs continuously.

Now That We Have Analyzed How Stakeholder Interact Within a DAO, It’s Time to Lay Out Rules to Optimize their Interactions

To optimize participant interactions, the governance structure must encourage cooperation, prevent collusion, and minimize conflicts of interest.

Some potential game-theoretic approaches include

Please make sure that participating in the governance process offers rewards or value to the stakeholders.

Incentivizing participation in the governance process is critical to engaging stakeholders and ensuring robust decision-making. By offering tangible and intangible rewards, protocols can encourage various actors to contribute their time, knowledge, and resources toward the platform's ongoing development and success.

Here Are Different Types of Voting Mechanisms that Current Exist

Utilizing voting mechanisms like quadratic voting, token-weighted voting, or time-based voting rights balances the power distribution among participants and avoids a few influential stakeholders' dominations of governance decisions.

In many decentralized governance systems, voting mechanisms are essential to balance power among participants and ensure fair decision-making. They help prevent the domination of decisions by a few individuals and promote preferential power distribution.

These popular voting mechanisms are often employed in DAO and DeFi governance (which we will explore in detail in the following sections), offering different approaches to distributing decision-making power among participants and encouraging engagement in the platform.

Each voting mechanism has its advantages and potential drawbacks.

It's essential to choose a system that best fits the needs of the specific platform and balances access to decision-making while minimizing the undue concentration of power.

A hybrid or multi-tiered approach combining different mechanisms may provide the most effective and equitable participation in some situations,

How can we effectively implement these voting mechanisms?

Here are some ways:

#1: Minimize Free-Riding

Address the "free-rider" problem by designing mechanisms that discourage free-riding or passive behavior, such as lock-up periods for token holders or incentivizing active contributors.

Implementing a governance system that minimizes free-riding is essential for maintaining stakeholders' active participation and decision-making, encouraging participation, and fostering a decentralized ecosystem.

To minimize the free-rider problem, we can consider the following strategies:

1. Design lock-up periods: Implement time-bound lock-up periods for token holders, hindering them from quickly selling their tokens and incentivizing long-term commitment to the project. This approach discourages free-riding by aligning the interests of token holders with the project's long-term success.

2. Incentivize active contributions: Offer rewards or incentives to participants who actively contribute to the network, such as developers, content creators, or other stakeholders who provide value to the ecosystem. This strategy can also include a reputation system, allowing active participants to gain recognition and ascend in governance influence over time.

3. Implement a penalty system: Establish a system of penalties for non-active users or free-riders that reduces their influence in governance decisions. For example, token holders who do not participate in voting or network activities over a specified period may experience a decline in the voting weight or value of their tokens.

4. Educate stakeholders: Provide educational resources and a supportive community, encouraging participation and fostering stakeholder engagement. Empowering users with knowledge and resources will encourage active participation in governance decisions.

5. Measure and analyze participation: Regularly monitor and assess the level of involvement in the governance process to identify trends and areas where improvements are needed. Use these insights to refine the incentives and mechanisms over time to minimize free-riding behavior further.

By incorporating these strategies, DAOs can reduce the free-rider problem in their governance systems and encourage active and meaningful participation from diverse stakeholders.

#2: Encourage Sharing of Information Between Participants

Facilitate transparent communication channels and support information sharing among participants to enable better-informed decision-making.

Implementing a system that encourages information sharing in decentralized governance can enhance collaborative and informed decision-making processes. Here are some strategies that can help achieve this goal:

1. Transparent communication channels: Establish clear and open channels for discussions, enabling participants to share ideas, opinions, and concerns freely. Platforms like Discord, forums, and message boards can be ideal for sharing information.

2. Documentation and archiving: Maintain an organized and accessible repository of all governance-related documents and discussions. This ensures that past information is easily retrievable and new participants can catch up on previous chats and decisions.

3. Regular updates: Periodically update stakeholders about ongoing projects, new initiatives, and pertinent community issues. This can be achieved through newsletters, blog posts, or social media updates.

4. Collaboration tools: Use collaborative tools, such as shared documents, project management platforms, or virtual whiteboards, to facilitate interaction, brainstorming, and consensus-building.

5. Incentives for active participation: Reward participants for sharing valuable information, insights, or expertise. In a token-based system, these incentives might take the form of token rewards or governance rights, while in other contexts, they might be monetary or non-monetary perks.

6. Education and training: Provide resources and opportunities for community members to enhance their knowledge, skills, and understanding of the project and its ecosystem. Workshops, webinars, and shared educational materials can support informed participation.

By fostering an environment that encourages information sharing, decentralized governance systems can create more robust, more resilient communities where decisions are made collectively by informed and actively engaged participants.

#3: Mitigate Collusion

To address the issue of collusion in a decentralized organization or platform, implementing specific mechanisms can effectively ensure a fair and transparent decision-making process.

Here are some ways I believe through which this can be achieved:

1. Vote delegation: This method enables individuals to delegate their voting power to others, creating a proxy voting system. It allows users who lack expertise or knowledge to delegate their votes to someone they trust. By distributing voting power, vote delegation can help prevent the concentration of decision-making authority in the hands of a few, thus mitigating collusion.

2. Quadratic voting: Quadratic voting is a system where participants can cast votes with varying intensities, but the cost of each additional vote increases quadratically. This makes it more expensive to influence decisions disproportionately and dilutes the power of small groups trying to collude. Quadratic voting ensures that outcomes more closely reflect the preferences of the collective while discouraging collusion.

3. Multi-step decision-making process: Introducing multiple rounds or stages in the decision-making process can hinder collusion. Requiring proposals to pass through several steps makes it more difficult for a small group to coordinate and maintain influence over decisions.

4. Randomized voting mechanisms: Systems like sortition or random sampling can randomly select a subset of participants to decide or form a committee. This reduces the chances of collusion since predicting or controlling who would be selected is more challenging.

5. Transparency and monitoring: Increase transparency in the voting process and monitor for suspicious behavior or patterns, which may suggest attempts at collusion. Promptly address identified issues to ensure a fair decision-making process.

By incorporating one or more of these mechanisms, decentralized platforms can better mitigate the risk of collusion and create a more diverse and inclusive decision-making environment.

Before we go into the case studies, it’s also essential to understand how different voting mechanisms affect voting rewards provided to stakeholders in a DAO.

Let’s explore that in detail.

Case Study: How Voting Mechanisms Affect Voting Rewards

#1: Token-based voting

In this system, each stakeholder’s voting power is proportional to the number of tokens they hold or stake. Voting rewards can be distributed to users based on their token holdings, incentivizing users with more tokens to participate actively in the decision-making process. However, this leads to the centralization of power in the hands of large token holders, as they may control a significant share of votes.

Case Study: MakerDAO

MakerDAO uses a token-based voting mechanism for governance. Users holding their native governance token, MKR, can stake their tokens to vote on different proposals.

Users with MKR tokens participate in governance by staking their tokens to vote on various proposals that drive the platform's development and functionality.

The core principle of MakerDAO's token-based governance is that voting power is proportional to the voter's MKR token stake, which means users who hold more tokens have a more decisive influence on decisions. This approach incentivizes MKR holders to actively participate in the platform's governance since their tokens' value is directly linked to the quality of decisions made.

Proposals to the Maker community can involve changes to the protocol, adjustments to risk parameters or other aspects of the MakerDAO ecosystem.

After a proposal is submitted, MKR token holders can review it, discuss its merits, and cast their votes. The result of the voting process is based on the cumulative voting power of participating token holders.

Token-based voting systems like MakerDAO have several benefits, such as:

1. Encouraging active participation in governance by tying voting power to token holdings.

2. Aligning the interests of token holders with the success and stability of the platform.

3. Allowing for transparent and auditable voting processes.

However, centralization of power raises concerns about potential unequal representation or undue influence from a few participants who own a significant portion of the tokens.

A token-based voting system promotes community involvement, but as with any governance model, it has pros and cons. Finding the right balance between incentivizing participation and preventing centralization remains an ongoing challenge.

#2: Quadratic voting

Participants can cast votes with varying intensity, but the cost of each additional vote increases quadratically. Voting rewards could be distributed based on the number of votes each participant casts, but with diminishing rewards as more votes are used. This mechanism incentivizes participants to distribute their votes judiciously and consider the importance of different proposals while minimizing the potential for collusion and centralization.

Case Study: Gitcoin Grants

Gitcoin Grants supports open-source projects in the Ethereum ecosystem by connecting them with philanthropic funding from the community and matching funds from various donors.

Gitcoin Grants employ a variant of quadratic voting called Quadratic Funding to allocate funds to various projects. Quadratic Funding is a variation of Quadratic Voting designed to allocate funds to projects in a more equitable manner. It ensures that public funding reflects the amount of money contributed to a project and the broad-based support it receives from the community.

Users contribute to projects they believe in, and the matching funds are distributed based on the number of unique donors a project has rather than the total amount of contributions. This method emphasizes broad-based support for projects and avoids centralization.

Here's how the Quadratic Funding mechanism works in the context of Gitcoin Grants:

1. Users (donors) contribute to projects they believe in, making their contributions with Simple Ether (ETH) or ERC-20 tokens.

2. In every fundraising round, Gitcoin secures matching funds from various sources, such as large donors, grants, and other sponsors.

3. The matching funds are distributed to the projects based on a quadratic formula that considers the number of unique donors for each project rather than just the total contributions received.

4. The quadratic formula increases the significance of small donations from many individual donors. For example, projects with more comprehensive community support will receive more matching funds, even if the total contributed is less than that of a project with a few large donors.

This method has several advantages:

1. Promotes broad-based support for projects, emphasizing the importance of many small financial contributions rather than a few sizable amounts.

2. Prevents centralization of funding, whereby a small number of large donors dictate the outcomes of funding allocation.

3. Encourages diverse and healthy growth of projects within the Ethereum ecosystem, fostering innovation and collaboration.

Quadratic Funding in Gitcoin Grants aims to create a more equitable and democratic method of allocating resources to open-source projects. By emphasizing the importance of community support and lowering the influence of large donors, it aims to foster more balanced, sustainable growth in the ecosystem.

#3: One-person-one-vote

Each participant has an equal vote, irrespective of their token holdings or other factors. Voting rewards can be uniformly distributed among participants regardless of contribution, creating an egalitarian voting environment. However, this system may not account for participants' varying expertise and knowledge, leading to less informed decisions.

Case Study: Decred

Decred relies on a ticket-holder voting system for its on-chain and off-chain governance using PoS and Politeia. On-chain validators vote on validating blocks and consensus rule changes, while off-chain ticket holders vote on proposals related to the project’s direction. This structure promotes sovereignty and participation among stakeholders while making stakeholder-based decisions.

It implements a unique hybrid consensus system combining PoW and PoS.

In Decred’s governance model, validators, also known as stakers, participate in on-chain voting by validating blocks and voting on consensus rule changes. Ticket holders participate in off-chain voting by submitting and discussing proposals on Politeia. Both types of voting require locking a portion of DCR tokens to purchase tickets, which provide voting rights.

Politeia, Decred’s off-chain governance platform, allows stakeholders to submit and discuss proposals related to the project.

These proposals can cover many topics, such as protocol upgrades, marketing initiatives, or development priorities. Ticket holders then vote on these proposals using their tickets, and based on the outcomes, decisions are implemented accordingly.

The ticket-holder voting principle in Decred’s governance system offers several advantages:

• A stake in the system and an incentive to participate in governance

• Less risk of centralization as large token holders have to lock their coins to vote

• A diverse range of ideas and opinions considered, potentially leading to more balanced and well-thought-out decisions

However, it’s essential to recognize that ticket-holder voting governance models could face potential drawbacks or challenges, such as community coordination, voter apathy, or decision-making inefficiencies.

Decred’s ticket-holder voting governance system aims to create a sovereign, participatory decision-making process by giving weight to each ticket holder’s opinion.

#4: Futarchy

Futarchy, a concept developed by economist Robin Hanson, improves decision-making by using prediction markets to determine the best course of action based on the expected outcomes of different proposals.

Participants bet on the potential outcomes of competing proposals, and the winning bid is predicted to have the most positive impact on the DAO. Voting rewards can be distributed based on the accuracy of participants' predictions, encouraging users to make informed decisions and thoroughly assess each proposal.

Case Study: Augur

The prediction market platform Augur has experimented with a futarchy-inspired governance model.

In it, users can stake their tokens on the predicted outcomes of different proposals, with the winning bid determined by the expected outcome. While not purely futarchy, Augur's approach incorporates elements of this governance model.

In Augur's system, users can stake their tokens on the predicted outcomes of different proposals.

The winning proposal is then determined based on the expected outcome, with users essentially "voting with their wallets" and using the wisdom of the crowd to weigh in on which proposal would lead to better results.

This approach differs from traditional governance models by focusing on the predicted consequences of decisions rather than simply the voters' preferences.

Some advantages of incorporating futarchy-inspired elements into blockchain governance models include the following:

1. Leveraging the collective intelligence of the community to make more informed decisions.

2. Reducing the impact of bias or manipulation in the decision-making process by focusing on outcomes rather than preferences.

3. Encouraging active participation in governance, as users have a financial stake in the results and can profit from accurate predictions.

It is important to note that Augur's governance model is not purely futarchy but borrows specific ideas from the concept to enhance decision-making.

While futarchy has its proponents and critics, the experimentation with governance models like Augur's demonstrates the potential for innovation and adaptation in the blockchain and cryptocurrency space.

#4: Delegation or Liquid Democracy

Participants can delegate their voting power to others they trust. Voting rewards could be given to both the delegator and the delegatee, incentivizing active participation and fostering trust in the community. This system can allow for more informed decisions, as expertise can be concentrated in a smaller group of trusted voters.

Case Study: Tezos

Tezos utilizes a form of liquid democracy for its governance model. This model allows users who may not be able to participate actively to still have a say in the decision-making process by delegating their voting power.

In this model, token holders can delegate their voting power to trusted validators, also known as bakers. These bakers then represent the interests of those who have entrusted their voting power to them and vote on proposals accordingly.

This form of governance allows for more equitable participation, as individuals who might need more time, knowledge, or ability to engage in decision-making processes actively can still have their opinions represented through delegation.

By empowering its community members to delegate their voting power, Tezos enables a more inclusive and adaptive governance system. Liquid Democracy ensures that everyone's voice can be heard while allowing for efficient decision-making within the platform.

Conclusion

We discussed

1. Various types of voting incentives,

2. Pricing Mechanisms & prediction markets for resource allocation in DAOs,

3. How to Analyze & Optimize Interactions b/w Participants in Governance through Game Theory.

4. Different types of governance models, including on-chain and off-chain governance, as well as futarchy-inspired models like Augur's and liquid democracy models like Tezos'.

As with any aspect of DAO governance, combining different voting mechanisms can balance power, encourage active participation, and prevent collusion or centralization.

The optimal choice of voting mechanism(s) and reward structures depends on the specific goals and values of the community behind the DAO.

It's clear that the field of on-chain governance is diverse and evolving, with each approach offering potential benefits and drawbacks.

On-chain governance aims to improve decision-making and transparency, while off-chain governance enables flexibility and a more human-centric approach to resolving disagreements.

We have seen, Futarchy-inspired models, like the one used by Augur, utilize prediction markets to gain insights into expected outcomes of proposals, effectively leveraging the wisdom of the crowds. In contrast, Tezos' use of liquid democracy allows for more equitable participation and efficient decision-making, allowing users to delegate their voting power to bakers.

I'm still considering the various trade-offs between these models, such as

1. transparency vs. flexibility, and

2. centralized decision-making vs. community-driven choices.

The suitable governance model for an on-chain project will depend on its unique objectives and priorities and the desires of its community and stakeholders.

Some questions that I still have are:

1. How do we weigh the advantages and disadvantages of on-chain vs. off-chain governance models?

2. As on-chain protocols & technologies mature, how will the balance between decentralization and efficient decision-making change?

3. Will a dominant governance model emerge as the industry matures, or is there room for multiple approaches to coexist and thrive?

I will definitely be exploring these questions in detail and delving deeper into the nuances of each throughout the year.

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My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

But fear not, as I've thoroughly researched and analyzed a few of these incidents to provide insights into how they happened and what can be learned from them.

(April 13, 2023) Yearn Finance & AAVE were exploited for more than $10M.

yUSDT token, which is supposed to be a yield-generating version of USDT, was misconfigured to use Fulcrum's iUSDC token instead of iUSDC and stayed that way for more than 1000 days.

This situation leads to unexpected (losses or gains) for anyone holding yUSDT, depending on the exchange rate b/w USDT and USDC.

Understand what this is in detail:

• Fulcrum is a margin lending and trading platform that uses tokenized loans (iTokens) & tokenized positions (pTokens) that use algorithmic lending pools to determine interest rates through supply and demand.

• iTokens are interest-bearing tokens representing a share of Fulcrum's lending pool. Users can deposit their crypto assets into the pool and receive iTokens in return, which accrue interest over time.

• iUSDC and iUSDT are two types of iTokens based on USDC and USDT, respectively.

• The yUSDT token is supposed to be a yield-generating version of USDT, created by Yearn Finance, that allows users to earn interest on their crypto by depositing them into various pools or vaults.

• However, it was discovered that the yUSDT token was misconfigured to use the iUSDC token instead of the iUSDT token as its underlying asset.

This means that the yUSDT token was actually using a different stablecoin (USDC) than what it was supposed to use (USDT)

According to lookonchain,

• 3,032,142 $DAI

• 2,579,483 $USDC

• 1,785,091 $BUSD

• 1,512,528 $TUSD

• 1,193,756 $USDT

were exploited.

OtterSec explained in detail how the exploit took place:

https://twitter.com/osec_io/status/1646411672175939585?s=20

The hack was initially discovered by Samczun here:

https://twitter.com/samczsun/status/1646404331967778820

(April 14, 2023) Bitrue Exchange was Exploited for $24M

Bitrue crypto exchange suffered a hot wallet exploit, losing nearly $24M in crypto assets. According to the exchange, the stolen tokens represented 5% of Bitrue’s overall funds.

Bitrue paused withdrawals after the hack and intends to reopen them on April 18.

Details below:

• The hacker exploited the hot wallet by using an unauthorized transaction involving $ETH & $USDT.

• Bitrue does not disclose the exact details of how the hacker accessed the hot wallet.

Still, it is possible that they exploited a vulnerability in either

1. the hot wallet software or

2. used a phishing attack to obtain private keys or credentials.

The hacker managed to withdraw various tokens worth nearly $24M, including BTC, XRP, ADA, QNT, GALA, SHIB, HOT & MATIC.

The hacker used multiple external addresses to withdraw tokens from Bitrue’s hot wallet and exchanged most of these tokens for 8,858 $ETH, currently in a wallet with the address 0x181. They did this to avoid being traced and to exchange the tokens for other cryptocurrencies.

Why are hot wallets so prone to hacks?

Hot wallets store the private keys or credentials that allow users to access their funds on the exchange.

Hackers can withdraw funds from the hot wallet to external addresses if they obtain these keys or credentials. They can also exploit vulnerabilities in the hot wallet software or the exchange’s security system to access the hot wallet.

Hot wallets are usually used to store a small portion of the exchange’s total funds, while most are held in cold wallets, which are offline wallets used for storage.

However, some exchanges may store significant funds in hot wallets to facilitate liquidity and trading volume. This increases the risk of losing a substantial amount of funds in case of a hack.

(April 16, 2023) Hundred Finance was Exploited for More than $7 Million.

Hundred Finance was hacked by an attacker who exploited a vulnerability in the $hWBTC market on Optimism.

• The attacker manipulated the price of hWBTC by depositing and withdrawing $WBTC to inflate the value of hWBTC relative to other assets.

• The attacker then used the inflated $hWBTC as collateral to borrow funds from other markets on Hundred Finance, such as $ETH, $USDC, $DAI, etc.

• The attacker could borrow more than the value of their collateral because of price manipulation.

• The attacker then withdrew the borrowed funds from optimism to ethereum, leaving behind a large debt on Hundred Finance.

The total loss for the protocol was estimated at around $11M.

So why did this happen?

The hacker used a "re-entrancy" attack to exploit the protocols. A "re-entrancy attack" works by allowing the hacker to call the same function multiple times before the state of the contract is updated and thus borrow more funds than their collateral. (I have explained how this works step by step in the following tweet)

The hacker donated 200 WBTC to Hundred Finance, which gave them 200 hWBTC in return, then they deposited 500 WBTC, which increased the price of hWBTC by 250 times, then used hWBTC as collateral to borrow funds from other markets.

• The hacker donated 200 $WBTC to Hundred Finance by calling the deposit function on the $hWBTC market contract with 200 WBTC as the input parameter.

• The protocol gave them 200 $hWBTC in return for minting new $hWBTC tokens and sending them to the hacker’s address.

• The hacker deposited 500 $WBTC, which increased the price of hWBTC by 250 times by calling the "deposit" function again on the hWBTC market contract with 500 $WBTC as the input parameter.

• The price of hWBTC increased by 250 times because the protocol calculated the exchange rate of hWBTC based on the ratio of WBTC and hWBTC in the pool, meaning that after the hacker deposited 500 WBTC, there were more WBTC than hWBTC in the pool, so each hWBTC was worth more WBTC than before.

• The hacker used hWBTC as collateral to borrow funds from other markets by calling the borrow function on different market contracts with their hWBTC as the input parameter, meaning that they used their inflated hWBTC tokens to take other tokens from the protocol, such as $ETH, $USDC, and $DAI.

The reasons why this happened were threefold:

1. Re-entrancy vulnerability in the $hWBTC market on Optimism, meaning that the attacker could call the same function multiple times before the state of the contract was updated.

2. Lack of price oracles for $hWBTC, meaning that the protocol relied on the internal exchange rate of hWBTC, which the attacker could easily manipulate.

3. Low liquidity of $hWBTC, meaning that the attacker only needed a small amount of $WBTC to inflate the price of hWBTC by a significant factor.

These reasons combined allowed the attacker to create a massive discrepancy between the value of their collateral and their debt and drain the funds from other markets.

How re-entrancy attacks work step-by-step:

• The hacker finds a function in the contract that makes an external call to another contract and does not update the state before the call.

• The hacker calls this function with their own malicious contract as the recipient of the external call.

• The function checks if the hacker has enough collateral to borrow some funds from the contract and sends them the funds.

• The malicious contract receives the funds and triggers its fallback function, which is a default function that runs when no other function is specified.

• The fallback function calls the same function in the original contract again before the state is updated.

• The function checks if the hacker has enough collateral to borrow some more funds from the contract and sends them more funds.

• The malicious contract receives more funds and triggers its fallback function again, repeating the process until the original contract runs out of funds or gas.

• The hacker ends up borrowing more funds than their collateral because the original contract never updated its state to reflect the previous withdrawals.

Also, Mudit Gupta mentioned here that Agave's smart contract was very similar to Aave's smart contract, but Aave’s had more safeguards to prevent re-entrancy attacks.

https://twitter.com/Mudit__Gupta/status/1503783647903576065

Some people in my network mentioned that the best way to prevent re-entrancy attacks from happening would be to:

1. make sure the contract updates its records before giving any money to anyone.

2. use some code that prevents the same function from being called again until it is done.

3. use a safer method of sending money that stops the function if something goes wrong.

(April 3, 2023) A Solo Validator Exploited Five MEV Bots and Earned a $20M Block reward.

Samczun found out about this

https://twitter.com/samczsun/status/1642848556590723075?s=20

Simpler explanation of this:

Ethereum is a big playground where people can play games and trade toys. Some people have special machines that can make new toys and give them to others who play the games. These machines are called validators. Sometimes, people want to trade their toys with other people, but they have to pay some candy to the validators to make the trade happen. The more candy they pay, the faster the trade happens.

Some people are very smart and sneaky, and they try to trick other people who are trading their toys. They see what toys they want to trade and quickly offer a better deal to the person who has the toy they want. They also pay more candy to the validators to make their trade happen first. This way, they get the toy they want for a cheaper price, and then they can sell it for a higher price later. This is called front-running.

There is a group of people who want to stop this from happening. They are called Flashbots. They have a special network connecting them with the validators, and they let people send their trades directly to them without anyone else seeing them. They also let people pay extra candy to the validators if they want their trades to happen faster. This way, they can avoid being tricked by sneaky people.

However, Flashbots has a problem with its network. Sometimes, when people send their trades to the validators, they don’t send all the information about their trades. They only send a secret code that represents their trades. The validators must ask Flashbots for the rest of the information before making the trade happen. But sometimes, Flashbots can’t give them the information because of a mistake in their network. This makes the validators unhappy, and they can’t make the trade happen.

One person found out about this problem and decided to use it for their own benefit. They made a fake trade that looked like a real one, but it was actually a trick. They also made two other trades that would help them make more money from their fake trade. They put these three trades together and sent them to Flashbots with a secret code and a lot of candy for the validators. The validators saw the secret code and the candy and wanted to make the trade happen. But when they asked Flashbots for the rest of the information, Flashbots couldn’t give it to them because of their mistake.

The person then waited for a validator not using Flashbots’ network. They sent them all the information about their three trades and even more candy. The validator didn’t know that one of the trades was fake and a trick. They accepted all the information and made the trade happen. The person then made a lot of money from their trick and gave some of it to the validator as candy.

The person made about $20 million from this trick, which was paid as candy by Flashbots to the validator who made their trade happen. This was not a regular candy reward but a special candy reward from tricking other people who were trading their toys.

There’ll be many more, so be sure to subscribe so that you get these posts in your email directly.

Also, Let's not forget that early internet hacks were commonplace - from nerds hacking their school grades to stealing login info and creating viruses.

Impact on us?

It's no surprise that DeFi faces similar challenges, one we saw with YearnFinance & AAVE or Bitrue or Hundred Finance, but we're holding our own.

Thank you for reading through, and subscribe below for regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

15. Tokenomics 101: Case Study of dYdX

dYdX was founded by Antonio Juliano in July 2017 after he worked at Coinbase and built a search engine for decentralized apps called Weipoint. dYdX’s vision is to empower traders worldwide with open, secure, and robust financial products that run on Ethereum.

• dYdX’s first product was Expo, a brokerage app allowing users to buy leveraged tokens representing short or long-margin positions on ETH.

• dYdX’s second product was Solo, a margin trading protocol that enabled users to borrow, lend, and trade any supported asset with up to 4x leverage.

• dYdX’s third and current product is a decentralized exchange that offers perpetual contracts, margin trading, and spot trading for various crypto assets.

dYdX leverages L2 scaling solutions provided by StarkWare, a company specializing in zero-knowledge proofs and scalability engines. It uses StarkWare’s StarkEx technology to move most of its trade execution and settlement off-chain while maintaining data availability and security on-chain.

Recently, dYdX announced that it had completed its v4 milestone 3 by successfully integrating StarkWare’s Cairo programming language and StarkNet network into its platform.

More about dYdX’s v4 Milestone in the end

By using Cairo and StarkNet, dYdX will be able to offer fast and cheap trading on Ethereum with the following:

• zero gas costs,

• low minimum trade sizes,

• low trading fees,

• high throughput, and

• non-custodial security.

Let’s Dive Straight Into dYdX Tokenomics.

dYdX has its own governance token called DYDX, which can be used to participate in staking pools, governance proposals, trading rewards, and fee discounts on the platform.

DYDX tokens have a maximum supply of 1 billion, which will be fully unlocked by July 2026. Starting five years after launch, a maximum perpetual inflation rate of 2% per year may be utilized by governance to increase the supply of dYdX.

DYDX tokens are distributed to various groups according to the following initial allocation.

• Investors: 27.7% (~277 million tokens)

• Trading Rewards: 25% (~250 million tokens)

• Employees and Consultants: 15.3% (~153 million tokens)

• Airdrop: 7.5% (~75 million tokens)

• Liquidity Provider Rewards: 7.5% (~75 million tokens)

• Future Employees and Consultants: 7% (~70 million tokens)

• Treasury: 5% (~50 million tokens)

• Liquidity Staking Pool: 2.5% (~25 million tokens)

• Safety Staking Pool: 2.5% (~25 million tokens)

However, since the launch of DYDX, several governance proposals have resulted in changes to the initial allocation. The updated allocation is reflected in the following chart.

The updated allocation of DYDX tokens is as follows:

• Investors: 27.7% (277 million tokens)

• Trading Rewards: 20.2% (202 million tokens)

• Employees and Consultants: 15.3% (153 million tokens)

• Airdrop: 5% (50 million tokens)

• Liquidity Provider Rewards: 7.5% (75 million tokens)

• Future Employees and Consultants: 7% (70 million tokens)

• Treasury: 16.2% (162 million tokens)

• Liquidity Staking Pool: 0.6% (6 million tokens)

• Safety Staking Pool: 0.5% (5 million tokens)

Staking pools for DYDX tokens are divided into two types: Safety pool and Liquidity pool.

The safety pool acts as a backstop for the platform in case of insolvency or liquidation events, while the liquidity pool rewards users who provide liquidity to the platform’s markets.

The safety staking pool is a smart contract-based component that allows dydx token holders to stake their tokens and earn rewards for securing the protocol. The staked dydx tokens can be used as a mitigation tool in case of a shortfall event on the protocol, such as exchange insolvency, smart contract attacks, or other issues that result in a deficit.

The occurrence and interpretation of a shortfall event are subject to dydx governance votes. The staked dydx tokens can be slashed and transferred to another address or contract to cover the losses in a shortfall event. The safety staking pool functions as an additional layer to protect users in the case of insolvency or other issues with the protocol.

• 0.5% of the dydx token supply (5M DYDX) will be distributed to users who stake DYDX to the safety staking pool.

• DYDX rewards will be distributed continuously according to each staker’s portion of the total DYDX in the pool.

A staker must request to withdraw DYDX at least 14 days (Blackout Window) before the end of an epoch to be able to withdraw their DYDX after the end of that epoch.

• If stakers do not request to withdraw, their staked DYDX is rolled over into the next epoch.

• Withdrawals cannot be requested during the Blackout Window.

Risks: All funds in the contract, active or inactive, are slashable. Stakers may lose dydx in the event of a shortfall event. Stakers could lose a portion of their staked DYDX if a market maker were to lose DYDX via poor trading and cannot replenish the safety staking pool.

The liquidity pool is a smart contract-based component that allows USDC holders to stake their tokens and earn rewards for providing liquidity to the platform’s markets.

The liquidity staking pool is a smart contract-based component that allows USDC token holders to stake their tokens and earn dYdX rewards for providing liquidity to the dYdX Layer 2 protocol. The staked USDC tokens are used by community-approved liquidity providers who can make markets on the dYdX L2 perpetual protocol, offering competitive prices and tight spreads across various markets.

The liquidity providers are restricted from using borrowed funds outside the dYdX L2 protocol. The liquidity staking pool is a similar incentive that market makers use from centralized exchanges: interest-free, uncollateralized credit lines to be used solely on the dYdX L2 perpetual protocol.

The liquidity staking pool also benefits traders who can enjoy tighter spreads and more depth across all markets.

• 0.6% of the dYdX token supply (6M dYdX) will be distributed to users who stake USDC in the liquidity staking pool.

• dYdX rewards will be distributed continuously according to each staker’s portion of the total USDC in the pool.

A staker must request to withdraw USDC at least 14 days (Blackout Window) before the end of an epoch to be able to withdraw their USDC after the end of that epoch.

• If stakers do not request to withdraw, their staked USDC is rolled over into the next epoch, and

• Withdrawals cannot be requested during the Blackout Window.

Risks: Stakers may lose USDC if a borrower never repays a debt or loses USDC via poor trading and cannot replenish the liquidity staking pool.

Governance mechanism for DYDX tokens.

Snapshot, a gasless off-chain voting tool, facilitates the governance process.

DYDX tokens grant their holders the right to participate in the governance of the dYdX Layer 2 protocol. DYDX token holders can create and vote on proposals that can change various aspects of the protocol, such as risk parameters, staking pool payouts, trading fee discounts, community treasury allocations, and more.

DYDX token holders can also delegate voting power to other addresses or entities they trust or support.

The governance process consists of four stages:

• Proposal creation is an off-chain process that allows anyone with at least 1 DYDX token to create a draft proposal on Snapshot and gather feedback and support from the community.

• Proposal submission is an on-chain process that requires at least 1% of the total DYDX supply (10 million tokens) to submit a proposal to the dYdX Governance contract.

• The voting period is an off-chain process that lasts three days and allows DYDX token holders or delegates to cast their votes on Snapshot using their token balance at the time of proposal submission.

• The execution period is an on-chain process that lasts two days and allows anyone to execute a successful proposal that has received more than 50% of the votes cast and at least 4% of the total DYDX supply (40 million tokens).

Snapshot is a gasless off-chain voting tool that enables DYDX token holders or delegates to vote on proposals without spending any gas fees or locking their tokens. Snapshot uses signatures to verify votes and stores them on IPFS, a decentralized storage network.

Trading rewards for DYDX tokens

Trading rewards incentivize users to trade on the dYdX L2 protocol and earn DYDX tokens for their activity.

Trading rewards are distributed to users who trade on the perpetual markets, which are leveraged contracts that track the price of an underlying asset without expiry.

Trading rewards are based on a combination of fees paid and open interest on the protocol.

• Fees are determined by the 30-day volume-weighted maker-taker schedule, which ranges from 0.05% to 0.15% for takers and from 0% to -0.025% for makers.

• Open interest is measured every minute across all markets and averaged across a given epoch.

Trading rewards are calculated using a formula considering the user’s trading tier, market share, and reward rate. The formula is as follows:

• Trading Score = (Fees Paid + Open Interest) * Tier Multiplier

• Market Share = Trading Score / Total Trading Score

• Reward Rate = DYDX Distributed / Total Trading Score

• Trading Rewards = Market Share * Reward Rate

The trading tier is a factor that increases the user’s trading score based on their trading volume. There are four tiers: Bronze (1x), Silver (1.25x), Gold (1.5x), and Platinum (2x). The tier thresholds are as follows:

• Bronze: Less than $100k in trading volume

• Silver: Between $100k and $1M in trading volume

• Gold: Between $1M and $10M in trading volume

• Platinum: More than $10M in trading volume

The market share is the user’s proportion of the total trading score across all users in a given epoch. The reward rate is the amount of DYDX tokens distributed per unit of trading score in a given epoch.

The rewards are the amount of DYDX tokens the user earns in a given epoch based on their market share and reward rate. Trading rewards are distributed at the end of each epoch, lasting 28 days.

Trading rewards initially had 25% of the total DYDX token supply (250 million tokens) allocated for distribution over five years. However, this was reduced to 20.2% (202 million tokens) after a governance vote. Trading rewards are subject to change based on future governance proposals or market conditions.

The discounts, however, are based on a sliding scale that depends on the user’s token balance and staking duration.

Fee discounts reduce the trading fees for users who hold or stake DYDX tokens on the dYdX Layer 2 protocol. They are based on the user’s current balance of DYDX and stkDYDX (staked DYDX) tokens in their wallet. The higher the balance, the higher the discount.

Fee discounts are also based on the user’s staking duration of DYDX tokens in the liquidity pool.

The longer the staking duration, the higher the discount.

Discounts are applied to both maker and taker fees according to the following table:

Some Insights and Challenges for dYdX

dYdX has several competitive advantages that make it one of the leading crypto derivatives platforms in the market.

Some of these are:

• Scalability: dYdX leverages L2 scaling solutions provided by StarkWare to offer fast and cheap trading on Ethereum, with zero gas costs, low minimum trade sizes, low trading fees, high throughput, and non-custodial security.

• Liquidity: dYdX has abundant liquidity through collaboration with various market makers such as Amber Group and Sixtant, as well as liquidity provider rewards and staking pools that incentivize users to provide liquidity to the platform’s markets.

• Innovation: dYdX is constantly innovating and adding new features and products to its platform, such as perpetual contracts, cross-margin trading, limit orders, stop-loss orders, isolated margin trading, and more.

• Governance: dYdX has a decentralized governance mechanism that allows DYDX token holders to vote on proposals that affect the platform’s parameters, features, and policies.

dYdX faces several regulatory risks that could hamper its growth or operations.

Some of these are:

• Security token classification: dYdX may face regulatory scrutiny from the US Securities and Exchange Commission (SEC) or other regulators if its DYDX token is deemed a security token rather than a utility token. This could result in legal actions, fines, or restrictions for the platform and its users.

• KYC/AML compliance: dYdX may be required to implement know-your-customer (KYC) and anti-money laundering (AML) procedures to comply with local or international laws and regulations. This could compromise the privacy and anonymity of its users, as well as increase the operational costs and complexity of the platform.

• Jurisdictional limitations: dYdX may be prohibited or restricted from operating in certain jurisdictions that have unfavorable or unclear laws or regulations regarding crypto derivatives trading. This could limit the market size and user base for the platform.

dYdX has achieved impressive user adoption since its launch in 2017.

Some of its user adoption metrics are:

Trading volume: As of April 18, dYdX has processed over $19.2 billion in cumulative trading volume across its perpetual, margin, and spot markets in 2023 alone.

Number of users: dYdX has over 40,000 active users who trade on its platform regularly.

Token distribution: dYdX has distributed over 156 million DYDX tokens to its users through various programs such as airdrops, trading rewards, liquidity provider rewards, staking pools, and governance proposals.

dYdX has an ambitious future roadmap to make it the largest global cryptocurrency exchange.

Some of its future plans are:

• Launching its own blockchain: dYdX plans to launch its standalone blockchain called the dYdX Chain in Q2 2023. The dYdX Chain will be based on Cosmos SDK and Tendermint consensus protocol and use DYDX as its native token. The dYdX Chain will enable complete decentralization of the platform’s off-chain orderbook perpetual futures exchange.

• Expanding its product offerings: dYdX plans to expand its product offerings to include more markets, assets, order types, leverage options, risk management tools, and analytics features. Some of the products in development or planned are options contracts, futures contracts, portfolio margining, trailing stop orders, conditional orders, subaccounts, and more.

dYdX plans to grow its community and ecosystem by engaging more with its users, partners, developers, validators, and regulators.

Some of the initiatives that are underway or planned are:

• Launching a developer portal and SDK: dYdX intends to launch a developer portal and SDK that will allow developers to quickly build applications and integrations on top of the dYdX Chain and protocol.

• Supporting bridges and interoperability: dYdX plans to support bridges and interoperability with other blockchains and platforms, such as Ethereum, Polygon, Binance Smart Chain, Solana, and more. This will allow users to access dYdX from various wallets, networks, and devices.

• Educating and informing users: dYdX plans to educate and inform users about its platform, products, features, and benefits through various channels and resources, such as blogs, podcasts, videos, webinars, tutorials, guides, newsletters, social media, and more.

• Collaborating and partnering with stakeholders: dYdX plans to collaborate and partner with various stakeholders in the crypto space, such as market makers, liquidity providers, exchanges, aggregators, data providers, research firms, media outlets, influencers, regulators, and more. This will help dYdX increase its exposure, reputation, trust, and compliance.

Latest Updates on dYdX

#1

dYdX token’s large wallet investors have steadily accumulated the asset since March 2023. They have been buying more tokens and increasing their holdings over time. This can be seen from the data provided by Santiment, a crypto analytics platform, which shows that this segment of whales now holds over 5.6% of the total dYdX supply.

Whale accumulation coupled with a declining supply on exchanges is considered a bullish sign for the token. This creates a scarcity effect that can drive up the token's price.

The supply of dYdX tokens on exchanges has declined by over 10 million between February and April 2023, indicating lower selling pressure.

Experts predict a sustained uptrend in dYdX. Some of the factors that support this prediction are:

• The breakout of dYdX from its downtrend and consolidation phase signals a change in market sentiment and momentum.

• The reduction of trading rewards by 45% after a governance vote aims to improve the tokenomics and sustainability of the platform.

• The announcement of launching its standalone blockchain, called the dYdX Chain, in Q2 2023 will enable complete decentralization and innovation for the platform.

#2

dYdX has announced its exit from the Ethereum network and its plan to launch its standalone blockchain called the dYdX Chain in Q2 2023 using the Cosmos SDK. This framework allows developers to build custom blockchains that can interoperate with each other.

The dYdX Chain will be based on Cosmos SDK and Tendermint consensus protocol and will use DYDX as its native token for governance and for paying fees, staking, and voting.

The dYdX Chain aims to decentralize the platform’s off-chain orderbook perpetual futures exchange fully. The orders will be matched in real-time by the network of validators and then committed on-chain. This will enable faster and cheaper trading without compromising security or transparency.

But why did dYdX decide to leave Ethereum and choose Cosmos for their blockchain:

• Scalability: dYdX faced scalability issues on Ethereum due to its high gas fees, low throughput, and network congestion. These issues limited the platform’s growth and user experience. By moving to Cosmos, dYdX expects to increase its processing capacity by at least ten times and eliminate gas fees for trading.

• Customization: dYdX wanted more control and flexibility over its blockchain and protocol parameters. Using Cosmos SDK, dYdX can customize its blockchain to suit its specific needs and optimize its performance. For example, dYdX can choose its consensus algorithm, block time, transaction format, fee structure, etc.

• Interoperability: dYdX wanted to be able to connect and communicate with other blockchains and platforms in the crypto space. By joining Cosmos, dYdX can leverage the Inter-Blockchain Communication (IBC) protocol, enabling the cross-chain transfer of tokens and data. This will allow dYdX to access more liquidity, markets, assets, and users.

#3

dYdX has extended the lock-up period for DYDX tokens issued to investors, employees, and consultants until Dec 1, 2023. These tokens were initially scheduled to be unlocked on Feb 1, 2023, but they will remain locked for another 10 months.

The move signals the long-term support and commitment of the stakeholders to the dYdX protocol and its vision showing their confidence and loyalty to the dYdX project and its future goals. The move also indicates that the stakeholders are not interested in selling their tokens in the short-term and are willing to wait for the long-term growth and development of the platform.

The extension of the lock-up period affects 156 million DYDX tokens, representing about 15.6% of the total supply of 1 billion DYDX tokens. These tokens are held by various parties, such as:

• Past investors of dYdX Trading Inc., the company behind the dYdX protocol, received 27.7% of the total DYDX supply in exchange for their funding.

• Founders, employees, advisors, and consultants of dYdX Trading Inc. and dYdX Foundation, the non-profit organization that supports and governs the dYdX protocol, received 15.3% of the total DYDX supply as compensation for their work.

A mutual agreement decided the extension of the lock-up period between dYdX Trading Inc., dYdX Foundation, and certain parties who hold the Warrants to Purchase Tokens (Warrants). These contracts grant the right to buy DYDX tokens at a fixed price.

The agreement was signed on Jan 24, 2023, and announced on Jan 31, 2023.

The market and the community have well received the extension of the lock-up period, as it shows a strong alignment of interests and incentives between the stakeholders and the platform. The news also reduced the selling pressure and increased the scarcity of DYDX tokens in circulation.

dYdX v4 Milestones

dYdX’s v4 milestone is the final stage of its roadmap to launch its own decentralized blockchain for trading perpetual contracts on Layer 2. The v4 milestone consists of five sub-milestones, each with a set of features to be built and a network release to be launched1. The sub-milestones are:

After Thoughts

dYdX has achieved impressive user adoption, trading volume, innovative product offerings, and governance features. The platform faces several challenges, such as regulatory risks, jurisdictional limitations, and competition from other platforms.

However, the platform has several competitive advantages, such as liquidity, interoperability, and community engagement. For example, the platform has recently announced its plan to launch its standalone blockchain called the dYdX Chain in Q2 2023, enabling complete decentralization and performance optimization.

The platform has also extended the lock-up period for DYDX tokens issued to investors, employees, and consultants until Dec 1, 2023, which signals the long-term support and commitment of the stakeholders to the dYdX protocol and its vision.

Thank you for reading through, and subscribe below for regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

14. Micro to Macro: Web3's 3-Wave Model of Evolution of Complex Systems

The goal of this research is not to build a long-lasting framework but to understand and categorize decentralized infrastructure as a system that lets its users contribute and build on top of it.

I have tried to explain the parts of the 3-wave model with various examples, including MakerDAO, Uniswap, BitTorrent, AAVE, Polygon & Solana.

But it is all early stages, and I will iterate on this framework throughout the year upon having detailed conversations with builders, investors, and contributors.

If you want to stay updated with this framework and my future research posts, do consider subscribing below

The 3-wave model of evolution of complex systems is so interesting to me, and I've been looking for parallels between this model and Web3.

Especially if you are a founder, this should be interesting.

For context, the 3-wave model is based on the idea that complex systems undergo three phases of evolution:

• Self-organization: process of the spontaneous formation of patterns and structures from interacting agents.

• Entropy: measure of disorder and randomness in a system.

• Development: process of increasing the complexity and functionality of a system.

In Web3, I'd like to add another trait everyone should resonate with:

• Chaos: the state of unpredictability and sensitivity to initial conditions in a complex system that may lead to new forms of self-organization or the destruction of existing patterns.

Some questions I’ve asked myself to include Chaos into the 3-wave model, especially if I want to build this framework for evaluating decentralized infrastructure:

How to define the criteria for chaos in a complex system? What are some indicators or measures of chaos?

I would define chaos as the state where the system’s behavior is highly sensitive to small changes in initial conditions or parameters.

For example, a dApp that relies on a consensus mechanism or a voting system could exhibit chaotic behavior if a small fraction of nodes or voters change their preferences or strategies.

How to design and deploy smart contracts that account for chaos in a decentralized application? What are some benefits and risks of introducing chaos in a network?

I would design and deploy smart contracts that use random or probabilistic functions to introduce chaos in a decentralized application.

For example, a dApp that implements a lottery or a gambling game could use smart contracts that generate random numbers or outcomes to create chaos and uncertainty in the network.

How to monitor and analyze the effects of chaos on the system and its elements over time? What are some tools or methods for studying chaotic systems?

I would monitor and analyze the effects of chaos using different ways of looking at the system and its behavior. These ways can help me see when and how the system becomes chaotic and what patterns or shapes it makes from chaos.

For example,

• one way of looking at the system is to see how it changes when I change something, like the number of nodes or the speed of transactions.

• Another way of looking at the system is to see how fast or slow it reacts to small changes or differences, like a node going offline or a delayed transaction.

• A third way of looking at the system is to see how complicated or straightforward it seems when I zoom in or out, like a picture with many details or a shape that repeats itself.

If you were to build a decentralized app or an infrastructure, how would you go about it?

One possible way would be to use a smart contract to create dApps with programmable logic and rules. You then define the initial conditions and parameters of your dApp, such as the number of tokens, the distribution mechanism, the governance model, the functionality, etc. you also define some criteria or triggers for transitioning between the phases of evolution.

For example,

-- you can start your dApp in the self-organization phase, where users can join the network, interact with each other, and form clusters or communities based on their preferences or interests.

-- you then monitor the network activity and entropy level to determine when to move to the entropy phase. in this phase,

-- you introduce some randomness or uncertainty into the system, such as changing the token rewards, altering the network topology, or adding new features or challenges. This creates some disruption and diversity in the system, leading to new patterns and behaviors.

next,

-- you move to the development phase, where you increase the complexity and functionality of your dApp, such as adding more layers, modules, or services. You can also allow users to propose and vote on changes or improvements to the dApp, using a democratic or consensus-based mechanism.

Finally,

-- you move to the chaos phase, where you introduce some extreme randomness or uncertainty into the system, such as changing the network rules, altering the token supply, or adding new challenges or threats. This creates some disruption and diversity in the system, leading to new patterns and behaviors or the collapse of existing or unrewarding ones.

Then,

-- you return to the development phase, where you improve the functionality and complexity of the app.

The cycle repeats itself, growing more affluent and complex until you decide to stop. You give users the option to continue migrating the system or release the code or tokens to the mainnet.

In the above scenario, you are clearly following a deterministic approach. You can control every aspect of the system and integrate everything in line with predefined requirements.

To evaluate decentralized startups using the 3-wave model of evolution of complex systems, you would need to assess how well they perform in each phase of evolution and how they transition between them.

You should compare them with other startups in the same domain or market and the existing centralized solutions (which I have later in this research).

A hypothetical framework that will help with using the 3-wave model for evaluation of Web3 startups could be as follows:

Let’s try to implement the 3-wave model of complex systems, including chaos with decentralized applications. I have brainstormed two different outlines and I’ll be trying out both.

Here are some possible steps:

1. Choose a domain or a problem that can be modeled as a complex system with decentralized applications. For example, a social network, a marketplace, or a governance system.

2. Identify the elements, interactions, and environment of the system. For example, the elements could be users, products, or votes; the interactions could be messages, transactions, or proposals; and the environment could be the network, the market, or the community.

3. Define the criteria for self-organization, entropy, development, and chaos for the system and its elements. For example,

   • Self-organization could be measured by the degree of clustering or modularity in the network;

   • Entropy could be measured by the level of diversity or uncertainty in the system;

   • Development could be measured by the rate of growth or innovation in the system; and

   • Chaos could be measured by the sensitivity or unpredictability of the system’s behavior.

4. Design and deploy smart contracts that encode the rules and incentives for the system and its elements to achieve self-organization, entropy, development, and chaos. For example, smart contracts enable users to join and leave the network freely; create and exchange products or services; propose and vote on policies or changes; and generate or experience random events or outcomes.

5. Monitor and analyze the behavior and evolution of the system and its elements over time. For example,

   • use data visualization tools or techniques to observe the patterns and structures that emerge from self-organization, entropy, development, and chaos;

   • use statistical tools or techniques to test hypotheses or measure correlations between variables;

   • use computational tools or techniques to simulate scenarios or optimize parameters.

OR

1. Identify the domain or market of the Web3 startup and its centralized and decentralized competitors.

2. Define the criteria or metrics for evaluating the performance and potential of the Web3 startup in each phase of evolution. For example, you could use network size, activity, diversity, resilience, innovation, efficiency, scalability, security, usability, profitability, etc.

3. Collect data on the Web3 startup and its competitors using various sources, such as web analytics, blockchain explorers, user feedback, market reports, etc.

4. Analyze the data using appropriate methods, such as descriptive statistics, network analysis, trend analysis, benchmarking, etc.

5. Evaluate the web3 startup in each phase of evolution using the criteria or metrics defined in step 2.

   1. For example, you could assess how well the Web3 startup self-organizes its network of users and nodes, how it manages entropy and randomness in its system, and how it develops its complexity and functionality over time.

6. Evaluate the web3 startup's transitions between the phases of evolution using the criteria or metrics defined in step 2.

   1. For example, you could assess how smoothly and effectively the web3 startup moves from self-organization to entropy to development and back again.

7. Compare the Web3 startup with its competitors in each phase of evolution and their transitions using the criteria or metrics defined in step 2.

   1. For example, you could compare how well the Web3 startup performs relative to other Web3 startups or centralized solutions regarding network size, activity, diversity, resilience, innovation, efficiency, scalability, security, usability, profitability, etc.

8. Synthesize the results and draw conclusions about the strengths and weaknesses of the Web3 startup and its competitors in each phase of evolution and their transitions.

   1. For example, you could identify what makes the web3 startup stand out or lag behind in terms of self-organization, entropy, or development; what are the opportunities or challenges for improving its performance or potential; what are the best practices or lessons learned from other web3 startups or centralized solutions; etc.

9. Communicate the results and conclusions using appropriate formats and channels, such as reports, presentations, dashboards, blogs, podcasts, etc.

Let’s Evaluate a few DAOs, DeFi protocols, and a few Networks

BitTorrent

BitTorrent is a peer-to-peer file-sharing network that allows users to download and upload files without relying on a central server.

Here is how BitTorrent could be modeled using the 3-wave model of complex systems, including chaos:

The system of interest is the BitTorrent network, and its elements are the users (peers) and the files (torrents). The interactions are the requests and responses for file pieces between peers. The environment is the internet and the bandwidth availability.

The criteria for

• self-organization is the degree of connectivity and cooperation among peers.

• entropy is the level of diversity and availability of torrents.

• development is the rate of growth and innovation of the network.

• chaos is the sensitivity and unpredictability of the network’s performance.

The smart contracts that encode the rules and incentives for the system and its elements are based on the BitTorrent protocol, which defines how peers discover, request, and exchange file pieces.

• The protocol uses a distributed hash table (DHT) to enable peers to discover each other and locate file pieces. The protocol also uses a tracker to coordinate the communication between peers and manage the swarm of peers sharing a file.

The protocol also implements a tit-for-tat strategy that rewards peers who upload more than they download and punishes peers who leech or cheat.

• The protocol uses a choking algorithm to determine which peers to upload file pieces to. The algorithm prioritizes peers who have uploaded more file pieces to the user in the past, and chokes or blocks peers who have uploaded less or nothing. This creates an incentive for peers to upload as much as they download, and discourages peers who leech or cheat by downloading without uploading.

The BitTorrent protocol introduce some randomness in choosing peers to connect with, but not for the sake of creating chaos or diversity. Rather, the randomness is intended to prevent starvation or unfairness in the network.

• The protocol uses a rarest-first algorithm to select which file pieces to request from peers, which ensures that all file pieces are equally distributed among the swarm. The protocol also uses an optimistic unchoking algorithm to occasionally unchoke a random peer, which allows new or slow peers to join the swarm and receive file pieces.

The behavior and evolution of the system and its elements can be monitored and analyzed using various tools and techniques, such as data visualization, network analysis, game theory, or agent-based modeling. These tools and techniques can help observe the patterns and structures that emerge from self-organization, entropy, development, and chaos; test hypotheses or measure correlations between variables; simulate scenarios or optimize parameters.

MakerDAO

MakerDAO is a decentralized autonomous organization that allows users to create and manage a stablecoin called DAI, which is pegged to the US dollar.

Here is how MakerDAO could be modeled using the 3-wave model of complex system including chaos:

The system of interest is the MakerDAO network, and its elements are the users (holders, borrowers, and governors) and the tokens (DAI and MKR). The interactions are the creation and redemption of DAI, the borrowing and repayment of DAI, and the voting and governance of MakerDAO. The environment is the cryptocurrency market and the global economy.

The criteria for

• self-organization is the degree of alignment and participation among users.

• entropy is the level of volatility and risk in the system.

• development is the rate of growth and innovation of the network. The criteria for

• chaos is the sensitivity and unpredictability of the system’s stability.

The smart contracts that encode the rules and incentives for the system and its elements are based on the Maker protocol, which defines how DAI is created, backed, and managed by collateral assets.

• The protocol uses smart contracts to lock up collateral assets, such as ETH, WBTC, USDC, etc., in exchange for DAI. The protocol also uses smart contracts to manage the solvency and stability of the system, such as liquidating undercollateralized positions, adjusting risk parameters, distributing fees, etc.

The protocol also implements a governance mechanism that allows MKR holders to vote on various parameters and policies that affect the system, such as interest rates, collateral types, oracles, etc.

• Maker protocol uses a governance mechanism to enable MKR holders to propose and vote on changes to the protocol or its parameters. These changes can include adding or removing collateral types, setting interest rates or stability fees, choosing oracle providers or price feeds, approving core units or budget distributions, etc. The governance mechanism uses a quadratic voting system that weights votes based on the square root of MKR staked.

The protocol also introduces some randomness in choosing oracles to provide price feeds to create some chaos and diversity in the network.

• The protocol does introduce some randomness in choosing oracles to provide price feeds, but not for the sake of creating chaos or diversity. Rather, the randomness is intended to prevent manipulation or collusion among Oracle providers.

• The protocol uses a decentralized oracle network called Maker Oracles, which consists of a set of nodes that report market prices of various assets to the protocol.

• The protocol randomly selects a subset of these nodes to form a quorum for each asset and calculates the median price from their reports. This ensures that the price feeds are accurate and reliable.

Let’s implement the 3-wave model.

Self-organization: We can evaluate the degree of connectivity and cooperation among the MakerDAO network participants by looking at the

• number and diversity of users, borrowers, and governors;

• frequency and quality of interactions and transactions among them; and

• level of consensus and satisfaction among them.

We can also evaluate the emergence of patterns and structures that enhance the functionality and value of the network by looking at the stability and scalability of the DAI stablecoin, the variety and quality of the collateral assets, and the alignment of incentives and goals among the network participants.

Entropy: We can evaluate the level of diversity and uncertainty in the MakerDAO network by looking at the

• volatility and risk of the cryptocurrency market;

• exposure to external shocks and internal fluctuations such as hacks, attacks, or black swan events; and

• balance between exploration and exploitation of opportunities such as new collateral types, interest rates, oracles, etc.

We can also evaluate the trade-off between efficiency and robustness by looking at the cost and speed of transactions, the security and reliability of the smart contracts, and the resilience and adaptability of the network to disruptions or changes.

Development: We evaluate the rate of growth and innovation in the MakerDAO network by looking at the

• adoption and usage of DAI stablecoin;

• creation and improvement of new products or services such as lending platforms, decentralized exchanges, or DeFi protocols; and

• competitiveness and utility of the network in the cryptocurrency ecosystem.

We can also evaluate the adaptation to changing environments and user needs by looking at the feedback and learning mechanisms that improve the network’s performance, such as governance votes, risk assessments, audits, etc.

Chaos: We can evaluate the sensitivity and unpredictability of the MakerDAO network’s behavior by looking at

• how small changes or differences in initial conditions or parameters affect the system’s outcomes or behaviors, such as DAI price, collateral ratio, liquidation events, etc.

• the generation of novel and unexpected outcomes or behaviors by examining how randomness or probabilistic functions introduce chaos and uncertainty in the network, such as oracle price feeds, governance votes, etc.

• the instability or collapse of existing patterns or structures by looking at how crises or challenges threaten or disrupt the network’s stability, such as collateral shortfall events, governance attacks, protocol upgrades, etc.

We can also evaluate the emergence of new forms of self-organization or entropy by looking at how chaos creates novel and unexpected patterns or structures that enhance or reduce the functionality and value of the network, such as flash loans, arbitrage opportunities, forks, etc.

Now let’s try to evaluate the transition between phases as well.

Self-organization to entropy: We can evaluate how MakerDAO responds to triggers or signals that indicate a change from self-organization to entropy by looking at

• how the network reacts to increasing diversity and uncertainty in the cryptocurrency market,

• how the network balances between efficiency and robustness; and

• how the network prepares for or anticipates potential shocks or fluctuations.

• how the network leverages its existing patterns and structures to cope with entropy, explores new opportunities or challenges, and maintains its functionality and value.

Entropy to development: We can evaluate how MakerDAO responds to triggers or signals that indicate a change from entropy to development by looking at

• how the network reacts to increasing growth and innovation in the cryptocurrency ecosystem, how the network adapts to changing environments and user needs;

• how the network learns from feedback and improves its performance.

• how the network leverages its existing diversity and uncertainty to foster development, exploits new opportunities or challenges, and increases its functionality and value.

Development to self-organization: We can evaluate how MakerDAO responds to triggers or signals that indicate a change from development to self-organization by looking at

• how the network reacts to increasing connectivity and cooperation among the network participants,

• how the network aligns incentives and goals among them, and how the network achieves consensus and satisfaction among them.

• how the network leverages its existing growth and innovation to enhance self-organization, creates new patterns and structures, and maintains its functionality and value.

Evaluating the transition phases between waves will be much clearer if we compare MakerDAO with another DAO.

One possible example of another DAO that we can compare with MakerDAO using this model is Uniswap. Uniswap is a decentralized autonomous organization that allows users to exchange tokens without intermediaries or fees.

Here is how we can compare Uniswap with MakerDAO using this model:

Self-organization:

MakerDAO and Uniswap have a high degree of connectivity and cooperation among the network participants, allowing anyone to join and interact with the network freely and transparently. This is true, as both projects are open and permissionless protocols that enable anyone to access their services or contribute to their development.

• For example, anyone can generate or borrow DAI on MakerDAO, or provide or swap tokens on Uniswap, without any intermediaries or gatekeepers. Anyone can also participate in their governance or community activities, such as proposing or voting on changes, providing feedback or suggestions, joining core units or working groups, etc.

Both networks also have patterns and structures that enhance their functionality and value, such as the DAI stablecoin, the collateral assets for MakerDAO and the liquidity pools, and the automated market makers for Uniswap. This is also true, as both projects have designed and implemented various mechanisms or components that improve their performance or utility. For example,

• MakerDAO has created the DAI stablecoin, a decentralized and censorship-resistant currency that maintains a soft peg to the US dollar. MakerDAO also supports various collateral assets that can be used to generate DAI, such as ETH, WBTC, USDC, etc., as well as real-world assets such as solar bonds or music royalties.

• Similarly, Uniswap has created liquidity pools, which are pools of tokens that facilitate trading on the protocol. Uniswap also uses automated market makers (AMMs), which are algorithms that determine the price of each token in a pool based on the ratio of their reserves.

However, MakerDAO does have a more formal governance structure than Uniswap, as it has a well-defined process for creating and advancing governance proposals through various stages.

• MKR token holders can vote on key decisions that affect the network, such as changes to risk parameters, collateral types, core units, budget distributions, etc., using a quadratic voting system that weights votes based on the square root of MKR staked.

• However, this voting process is not carried out through the MakerDAO Governance Portal anymore, as it has been replaced by a new interface called GovAlpha Portal in September 2022. The GovAlpha Portal is a more user-friendly and accessible platform that allows MKR holders to view and vote on proposals using different wallets or devices.

In contrast, Uniswap does have a more informal governance structure than MakerDAO, as it does not have a clear or consistent process for developing or advancing governance proposals. However, there is a formal voting process for some proposals that involve changes to the protocol or its parameters.

• These proposals are submitted and voted on using the UNI token through the Uniswap Governance Portal. The Uniswap community can also signal support or opposition to proposals through other platforms such as Snapshot, which is an off-chain voting interface that does not require gas fees.

• In December 2022, the Uniswap Foundation proposed some changes to the governance and voting processes of Uniswap, such as reducing the quorum requirement, simplifying the proposal stages, and introducing temperature checks and consensus checks. These changes are intended to reduce friction in governance and increase participation and engagement from the community.

Entropy:

Both MakerDAO and Uniswap are known to have a high level of diversity and uncertainty in the network, as they are exposed to the volatility and risk of the market, as well as hacks, attacks, or black swan events as both projects rely on smart contracts that can be vulnerable to bugs, exploits, or malicious actors. They also depend on the price movements of their underlying assets, which can be affected by market sentiment, whale movements, or other factors. For example,

• In September 2022, MakerDAO suffered a flash loan attack that drained $12 million worth of DAI from its protocol.

• Similarly, in October 2022, Uniswap faced a front-running attack that manipulated its oracle price feeds and caused $5 million worth of losses for its users**.**

Both networks also balance between exploration and exploitation of opportunities, such as new collateral types, interest rates, oracles, etc., for MakerDAO, and new tokens, liquidity pools, fees, etc., for Uniswap. This is also true, as both projects constantly seek to improve their services or features by experimenting with new options or optimizing existing ones. For example,

• MakerDAO regularly adds new collateral types to its protocol, such as real-world assets (RWA), synthetic tokens (sTokens), or wrapped tokens (wTokens), to diversify its risk profile and increase its DAI supply. MakerDAO also adjusts its interest rates or stability fees to maintain the DAI peg and incentivize borrowing or saving.

• Similarly, Uniswap supports new tokens or liquidity pools on its protocol, such as stablecoins (USDC/DAI), governance tokens (UNI/MKR), or L2 tokens (OPT/ARB), to increase its trading volume and liquidity. Uniswap also changes its fees or fee tiers to balance between profitability and competitiveness.

Development:

MakerDAO and Uniswap have a high rate of growth and innovation in the network, as they have high adoption and usage of their products or services, such as DAI stablecoin and lending platforms for MakerDAO, and token exchange and decentralized exchanges for Uniswap.

• This is true, as both projects have seen significant growth in terms of total value locked (TVL), trading volume, users, and governance participation in 2021. For example, MakerDAO’s TVL reached over $10 billion in 2021, while Uniswap’s trading volume surpassed $100 billion in August 2021, Both projects have also launched new products or services this year, such as MakerDAO’s Real-World Assets (RWA) program that allows non-crypto assets to be used as collateral, and Uniswap’s version 3 protocol that introduces concentrated liquidity and multiple fee tiers.

Both networks also adapt to changing environments and user needs, as they learn from feedback and improve their performance, such as governance votes, risk assessments, audits, etc. for MakerDAO, and community proposals, discussions, upgrades, etc. for Uniswap. This is also true, as both projects have active and engaged communities that participate in shaping the future direction and development of the protocols. For example,

• In 2022, MakerDAO conducted about 150 governance polls and 50 executive votes. Some of the topics covered by these polls and votes include onboarding new collateral types, adjusting risk parameters, approving core units, distributing budgets, updating oracle fees, deploying new modules, etc.

• In 2022, Uniswap implemented about 10 governance proposals. Some of the topics covered by these proposals include creating a DeFi Education Fund, deploying Uniswap v3 on Optimism, forming a Uniswap Grants Program, simplifying the community governance process, implementing a fee switch pilot program, etc.

However, MakerDAO has a more competitive and utility advantage than Uniswap, as it offers a unique product that is not easily replicated by other networks. At the same time, Uniswap faces more competition from other similar networks. This statement might have split support, including mine. This is partly true, but it depends on how you define competitive and utility advantage.

• MakerDAO does offer a unique product that is not easily replicated by other networks, as it is the first and largest decentralized stablecoin issuer on Ethereum. However, MakerDAO also faces competition from other stablecoin issuers or lenders that offer lower fees or higher yields than DAI or Maker Vaults.

• Uniswap faces more competition from similar networks, such as SushiSwap, Curve, Balancer, etc., that offer different features or incentives for liquidity providers or traders. However, Uniswap also has a utility advantage over other networks, as it is the most liquid and widely integrated decentralized exchange on Ethereum.

Chaos

Both MakerDAO and Uniswap have a high sensitivity and unpredictability of the network’s behavior, as they are affected by small changes or differences in initial conditions or parameters such as DAI price, collateral ratio, liquidation events, etc. for MakerDAO, and token price, liquidity ratio, slippage events, etc. for Uniswap. This is true, as both projects operate on complex and dynamic systems that can exhibit nonlinear and emergent behaviors that are hard to predict or control. For example,

• MakerDAO experienced a collateral shortfall event in March 2020, when a sudden drop in ETH price triggered a massive liquidation of undercollateralized vaults.

• Similarly, Uniswap experienced a slippage event in November 2020, when a large trade of DAI/USDC caused a temporary price deviation of DAI from its peg.

Both networks generate novel and unexpected outcomes or behaviors by introducing randomness or probabilistic functions such as oracle price feeds, governance votes, etc., for MakerDAO, and liquidity pool selection, fee distribution, etc., for Uniswap. This is also true, as both projects rely on stochastic processes that can introduce uncertainty or variability into their outcomes or behaviors. For example,

• MakerDAO uses oracle price feeds to determine the market prices of its collateral assets and DAI. However, these price feeds can be subject to delays, errors, or manipulation that can affect the accuracy or timeliness of the data.

• Similarly, Uniswap uses liquidity pool selection to determine the best route for a trade across multiple pools. However, this selection can be influenced by factors such as pool size, fee tier, gas cost, etc., that can change over time or across transactions.

However, MakerDAO has a higher risk of instability or collapse of existing patterns or structures than Uniswap, as it faces more severe crises or challenges that threaten or disrupt its stability, such as collateral shortfall events, governance attacks, protocol upgrades, etc. In contrast, Uniswap has more resilience and adaptability to such disruptions or changes. This statement might have split support, including mine. This is partly true, but it depends on how you measure instability or resilience.

• MakerDAO does face more severe crises or challenges that threaten or disrupt its stability, as it has to maintain the solvency and stability of its system under various market conditions and external shocks. For example, MakerDAO had to deal with collateral shortfall events in March 2020 and May 2021, governance attacks in October 2020 and January 2021, protocol upgrades in April 2020 and November 2021, etc.

  • However, MakerDAO also has some resilience and adaptability to such disruptions or changes, as it has implemented various mechanisms or solutions to mitigate or prevent them. For example, MakerDAO has introduced the Peg Stability Module (PSM) to improve DAI’s peg stability, the Liquidations 2.0 system to improve the efficiency and fairness of liquidations, the Real-World Assets (RWA) program to diversify its collateral portfolio, etc.

• Similarly, Uniswap has more resilience and adaptability to such disruptions or changes, as it has a simpler and more flexible design that allows it to operate with minimal intervention or maintenance. For example, Uniswap has launched its version 3 protocol that allows users to customize their liquidity provision with concentrated liquidity and multiple fee tiers, deployed its protocol on multiple L2 solutions such as Optimism and Arbitrum , integrated its protocol with various cross-chain bridges such as Hop Protocol and Gelato Network , etc.

  • However, Uniswap also has some risk of instability or collapse of existing patterns or structures, as it faces competition from other similar projects that offer different features or incentives for liquidity providers or traders. For example, Uniswap has lost some market share to other decentralized exchanges such as SushiSwap, Curve, Balancer, etc., that offer different AMM models or reward schemes.

AAVE

One possible example of a DeFi protocol to which we can apply this model is AAVE. AAVE is a lending protocol allowing users to borrow various tokens without intermediaries or fees.

Here is how we can apply this model to AAVE:

Self-organization: We can evaluate the degree of connectivity and cooperation among the AAVE network participants by looking at the

• number and diversity of users, borrowers, and lenders;

• the frequency and quality of interactions and transactions among them;

• the level of consensus and satisfaction among them.

• the emergence of patterns and structures that enhance the functionality and value of the network by looking at the stability and scalability of the lending platform,

• the variety and quality of the tokens available for borrowing and lending, and the alignment of incentives and goals among the network participants.

Entropy: We can evaluate the level of diversity and uncertainty in the AAVE network by looking at the

• volatility and risk of the cryptocurrency market;

• exposure to external shocks and internal fluctuations such as hacks, attacks, or liquidation events; and

• balance between exploration and exploitation of opportunities such as new tokens, interest rates, flash loans, etc.

We can also evaluate the trade-off between efficiency and robustness by looking at the cost and speed of transactions, the security and reliability of the smart contracts, and the resilience and adaptability of the network to disruptions or changes.

Development: We can evaluate the rate of growth and innovation in the AAVE network by looking at the

• adoption and usage of the lending platform; the creation and improvement of new products or services such as staking, governance, or insurance;

• competitiveness and utility of the network in the cryptocurrency ecosystem.

Chaos: We can evaluate the sensitivity and unpredictability of the AAVE network’s behavior by looking at

• how small changes or differences in initial conditions or parameters affect the system’s outcomes or behaviors, such as token price, liquidity ratio, interest rate, etc.

• the generation of novel and unexpected outcomes or behaviors by introducing randomness or probabilistic functions such as flash loans, liquidation bonuses, etc.

• instability or collapse of existing patterns or structures by looking at how crises or challenges threaten or disrupt the network’s stability, such as liquidity shortages, governance attacks, protocol upgrades, etc.

• how chaos creates novel and unexpected patterns or structures that enhance or reduce the functionality and value of the network, such as arbitrage opportunities, yield farming strategies, forks, etc.

Evaluating the transition between phases would include the same criteria as MakerDAO.

Polygon

Polygon is a Web3 startup that provides a platform for scaling and developing Ethereum-compatible blockchain networks. Polygon was founded in 2017 and is based in India.

Let’s see how we can apply the framework to evaluate Polygon using the 3-wave model of the evolution of complex systems.

1. Identify the domain or market of Polygon and its centralized and decentralized competitors.

   1. Polygon operates in ethereum scalability and interoperability, a crucial challenge for Ethereum-based applications that require fast, cheap, and secure transactions.

   2. Polygon’s main competitors include other L2 solutions for Ethereum, such as Optimism, Arbitrum, zkSync, and StarkWare, as well as other blockchain platforms that offer scalability and interoperability, Cosmos, Polkadot, Avalanche, and Solana.

2. Define the criteria or metrics for evaluating the performance and potential of Polygon in each phase of evolution.

   1. For example, we could use network size, activity, diversity, resilience, innovation, efficiency, scalability, security, usability, profitability, etc.

3. Collect data on Polygon and its competitors using various sources, such as web analytics, blockchain explorers, user feedback, market reports, etc.

   1. For example, we could use websites like DappRadar, DeFi Pulse, CoinGecko, Etherscan, etc., to get data on the number of users, transactions, fees, value locked, market capitalization, etc. of Polygon and its competitors.

4. Analyze the data using appropriate methods, such as descriptive statistics, network analysis, trend analysis, benchmarking, etc.

   1. For example, we could use charts, tables, graphs, etc., to visualize and compare the data on Polygon and its competitors regarding network size, activity, diversity, resilience, innovation, efficiency, scalability, security, usability, profitability, etc.

5. Evaluate Polygon in each phase of evolution using the criteria or metrics defined in Step 2. For example:

   1. Self-organization: We could evaluate how well Polygon self-organizes its

      1. network of users and nodes by looking at the number of users (both individual and institutional),

      2. transactions (both simple and complex),

      3. fees (both fixed and variable), value locked (both native and bridged),

      4. market capitalization (both absolute and relative), etc.

      5. distribution of users and nodes across different regions (both geographic and demographic),

      6. applications (both general and specific),

   2. Entropy: We could evaluate how Polygon manages entropy and randomness in its system by looking at the

      1. level of disorder and diversity in its network.

      2. variance of users (both active and inactive),

      3. transactions (both successful and failed),

      4. fees (both high and low),

      5. value locked (both stable and volatile),

      6. market capitalization (both rising and falling), etc.

      7. diversity of users and nodes across different regions (both geographic and demographic),

   3. Development: We could evaluate how Polygon develops its complexity and functionality over time by looking at the

      1. number of features and services it offers its users and nodes.

      2. number of applications (both existing and new),

      3. integrations (both internal and external),

      4. upgrades (both planned and unplanned),

      5. innovations (both incremental and radical), etc.

6. Evaluate Polygon in terms of its transitions between the phases of evolution using the criteria or metrics defined in step 2. For example:

   1. Self-organization to entropy: We could evaluate how smoothly and effectively Polygon moves from self-organization to entropy by looking at

      1. how it balances order and disorder in its network.

      2. how it maintains stability and security while allowing for diversity and innovation; incentivizes participation while preventing exploitation; adapts to changing conditions while preserving its identity; etc.

   2. Entropy to development: We could evaluate how smoothly and effectively Polygon moves from entropy to development by looking at

      1. how it leverages disorder and diversity for complexity and functionality.

      2. how it uses randomness and uncertainty for creativity and discovery, diversity and competition for collaboration and cooperation, disruption and challenge for improvement and growth, etc.

   3. Development to self-organization: We could evaluate how smoothly and effectively Polygon moves from development to self-organization by looking at

      1. how it simplifies complexity and functionality for order and structure.

      2. how it reduces redundancy and inefficiency for optimization and performance, standardizes features and services for compatibility and interoperability, consolidates applications and protocols for scalability and usability, etc.

7. Synthesize the results and draw conclusions about the strengths and weaknesses of Polygon and its competitors in each phase of evolution and in terms of their transitions.

Furthermore, the 3-wave model of complex systems framework can be modeled across multiple scales.

This scale model consists of three waves:

• (start) microscopic level, where individual users interact with each other according to simple rules;

• (progress) mesoscopic level, where emergent patterns and structures arise from the collective behavior of the users; and

• (growth) macroscopic level, where the collective contribution is observed and measured.

Some of the key challenges and considerations while considering implementing the scale model of 3-wave model of complex systems for building dApps are:

1. How to design and implement simple and robust rules for users at the microscopic level that can generate complex and adaptive behavior at higher levels.

2. How to ensure the security, scalability, and performance of the dApps on a decentralized network that may be prone to attacks, congestion, or failures.

3. How to balance the trade-offs between decentralization and efficiency, such as gas fees, consensus mechanisms, and governance models.

4. How to measure and evaluate the macroscopic outcomes and impacts of the dApps on the users, society, and environment.

5. How to communicate and educate the users and stakeholders about the benefits and risks of using dApps and complex systems.

One possible example of how to apply this model to the Solana blockchain is as follows:

Microscopic level:

We can evaluate the individual users and their interactions with each other according to simple rules by looking at the

• characteristics and preferences of the users,

• types and frequencies of the interactions, and

• outcomes and feedback of the interactions.

We can also look at

• how the rules are defined and enforced by the protocol,

• how the users comply or deviate from the rules, and

• how the rules affect the users’ behavior and satisfaction.

For example, we can look at

• how Solana users choose which validators to delegate their tokens to;

• how Solana validators communicate and cooperate to produce blocks; and

• how Solana rewards or penalizes users and validators for their actions.

Mesoscopic level:

We can evaluate the emergent patterns and structures that arise from the

• collective behavior of the users by looking at the degree of connectivity and cooperation among the users;

• emergence of clusters, modules, or communities; and

• functionality and value of the patterns and structures.

We can also look at

• how the network topology, dynamics, and environment influence the patterns and structures;

• how the patterns and structures influence the network performance and potential; and

• how the patterns and structures evolve over time.

For example, we can look at

• how Solana users form groups or alliances based on their interests or goals;

• how Solana validators form clusters or subnets based on their location or capacity; and

• how Solana creates a scalable, fast, and secure network using its innovative features such as proof of history, tower consensus, etc.

Macroscopic level:

We can evaluate the collective contribution that is observed and measured by looking at the

• adoption and usage of the protocol,

• creation and improvement of new products or services, and

• competitiveness and utility of the protocol in the ecosystem.

We can also look at

• how the collective contribution is influenced by external factors such as market conditions, user needs, or regulatory frameworks;

• how the collective contribution influences external factors such as social impact, economic value, or environmental sustainability; and

• how the collective contribution evolves over time.

For example, we can look at

• how Solana attracts and retains users, developers, and investors with its high performance and low cost;

• how Solana supports and enables new products or services such as decentralized applications, smart contracts, oracles, etc.; and

• how Solana competes and cooperates with other blockchain platforms such as Ethereum, Binance Smart Chain, Polkadot, etc.

After Thoughts

The model can be applied to various domains and contexts, such as DeFi, DAOs, NFTs, etc., to understand their dynamics and potential.

On further implementation of this model, I’d be able to suggest some implications and challenges for the future of whatever domain I explore. But I will do that in the coming weeks, not now.

I truly believe that by using this model, we can better appreciate the complexity and diversity of Web3 and the decentralized infrastructure built on it and understand the overall impact on the collective.

Please share your thoughts here:

https://twitter.com/0xArhat/status/1645138362326474754

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I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

13. Identities without Borders: Decoding our online identity

This industry thesis on Decentralized Identities is an extension of that topic, focusing on how using a decentralized identity provides more transparency, accountability, and empowerment for online content and identity for individuals and institutions alike.

Decentralized identity is an open-standards-based identity framework that uses digital identifiers and verifiable credentials that are self-owned and independent and enable trusted data exchange.

ELI5

Imagine you have a special box that only you can open with a secret key. Inside the box, you have some cards that tell other people who you are and what you can do. For example, you have a card that says your name, a card that says your birthday, a card that says you can go to school, and so on. These cards are called credentials.

Now, sometimes you need to show these cards to other people to prove who you are and what you can do. For example, when you go to school, you need to show your teacher your name card and your school card. When you go to the library, you need to show your librarian your name card and your library card. And so on.

But what if someone else tries to take your cards or make fake cards? That would be bad, right? You don’t want anyone else to pretend to be you or do things that you can do. That’s why you need a way to protect your cards and make sure they are real.

That’s where decentralized identity comes in. Decentralized identity means that instead of keeping your cards in one place or trusting someone else to keep them for you, you can keep them in different places that are connected by a special network. This network is called a blockchain. A blockchain is like a big book that everyone can read, but no one can change. It records everything that happens on the network, like who has which cards and when they use them.

When you use a decentralized identity, you can store your cards in different places on the blockchain network. You can also use your secret key to sign your cards with a special code that proves they are yours. This way, no one can take your cards or make fake ones. And when you need to show your cards to someone else, you don’t have to give them the actual cards. You can just send them a copy of the cards and the code that proves they are yours. This way, you can keep your cards safe and private.

A decentralized identity gives you more control over your own identity and data. It also makes it easier and faster for you to prove who you are and what you can do to other people on the internet. It’s like having a magic box of cards that only you can open and use.

Creating a decentralized identity is a complicated process that I will not discuss in detail for this industry thesis.

This thesis will compare and differentiate between three types of identities we possess:

1. Centralized Identities: A vendor, employer, or educational institution stores the identity-related information of its users, including personal data and credentials.

2. Federated Identities: A consortium, alliance, or network agrees to share the identity-related information of their users across their domains or platforms.

3. Decentralized Identities: Users have complete control over their credentials and personal data stored within a digital wallet. The credentials and personal data are verified by a third party using a blockchain-based ledger that does not store the user’s data.

Unlike centralized and federated (integrated) identity systems, which rely on third-party intermediaries to verify and manage identities, the decentralized identity uses blockchain and other distributed ledger technologies to enable peer-to-peer trust and verification.

Centralized vs. Federated vs. Decentralized

With a Centralized Identity, a vendor, employer, or educational institution stores and manages any identity-related information of its users, including personal data and credentials. We are forced to rely on them to protect our data and provide access to the necessary resources and services. As we interact with several institutions, we may have multiple identities and passwords across different entities, which can be inconvenient and insecure.

For example,

• India’s Aadhar card is the world’s largest biometric digital identity scheme and is centralized, proprietary, and technically problematic.

• In the United States, Social Security Number (SSN) is used for taxation, social security, and other purposes.

• In China, the Resident Identity Card (RIC) is used for identification, travel, banking, and other purposes.

• The My Number system is used in Japan for tax and social security purposes.

• In Germany, the eID system secures online authentication and electronic signatures using a chip-enabled identity card.

With Federated Identity, a social media platform, bank, or identity provider acts as a middleman that authenticates our identity and gives us access tokens to access resources and services from other platforms. We can use a single identity and password across multiple entities, which can be convenient and secure. However, we must still trust the middlemen to protect our data and respect our privacy. We may also end up having limited control over what data is shared with whom.

For example,

• In India, the DigiLocker system is a platform that allows users to store and access their digital documents, such as educational certificates, driving licenses, and voter IDs, using their Aadhaar number. DigiLocker is linked to various issuers and requesters of documents, such as government departments, educational institutions, and banks.

• In China, the Alipay Trust Framework (ATF) allows users to verify their identity and credentials with various online services using their Alipay account, which is linked to their RIC.

• In Japan, the Japan e-Government Federation Framework (JEF) allows users to access various e-government services using their My Number card or other identity credentials issued by public agencies.

• In Germany, the Verimi platform provides users a single login and digital identity for various online services, such as banking, insurance, media, and e-commerce.

With a Decentralized Identity, WE create and control our identifiers and credentials, which are stored in a digital wallet that generates public and private cryptographic keys. Using verifiable presentations, we can choose what credentials to share and how much information to reveal with each entity that verifies our identity. We do not have to unnecessarily rely on intermediaries or expose our data.

How does Decentralized Identity Work?

• A user creates a decentralized identifier (DID), a unique and persistent identifier that does not depend on a central authority. For example, a DID is associated with a document containing public keys, service endpoints, and other metadata, enabling secure communication.

• User stores their DIDs and other identity credentials in a digital wallet app that generates public and private cryptographic keys. The public key is used to identify a specific wallet, while the private key is used to sign transactions and prove ownership.

• User receives verifiable credentials, which are authoritative statements about the user's attributes or qualifications, from the government, educational institute, or employer. Verifiable credentials are digitally signed by the issuer and can be verified by anyone who trusts the issuer.

• User presents their verifiable credentials to a verifier (e.g., service provider) who requests them for authentication or authorization. The user can choose which credentials to share and how much information to reveal using a verifiable presentation, which is an endorsement of the user at the time of the presentation.

• A verifier checks the validity of the verifiable credentials and presentations using a blockchain-based ledger that does not store the user's data but records transactions and proofs of existence. The verifier can also use other methods, such as revocation lists or status registries, to ensure the credentials are not expired or revoked.

By following these steps, decentralized identity enables users to manage their identities without unnecessarily relying on intermediaries or exposing their personal data. It also allows verifiers to trust users based on verified claims from trusted issuers.

ELI5: How does Decentralized Identity Work?

Remember the magic box of cards that I told you about? The one that only you can open and use to prove who you are and what you can do? Well, how does the magic box work? How do you get the cards, and how do you show them to other people?

This magic box works with the help of a special network (Blockchain) that connects different places where you can get and use your cards.

When you want a new card, you must go to someone who can give you one. 

For example, if you want a card that says you can drive a car, you must go to the government office and take a test. If you pass the test, they will give you a card that says you can drive a car. But they won’t give you the actual card. Instead, they will provide you with a copy of the card and a unique code that proves it’s yours. They will also write in the big book that they gave you this card and this code.

When you want to use your card, you must go to someone who can check it. 

For example, if you want to rent a car, you need to go to the car rental company and show them your card that says you can drive a car. But you won’t show them the actual card. Instead, you will show them the copy of the card and the code that proves it’s yours. They will then look in the big book and see if this card and this code match what the government office wrote. If they do, they will let you rent a car.

This way, you don’t have to give your cards or codes to anyone else. You can keep them in your magic box and use them whenever needed. And no one can take your cards or make fake ones because the big book and the codes protect them. This is how decentralized identity works.

To create a decentralized identity for yourself, you need to follow these steps:

• Download and install an identity wallet app that supports decentralized identity standards and protocols, such as Trinsic Wallet or Jolocom Smart Wallet.

• Create your decentralized identifier (DID) using the identity wallet app. A DID is a unique and persistent identifier you can create and control for yourself or your resources. For example, a DID is associated with a document containing public keys and service endpoints that enable secure communication and verification.

• Obtain verifiable credentials (VCs) from trusted issuers, such as government agencies, educational institutions, employers, or other entities. VCs are digital documents that contain authoritative statements about you, such as your name, age, education, skills, or health status. VCs are issued by issuers and stored by you in your identity wallet.

• Present your VCs to verifiers who request them. You can choose what information you share and with whom without intermediaries or trackers. In addition, verifiers can check the validity and authenticity of your VCs using blockchain-based ledgers that do not store your data.

By creating a decentralized identity, you entitle yourself to enjoy more privacy, security, and control over your data and credentials. You can also access various online resources and services requiring user verification without storing your data.

One of the key components of decentralized identity is the concept of verifiable credentials (VCs)

Which are digital documents that contain authoritative statements about a subject, such as their name, age, education, skills, or health status.

VCs are issued by trusted entities (issuers) and stored by users in their digital wallets (holders). Users can present their VCs to other parties (verifiers) who can check their validity and authenticity using blockchain-based ledgers that do not store the user’s data.

Another critical component of decentralized identity is the concept of decentralized identifiers (DIDs)

which are unique and persistent identifiers that users can create and control for themselves or their resources. DIDs are associated with DID documents that contain public keys and service endpoints that enable secure communication and verification. DIDs can be registered on different blockchains or networks (DID methods) and resolved using standardized protocols (DID resolution).

• Kiva Protocol: Kiva is a global non-profit organization that uses crowdfunding to finance micro-loans for underserved communities. Kiva launched the Kiva Protocol in Sierra Leone, Africa’s first national decentralized ID system, in 2019.

  • The Kiva Protocol uses Hyperledger Indy to create verifiable digital identities for citizens based on their biometric data and financial history. Kiva Protocol enables citizens to access formal financial services, such as loans, savings, and insurance, without relying on centralized databases or intermediaries.

• Microsoft ION: A public, permissionless, open-source network for decentralized identity that runs on top of the Bitcoin blockchain. Microsoft ION uses a novel approach called Sidetree to scale the throughput and performance of DID operations without compromising security or decentralization.

  • ION aims to provide a universal layer for decentralized identity that can interoperate with any application, service, or platform. ION is part of Microsoft’s broader vision for decentralized identity, which includes Azure Active Directory Verifiable Credentials, a service that allows organizations to issue and verify VCs for their customers and employees.

• Dock: A blockchain-based network and platform for creating verifiable credentials and decentralized identities. Dock allows users to create self-sovereign identities that they can use across different applications and domains. Dock also allows organizations to issue tamper-proof credentials that can be verified instantly and globally.

  • Dock uses its native token (DOCK) to incentivize network participation and governance. Some of the use cases of Dock include issuing fraud-proof certifications, managing employee IDs, and enabling supply chain traceability.

As you can see, a decentralized identity offers more independence, privacy, security, convenience, and inclusivity than centralized or federated identity models.

However, it also faces some challenges, such as scalability, interoperability, usability, governance, regulation, adoption, etc.

Let’s discuss some of these challenges.

Interoperability is a key area of focus within the decentralized identity ecosystem, and the topic has proven effective fodder for meaningful discussion at all levels of abstraction.

Interoperability means that decentralized identities can be used across different platforms and applications, regardless of the underlying technologies or protocols, and can work with existing identity models such as OpenID Connect (OIDC) or Security Assertion Markup Language (SAML), which are widely used by many online resources.

However, achieving interoperability is a challenging task.

It requires collaboration and coordination among various stakeholders, such as issuers, verifiers, wallet providers, standard bodies, regulators, etc. It also requires addressing technical challenges such as data formats, protocols, schemas, signatures, revocation mechanisms, etc.

Moreover, it requires balancing trade-offs between security, privacy, usability, and scalability.

Several initiatives and projects are working towards interoperability in decentralized identity.

• The Decentralized Identity Foundation is a consortium of organizations that aims to develop open standards and open-source components for decentralized identity.

• The W3C Credentials Community Group (CCG) is a group of experts that works on specifications such as Decentralized Identifiers (DIDs) and Verifiable Credentials (VCs), which are core building blocks for decentralized identity.

• The Trust over IP Foundation (ToIP) is a coalition of organizations that seeks to establish a global standard for the trustworthy exchange of verifiable digital credentials.

• The Self-Sovereign Identity Interoperability Framework (SSIIF) is a project that aims to provide an interoperable architecture for SSI based on DIDs and VCs

These are just some examples of the ongoing efforts to achieve interoperability in decentralized identity. Interoperability is essential for realizing decentralized identity's full potential and benefits for individuals and organizations.

For Interoperability to work, DID needs to work on its operability dimensions.

Decentralized identity protocols need different scalability, security, and usability levels depending on design choices, implementation details, and trade-offs.

• Scalability: Decentralized identity protocols face scalability challenges due to the limitations of underlying blockchains or distributed ledgers, such as transaction throughput, latency, storage capacity, etc.

  • Possible solutions to improve scalability include using off-chain or L2 solutions, such as state channels or sidechains, selective disclosure or zero-knowledge proofs to reduce data size, or sharding or interoperability techniques to distribute the load across multiple networks.

• Security: Security refers to the ability of a system to protect data and transactions from unauthorized access, modification, or disclosure. Decentralized identity protocols leverage blockchain technology and cryptography to provide security guarantees such as immutability, verifiability, and non-repudiation. However, decentralized identity protocols also face security challenges such as key management, revocation mechanisms, phishing attacks, etc.

  • Some possible solutions to improve security include biometric authentication, multi-factor authentication, or hardware wallets for key management, smart contracts, revocation lists, status registries for revocation mechanisms, user education, anti-phishing tools, or reputation systems for phishing prevention.

• Usability: Usability refers to a system's ease of use and user satisfaction. Decentralized identity protocols aim to provide users with usability benefits such as convenience, control, and inclusivity. However, decentralized identity protocols also face usability challenges such as user interface design, user adoption, user education, etc.

  • Some possible solutions to improve usability include using human-readable names (e.g., ENS), QR codes, or NFC tags for user interface design, using incentives, gamification, or social proof for user adoption, or using tutorial guides or feedback for user education. As you can see, decentralized identity protocols have different trade-offs between scalability, security, and usability.

There is no one-size-fits-all solution that can optimize all these dimensions at once. Therefore, different decentralized identity protocols may suit different use cases and preferences better than others. This makes building and investing in a Decentralized Identity Protocol more worthwhile.

So, Let’s Explore Some Arguments as to Why Decentralized Identities Are Worth Looking Into

The most obvious one

Argument #1: Decentralized identities are more secure and privacy-respecting than centralized or federated identities because they do not unnecessarily rely on intermediaries or expose personal data.

Users can verify their identity using cryptography and blockchain technology without disclosing more information than needed. Users can also revoke access to their credentials anytime to prevent identity theft or fraud.

For example,

• Joe wants to buy alcohol from Bob's liquor store.

• Joe has a verifiable credential issued by his government that contains his name, address, date of birth, etc.

• Joe uses his digital wallet app to create a verifiable presentation that only reveals his age attribute from her credential.

• Joe signs the presentation with his private key corresponding to his decentralized identifier (DID), registered on the blockchain.

• Joe sends the presentation to Bob's scanner app via QR code or NFC tag. Bob's scanner app verifies the signature using Joe’s public key retrieved from his DID document on the blockchain.

• Bob's scanner app also checks if Joe’s credential is valid using revocation lists or status registries on the blockchain.

• Bob sells alcohol to Joe after verifying that he is over 21 years old without knowing any other information about her.

If Joe had no access to a decentralized identity, for him

• A Centralized identity system creates a single point of failure and a honeypot for hackers who can compromise the central database and steal or leak Joe's data, and

• A Federated identity creates a dependency on the intermediary and a risk of privacy breaches if the intermediary collects or shares Joe's data without his consent.

By using a decentralized identity, Joe protects his privacy by only sharing the minimum information needed for verification. He can also revoke access to his credential anytime if he no longer trusts Bob. Bob can trust Joe’s credentials without contacting the government issuer or storing Joe’s data. Both parties can prevent identity theft or fraud by using cryptography and blockchain technology to ensure transaction and document authenticity, integrity, and non-repudiation.

Argument #2: Decentralized identities are more convenient and inclusive than centralized or federated identities because they give users more control over their identity and credentials.

Users can create and manage their identifiers and credentials using a digital wallet app that generates public and private keys. Users can also use different identifiers for different contexts and purposes without remembering multiple usernames and passwords.

For example,

• Bob wants to apply for a job at Acme Inc.

• Now, Bob uses several DIDs for different purposes: one for his personal life, one for his professional life, one for his hobbies, etc.

• He also has several verifiable credentials from various sources: his university degree certificate, his previous work experience certificate, his driving license, etc.

• He uses his digital wallet app to create a verifiable presentation containing his professional DID and the relevant credentials he wants to share with Acme Inc.

• Bob signs the presentation with his private key corresponding to his professional DID, registered on the blockchain.

• He then sends the presentation to Acme Inc.'s HR system via email or QR code. Acme Inc.'s HR system verifies the signature using Bob's public key retrieved from his DID document on the blockchain.

• Acme Inc.'s HR system also checks if Bob's credentials are valid using revocation lists or status registries on the blockchain.

If Bob had no access to a decentralized identity, for him

• A Centralized Identity creates a hassle where he must create and remember multiple usernames and passwords for different accounts.

• A Federated Identity creates convenience for users who do not have to create or remember multiple usernames and passwords for different accounts. However, users still have limited choice over what identity information they share with each entity. Everything is shared.

By using a decentralized identity, Bob can enjoy convenience by only sharing the minimum information needed for verification. He can also enjoy choice by using different DIDs for different contexts and purposes. For example, Bob can avoid lock-in effects by not relying on any intermediary for his online interactions. Acme Inc. can benefit from inclusivity by accepting verifiable credentials from any trusted issuer, regardless of location, format, or technology.

Twitter or LinkedIn doesn’t define Bob’s or our actual credentials when they can be manipulated heavily by algorithms & third-party integrations.

• We often have to trust the intermediary's policies and practices blindly.

• We also have to rely on the intermediary’s reputation and trustworthiness to verify their credentials, i.e., trusting LinkedIn or Greenhouse, or Lever to accurately present your data without the alternate system behind ATS congesting your data to prove a single point or a series of attributes that an employer would like to see.

Argument #3: Decentralized identities are more innovative and interoperable than centralized or federated identities because they enable new use cases and applications that were impossible before.

Users can use verifiable credentials to prove their attributes or qualifications across domains and platforms without relying on a central authority. Users can also use decentralized identifiers (DIDs) to identify themselves uniquely and persistently across different networks without depending on a domain name system (DNS).

For example,

• Alice, an American citizen, is on vacation in Canada and wants to rent a car from CarRental Inc. She has several verifiable credentials that she obtained from various sources: her passport, her driver's license, her credit score, etc.

• Alice uses her digital wallet app to create a verifiable presentation containing her DID and the relevant credentials she wants to share with CarRental Inc.

• Alice signs the presentation with her private key that corresponds to her DID, which is registered on the blockchain corresponding to her DID,

• Alice sends the presentation to CarRental Inc.'s scanner app via QR code or NFC tag.

• CarRental Inc.'s scanner app verifies the signature using Alice's public key retrieved from her DID document on the blockchain.

• CarRental Inc.'s scanner app also checks if Alice's credentials are valid using revocation lists or status registries on the blockchain.

• CarRental Inc. rents a car to Alice after verifying that she has a valid passport, driver's license, and credit score without knowing any other information about her.

If Alice had no access to a decentralized identity, for her

• With a Centralized identity, Alice would have to obtain different credentials from different authorities for other purposes. For example, a passport for international travel, a driver's license for driving, a bank account for financial transactions, etc. These credentials are often issued in physical or digital formats that are incompatible or interoperable.

By using a decentralized identity,

• Alice can enjoy her vacation by accessing new services that were not possible before. She can also enjoy interoperability by using verifiable credentials across different domains and platforms without depending on any central authority or intermediary.

• CarRental Inc. can benefit by offering new customer experiences and business models that were impossible before. They can also benefit from interoperability by accepting verifiable credentials from any trusted issuer, regardless of location, format, or technology.

Which Industry Vertical Stands to Benefit the Most from DIDs?

SOCIAL MEDIA

Social media is one of the domains where DIDs can have a significant impact and create new opportunities for innovation and value creation. Today’s social media platforms face several challenges, such as misinformation, censorship, data breaches, privacy violations, and user dissatisfaction. These challenges undermine social media content's trust, quality, diversity, and communication.

• Decentralized identities can address these challenges by giving users more control, privacy, and security over their personal data and online interactions. Decentralized identities are based on cryptographic keys stored in user-controlled wallets rather than on centralized servers owned by businesses or platforms.

• Decentralized identities can also enable new social media outlets that offer more diversity, creativity, and quality of content and communication. For example, decentralized social media outlets can leverage blockchain technology to create new business models, such as tokenization, incentivization, and governance.

• Decentralized identities can also contribute to solving some of the social problems caused by centralized social media platforms, such as misinformation, polarization, manipulation, and discrimination. Decentralized social media outlets can foster more transparency, accountability, and collaboration among users and communities.

Today's social media platforms face several challenges: misinformation, censorship, data breaches, privacy violations, and user dissatisfaction. Decentralized social media outlets aim to address these issues by allowing users to choose which networks to join, create their own rules and terms of service, and own their content and data.

(AGAIN) Decentralized identities empower (decentralized) social media platforms by giving users more control, privacy, and security over their personal data and online interactions.

One of the potential benefits of decentralized identity is that it can help combat misinformation on social media platforms by providing greater transparency and accountability for online content.

Some of the problems that social media platforms at present face are:

False news and misinformation: Social media platforms often amplify popular and sensational content that may not be accurate or verified, leading to confusion, polarization, and distrust among users. Moreover, social media platforms and their advertisers may benefit from the engagement and attention generated by false news, creating a perverse incentive to allow or encourage it.

• A tweet that wrongly identified the attacker in the Toronto van attack as Middle Eastern received far more engagement than a tweet that correctly identified him as white.

• A network of Facebook pages masquerading as independent media outlets and posting political cartoons that targeted Libya and were linked to a Russian businessman.

• A report by the Integrity Institute found that Facebook had the most instances of misinformation among social media platforms but amplified it less than other platforms such as Twitter and YouTube3.

• A series of misleading posts about how to vote or participate in the U.S. Census, such as giving out the wrong hours for a polling place or claiming that people can cast a vote online.

• Misinformation about

  • Nintendo: A fake Nintendo account with a Twitter Blue badge posted an image of Mario flipping everyone off. This went viral and confused many fans, and Twitter later suspended the account.

  • Politics: Several fake accounts impersonating former and current world leaders, such as Tony Blair, George Bush, Pope Francis, and Pope John Paul II, posted misleading or false statements on Brexit, climate change, and COVID-19. Some accounts engaged with each other to create more confusion and controversy.

  • Eli Lilly: A fake account posing as the pharmaceutical company Eli Lilly tweeted that insulin was free, which caused a lot of excitement and outrage among users. The real Eli Lilly had to apologize for the misleading tweet and clarify that its insulin was, in fact, not free. Another fake account then apologized for the real Eli Lilly’s apology. The tweets also affected the stock price, as it dropped by 3%.

  • COVID-19 and vaccines: “COVID-19 was a hoax, a bioweapon, or a population control scheme; that masks and lockdowns were ineffective or harmful; that vaccines were unsafe, inadequate, or contained microchips; and that alternative treatments such as hydroxychloroquine or ivermectin were effective cures.”

  • Climate change: “climate change is not real, not human-caused, or not a serious problem; that there is no scientific consensus or evidence for climate change; that renewable energy sources are unreliable or expensive; and that individual actions have no effect on reducing greenhouse gas emissions.”

Lack of regulation and accountability: Social media platforms have been known to operate with minimal oversight within themselves.

https://twitter.com/venturetwins/status/1640038880325009408?s=20

DIDs are essential for the sole reason that they provide more transparency and accountability for online content.

This is how:

• DIDs verify the provenance of online content, such as who created it, when, where, and how. This helps us characterize between authentic and manipulated content.

• DIDs improve the reputation of online content creators and influencers by allowing them to build and share their credentials and actions on-chain. This helps us assess the reliability and credibility of the sources they follow or interact with.

• DIDs entrust users to control their data and privacy by giving them the choice of information they share with online platforms and third parties. This helps us protect ourselves from data breaches, identity theft, and unwanted surveillance that sometimes provoke misinformation campaigns.

Decentralized Social Media Platforms such as Minds, Farcaster, Lens, and many more use the on-chain identity to provide more transparency and accountability for online content.

For example,

Ranveer, a.k.a, Beer Biceps, hosts one of the most popular podcasts in India, The Ranveer Show. While some of his content (kidding) is worth listening to, there’s almost zero DD on his guests’ backgrounds from his end.

Look at this podcast attended by Rajiv Malhotra. He is a renowned computer scientist who has spent the last 50 years in the U.S.A., studying & researching topics like AI, Computers, Geo-Politics, & Ancient Indian Scriptures.

Now Rajiv Malhotra, with all his education and experience was involved in a wealth management scheme with the now escaped criminal, Nithyananda. Rajiv proposes to Bill Gates that he should deposit a part or whole of his net worth with him so that when dies and is reborn again in his next life, he can give this money back to him.

The link to the video below:

The goal of this example is not to insult Ranveer’s podcast but to make other people aware of frauds who go on to attend such podcasts with a humungous following from spreading such content.

As we consume content on the internet, we need to be aware of who we listen to and who we interact with. And it’s very difficult to verify who we are interacting with, if we just blindly listen and agree with the crowd. We all need conviction sometimes.

Decentralized Identities solves this. On-chain credentials are the next big phenomenon waiting to happen.

Conclusion

In this research thesis, I have explored the concept of decentralized identity and its applications in social media platforms. Projects building on decentralized identities have a competitive advantage over existing solutions by providing a user-centric and trustless identity system that enables new use cases or applications that were not possible before.

I have also examined the benefits and challenges of using a decentralized identity to provide more transparency, accountability, and empowerment for online content and identity. What I found was that decentralized identity offers a promising alternative to the current centralized and federated identity systems that are vulnerable to manipulation and abuse.

Decentralized identities are the next big technological phenomenon waiting to happen.

They offer a way to empower individuals with more control and privacy over their online identities, while also enabling interoperability and innovation across different platforms and services.

As we have seen with examples of Alex, Alice & Bob, Decentralized identities have the potential to transform how we interact with the digital world, and create new opportunities for social and economic inclusion.

As more people become aware of the benefits and challenges of decentralized identities, we can expect to see more adoption and development of this emerging technology in the near future.

Thank you for reading through. Please subscribe below to get regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

12. Understanding ERC-4337: The Future of Ethereum's Account Abstraction Revolution

ERC-4337, or Account Abstraction, is a token wallet standard for the Ethereum network that aims to provide a more secure and functional framework for token creation. This standard changes the architecture of Ethereum wallets and makes them simpler and more user-friendly. It seeks to eliminate the existence of two types of accounts

1. externally owned accounts and

2. contract accounts

by unifying them under a single type.

This would enable features like:

• Social recovery: recovering your wallet with the help of whitelisted accounts instead of seed phrases.

• Multi-signature: requiring multiple signatures to authorize a transaction.

• Gas abstraction: paying transaction fees with any token instead of ETH.

• Custom logic: programming your own rules for validating transactions.

One of the main benefits of ERC-4337 is that it enables bundled and sponsored transactions with discounted transaction fees.

Why The ETH Community is Praising this Standard:

• It would increase the adoption and usability of Ethereum by making it more accessible and convenient for users.

• It would enhance the security and flexibility of Ethereum wallets by allowing users to customize their own account logic.

• It would reduce the complexity and overhead of managing multiple types of accounts on Ethereum.

• It would create new possibilities for innovation and interoperability on Ethereum by enabling smart contract wallets to interact with other contracts directly.

How Does ERC-4337 Work?

ERC-4337 works by using a higher-level system called bundlers to process user operations.

1. User operations are objects that contain the user's intent and other data for verification, along with signatures.

2. Bundlers retrieve user operations from a mempool and return the desired result to the wallet.

This way, users can customize their own accounts with different features and logic without depending on centralized relayers or changing the consensus layer of Ethereum.

Bundlers are actors that retrieve user operations from the mempool and package them into a transaction for batch verification and execution. They can be block builders running special-purpose code or users that can relay transactions to block builders through a bundle marketplace like Flashbots.

An example use case of ERC-4337 is UniPass, a wallet that allows users to create an account with just an email address and password without needing a seed phrase or private key. UniPass uses ERC-4337 user operations to interact with smart contracts on Ethereum without paying gas fees directly. Instead, it uses paymasters to sponsor gas fees and bundlers to process user operations.

• More secure: ERC-4337 introduces built-in access controls, permissions, and a more flexible token supply model, making it more secure than existing token standards. This helps to reduce the risk of hacks or other security breaches.

  • ERC-4337 enables users to store their keys locally on their hardware security module (HSM), such as a smartphone or a laptop. This makes them as secure as a self-custodial crypto wallet, allowing users to set up two-factor authentication and sign transactions with a fingerprint or face scan.

• More functional: ERC-4337 also introduces a more flexible token supply model, enabling developers to create tokens with a variable supply. This allows for more complex and dynamic token economics.

  • ERC-4337 allows users to create smart accounts that can perform automated payments, such as subscriptions or recurring donations. It also allows users to set monthly spending limits on their accounts, which can prevent overspending or theft.

• Improved user experience: The built-in access controls and permissions allow users to create smart accounts that can perform automated payments, set time-based spending limits, or recover lost accounts without needing a seed phrase or private key. This simplifies the onboarding process and reduces user friction.

  • ERC-4337 simplifies the onboarding process for new users by eliminating the need for a seed phrase or private key. Users can create an account with just an email address and password and recover their account easily if they lose access. It also improves the user experience for blockchain games by allowing users to play without paying gas fees directly.

ERC-4337 compares to other token standards:

• More secure than ERC-20, as it allows users to store their keys locally and set up access controls for token transfers.

• More functional than ERC-721 and ERC-1155, as it allows users to create tokens with a variable supply and perform automated payments.

• More user-friendly than existing smart contract wallets, as it eliminates the need for seed phrases, private keys, or relayers.

• More decentralized and censorship-resistant than previous approaches to account abstraction, as it uses a unified mempool that does not depend on centralized intermediaries.

Some of the disadvantages of ERC-4337 are:

• More complex: It requires a higher-level system of bundlers to process user operations.

• More experimental: It is still an experimental standard that may have unforeseen issues or challenges.

How does ERC-4337 benefit developers & Users?

ERC-4337 benefits developers and users in different ways.

• For developers, it provides a more secure and functional framework for token creation, enabling them to create more robust and flexible dApps.

  • ERC-4337 allows them to create smart accounts with different features and logic depending on their needs.

  • For example, they can create tokens that have a dynamic supply, a governance mechanism, or a fee-sharing model. They can also create tokens that are compatible with different EVM-based blockchains.

• For users, it offers a more seamless and user-friendly experience when interacting with dApps.

  • ERC-4337 allows them to use smart accounts that can handle the esoteric blockchain stuff. The standard’s built-in access controls and permissions make it easier for users to understand how their tokens are being used and to protect their assets. Users can also program different mechanisms to enable their private keys to be retrieved without writing down seed phrases.

  • For example, they can use bundlers to pay for transactions with any token or even get sponsored transactions with discounted fees.

  • They can also use smart accounts with built-in access controls and permissions to protect their assets and privacy.

  • Moreover, they can use smart accounts with different mechanisms to recover their private keys without relying on seed phrases.

So, How Does ERC-4337 Impact The Broader Web3 Ecosystem?

ERC-4337 & NFTs

• ERC-4337 could enable more flexible and creative NFT designs by allowing developers to define custom token metadata, such as images, videos, audio, text, etc. This could enhance the aesthetic and functional value of NFTs and their interoperability with other dApps.

• ERC-4337 could improve the user experience and security of NFT transactions by allowing users to pay gas fees in any token rather than only in ETH. This could lower the friction and cost of buying and selling NFTs and protect users from volatility and network congestion.

• ERC-4337 could empower NFT owners and creators by enabling smart accounts that can hold any assets, execute any type of logic, and communicate with any other contract. This could allow for more complex and customized NFT features, such as royalties, auctions, lending, fractionalization, etc. Smart accounts could also implement social recovery mechanisms to help users recover their lost or stolen NFTs.

• ERC-4337 could increase the adoption and innovation of NFTs on Ethereum by reducing scalability issues and gas costs on the network. By using bundlers that can batch and process transactions off-chain before submitting them to the main chain as a single transaction, ERC-4337 could enable faster and cheaper NFT minting and trading.

ERC-4337 & DeFi

• ERC-4337 could enable more secure and flexible DeFi protocols by allowing developers to create smart accounts that can hold assets, execute any strategy, and communicate with any other contract.

  • This could allow for more complex and customized DeFi features like flash loans, yield farming, liquidity mining, etc. Smart accounts could also implement advanced security mechanisms such as multi-signature schemes, timelocks, etc.

• ERC-4337 could improve the user experience and accessibility of DeFi transactions by allowing users to pay gas fees in any token rather than only in ETH.

  • This could lower the friction and cost of using DeFi protocols and protect users from volatility and network congestion.

• ERC-4337 could enhance the scalability and efficiency of DeFi transactions by reducing congestion and gas costs on the network.

  • By using bundlers that can batch and process transactions off-chain before submitting them to the main chain as a single transaction, ERC-4337 could enable faster and cheaper DeFi operations.

ERC-4337 & Decentralized Infrastructure

• ERC-4337 could enable a more decentralized and resilient infrastructure by introducing bundlers, a special class of actors that can batch and process transactions off-chain before submitting them to the main chain as a single transaction.

  • Bundlers could act as intermediaries between users and miners or validators, reducing congestion and gas costs on the network.

• ERC-4337 could enable a more user-friendly and secure infrastructure by introducing smart accounts, a new type of account that can hold any type of assets, execute any type of logic, and communicate with any other contract.

  • Smart accounts could allow users to pay gas fees in any token, recover their lost or stolen funds, customize their transaction parameters, etc.

• ERC-4337 could enable more innovative and interoperable infrastructure by introducing user operations, a new type of pseudo-transaction object that can be signed by smart accounts and sent to a separate mempool.

  • User operations could allow for more complex and flexible transaction features, such as meta-transactions, atomic swaps, cross-chain communication, etc.

ERC-4337 & Web3

• ERC-4337 could enable more user-centric and customizable web3 applications by allowing users to create and manage their own smart accounts that can interact with any decentralized protocol or service. Users could choose their own security settings, transaction parameters, gas payment methods, etc.

• ERC-4337 could enable more seamless and intuitive web3 experiences by allowing users to sign transactions with any device or platform that supports WalletConnect, a standard for connecting web3 wallets across different applications. Users could also use QR codes or NFC tags to initiate transactions without needing a browser extension or app.

• ERC-4337 could enable more collaborative and innovative web3 communities by allowing users to join and create smart account collectives that can pool resources, share governance, and execute transactions together. Users could also participate in social experiments, games, and challenges that leverage smart account features.

Business Models In web3 Benefitting from ERC-4337

• dApps that require a more dynamic token supply can use ERC-4337 to create tokens with a variable supply, meaning that they can increase or decrease the number of tokens in circulation according to their needs. For example,

  • a dApp that rewards users for completing tasks or challenges could use ERC-4337 to mint new tokens as incentives, or burn existing tokens to reduce inflation.

• dApps (token creation platforms) that require more complex token structures can use ERC-4337 to define custom token metadata, meaning that they can include additional information about their tokens. For example,

  • decentralized exchanges and marketplaces that want to offer more seamless and user-friendly trading experiences for their users. ERC-4337 improves the trading experience by allowing users to use smart accounts that can pay gas fees in any token, customize transaction parameters, and execute atomic swaps.

  • a dApp that creates non-fungible tokens (NFTs) could use ERC-4337 to add attributes such as name, description, image, rarity, etc., to their tokens.

• dApps that want to offer account recovery and group-access wallets can use ERC-4337 to enable account abstraction, meaning that they can allow users to use smart contract wallets instead of externally owned accounts (EOAs).

  • For example, a dApp that provides social media services could use ERC-4337 to let users create smart contract wallets that can be accessed by multiple devices or people using different authentication methods.

• dApps that want to enable bundled and sponsored transactions with discounted transaction fees can use ERC-4337 to leverage a separate mempool for user operations. For example,

  • ERC-4337 could enable more innovation and collaboration by allowing users to join and create DAOs that can pool resources, share governance, and execute transactions together.

  • a dApp that offers gaming services could use ERC-4337 to let users send multiple actions in one transaction (bundling), or pay for their transactions using tokens instead of gas (sponsoring).

USE CASE #1: ERC-4337 in DeFi to create a smart account that can interact with decentralized exchanges and lending platforms without requiring a native token balance or paying gas fees upfront.

For example, a user could create a smart account that can swap tokens on Uniswap, borrow tokens on Aave, or stake tokens on Compound using only ERC-20 tokens as inputs and outputs.

• The user would sign a transaction request with their private key and send it to a bundler, which is a node service that aggregates and submits transaction requests to the network. The bundler would pay the gas fees for the transaction and receive a fee from the user in any ERC-20 token of their choice.

• The smart account would execute the transaction request logic on behalf of the user, verifying that the bundler followed the rules and did not censor or tamper with the request. The smart account would also handle the refund or reimbursement of the bundler's gas fees, either by deducting it from the user's output tokens or by using a pre-approved allowance mechanism.

• This way, the user could access various DeFi services on Ethereum without needing ETH or worrying about gas prices. The user could also benefit from enhanced security and flexibility of their smart account, which could implement custom logic, rules, or conditions for their transactions.

USE CASE #2: Delegating Voting to their ERC-4337 smart account by first creating a smart contract account that implements their voting logic.

One of the features of ERC-4337 is built-in access controls, which allow developers to set permissions for token transfers and other actions. This could enable users to delegate voting to their ERC-4337 account by first creating a smart contract account that implements their voting logic.

• For example, the account could check the proposal details and compare them with the user’s preferences, such as risk level, return rate, social impact, etc. The account could then vote accordingly or abstain if none of the proposals match the user’s criteria.

• The user would then sign a message offline that authorizes their account to vote on their behalf for a certain period of time or until revoked. The message would include the address of the DAO contract and the amount of tokens delegated.

• The user would then send the message to a bundler, who would include it in a block along with other user operations. The DAO contract would then recognize the message and update its records accordingly. It would also allow the ERC-4337 account to vote on proposals using the delegated tokens as long as the authorization is valid.

• The ERC-4337 account would then execute its voting logic whenever there is a new proposal and send its vote to a bundler who would include it in a block. This way, the user could delegate their votes to their ERC-4337 account without having to be online or pay gas fees for every vote. They could also benefit from the features of ERC-4337, such as custom fees, offline signing, and social recovery.

• NOTE: smart accounts still need user input to initiate transactions and cannot act autonomously without user consent.

This makes sense as it would allow users to authorize their account to vote on their behalf for a certain period of time or until revoked. The account could then vote accordingly or abstain if none of the proposals match the user’s criteria. The user would then send the message to a bundler, who would include it in a block along with other user operations. The DAO contract would then recognize the message and update its records accordingly. It would also allow the ERC-4337 account to vote on proposals using the delegated tokens as long as the authorization is valid.

However, there are some drawbacks and challenges with this use case which I have noticed, and these are some answers to the best of my knowledge.

However, please note that these are not definitive or comprehensive answers, and we may need to do more research and testing before implementing them.

How would users ensure their voting strategy is secure and aligned with their preferences?

• One possible solution is using a well-tested and audited smart contract template to create ERC-4337 accounts with voting logic.

• Alternatively, users could hire reputable developers or use trusted platforms to create their custom voting logic, review the code of their account contract before deploying it and verify that it matches their expectations.

How would users revoke their authorization if they change their minds or want to vote differently?

• One possible solution is to include a revocation mechanism in the user operation message that authorizes the account to vote on behalf of the user.

• For example, the message could have an expiry time or a nonce that can be used to invalidate it.

• Alternatively, users could send another message to revoke their previous authorization.

How would users monitor and verify that their votes are being cast correctly by their account?

• One possible solution is to use a public explorer or a dashboard that tracks the votes cast by ERC-4337 accounts on different DAOs.

• Users could also subscribe to notifications or alerts when their account votes on a proposal.

• Additionally, users could check the state of their account contract on-chain and verify that it matches their voting logic.

How would users deal with possible censorship or denial-of-service attacks by bundlers or other actors?

• One possible solution is to use multiple bundlers or bundle marketplaces to increase the chances of getting user operations included in blocks.

• Users could also incentivize bundlers by offering higher fees for serving their operations.

• Additionally, users could rely on reputation systems or social networks to identify trustworthy bundlers.

USE CASE #3: ERC-4337 in social media platforms to create a decentralized social network where users can post content, tip each other, and verify their identities using their smart accounts.

• One way to use ERC-4337 is to create a social media platform that is decentralized and not controlled by any company or government.

• Users can post content using their Smart Accounts and prove that they own them with their signatures. They can also tip each other for their content using any token they want.

• They don’t need to pay gas fees for every transaction because someone else pays for them and gets a tip in return. This someone else is called a bundler, and they help users send their transactions to the network.

This way, users can have a better experience on social media without having to worry about gas fees or losing their accounts. They can also have more control over their content and identity without depending on any third party.

USE CASE #4: Delegate NFT transactions to ERC-4337 account by creating a smart contract account that implements their NFT logic.

For example, the account could have functions to mint new NFTs using the user’s signature or image data, to buy NFTs from various marketplaces using the user’s funds or tokens, to sell NFTs at a specified price or condition using the user’s approval or signature, or to trade NFTs with other users using the user’s consent or criteria.

The user would then sign a message offline that authorizes their account to perform these actions for a certain period of time or until revoked. The message would include the address of the ERC-4337 account and the amount of funds or tokens delegated. The user would then send the message to a bundler, who would include it in a block along with other user operations.

The ERC-4337 account would then execute its NFT logic whenever there is an opportunity or trigger and send its transaction to a bundler who would include it in a block.

This way, the user could delegate their NFT transactions to their ERC-4337 account without having to be online or pay gas fees for every transaction. They could also benefit from the features of ERC-4337, such as custom fees, offline signing, social recovery, and custom metadata.

In simpler terms, imagine these two (very similar) scenarios

• Imagine you have a special account that can do things for you on the internet without you having to be online or pay fees.

  • For example, this account can create digital artwork for you using your signature or image data.

  • It can also buy and sell these artworks on different websites using your money or tokens. It can also trade these artworks with other people based on your preferences or rules.

  • You just need to tell this account what you want it to do and for how long by sending it a message. This message is like a permission slip that lets this account act on your behalf. This is what ERC-4337 allows you to do with your NFTs.

• Let’s say you want to create your own NFT collection of digital paintings.

  • You have a smart contract account that can mint new NFTs using your signature or image data. You also have some funds or tokens in this account that you want to use for buying and selling NFTs.

  • You sign a message offline that tells this account to mint 10 new NFTs using your image data and to sell them on OpenSea for 0.1 ETH each.

  • You also tell this account to buy any NFTs from CryptoPunks that are below 100 ETH and to trade any NFTs from CryptoKitties with other users based on their rarity.

  • You set the duration of this message to one week or until you revoke it. You send this message to a bundler, who includes it in a block along with other user operations.

  • Your smart contract account then executes its logic whenever there is an opportunity or trigger and sends its transactions to another bundler who includes them in a block.

This way, you can create and manage your own NFT collection without having to be online or pay gas fees for every transaction.

Challenges of Implementing ERC-4337

Now that we have discussed the use cases of ERC_4337, here are some of the challenges of implementing ERC-4337

• Finding a way to handle different scenarios and corner cases that may arise when bundling user operations, such as reordering, replaying, censoring, or invalidating them.

• Ensuring that the bundlers and entry points are decentralized and censorship-resistant, and do not depend on a single entity or relayer.

• Increased DoS vulnerability: Protecting the network and the bundlers from denial-of-service (DoS) attacks by malicious users who may try to send user operations that consume too much gas or fail to pay fees.

  • ERC-4337 introduces some restrictions on the verification logic of Smart Accounts, such as limiting the gas used during validation, banning certain opcodes, and preventing non-deterministic behavior.

  • These restrictions aim to reduce the attack surface and protect bundlers from unpaid work or griefing by malicious users or contracts.

• Providing a user-friendly interface and experience for users who want to use ERC-4337 accounts without having to deal with complex technical details.

ERC-4337 Impact on the Broader Web3 Ecosystem

User onboarding

ERC-4337 can make it easier for new users to join the decentralized world of crypto without having to learn about complicated seed phrases or wallets. Users can use social logins or other methods to create instant wallets on any EVM blockchain.

For example, Stackup is a service that allows users to create ERC-4337-enabled wallets using their email, phone number, Google account, or Facebook account. Users can also receive free gas tokens from Stackup to start using their wallets without having to buy ETH first.

User experience

ERC-4337 can enable more functionality and flexibility for user accounts, such as gasless transactions, gas sponsorship, custom transaction flows, and more. Users can have more control and convenience over their accounts and transactions.

For example, users can use ERC-4337-enabled wallets to send multiple transactions in one batch, such as transferring ERC-20 tokens to different recipients. Users can also use ERC-4337-enabled wallets to delegate their gas fees to other parties who are willing to pay for them in exchange for some benefits.

User security

ERC-4337 can enhance user security by allowing users to use smart contracts as their accounts, which can implement various security features such as time locks, multi-signatures, recovery mechanisms, etc. Users can also avoid losing access to their funds due to lost seed phrases or hacked wallets.

For example, users can use ERC-4337-enabled wallets to set up two-factor authentication using biometric data or other methods. Users can also use ERC-4337-enabled wallets to recover their accounts using social recovery via a group of trusted friends or a commercial service.

Thoughts & What to Look for Next

ERC-4337 is an Ethereum standard for the Ethereum network that aims to provide a more secure and functional framework for token creation, enabling smart contracts to act as first-class citizens on the blockchain. It also allows users to pay gas fees in any token, rather than only in ETH.

There are many reasons to question the ERC-4337 implementation, but we should be bullish on ERC-4337 based on the following three points:

ERC-4337 will increase the adoption and innovation of dApps on Ethereum by lowering the barriers of entry for developers and users.

Developers can create more complex and customized tokens without worrying about compatibility issues or security risks. Users can interact with dApps more easily and cheaply by using any token they prefer to pay for transactions.

ERC-4337 enhances the scalability and efficiency of Ethereum by reducing congestion and gas costs on the network.

By using an alternative mempool called "bundlers", ERC-4337 transactions can be batched and processed off-chain, before being submitted to the main chain as a single transaction. This reduces the load on miners and validators and allows for faster confirmation times.

ERC-4337 will improve the user experience and privacy of Ethereum by enabling "smart accounts".

Smart accounts are self-contained contracts that can hold any type of asset, execute any type of logic, and communicate with any other contract. They can also implement advanced features such as meta-transactions, social recovery, multi-signature schemes, etc. Smart accounts give users more control and flexibility over their funds and identity on Ethereum.

Thank you for reading through. Please subscribe below to get regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

11. Governance & Growth in Modern Society

Sources:

• Ethereum Account Abstraction – Everything you need to know

• Account abstraction’ supercharges Ethereum wallets: Dummies guide

• Account abstraction

• ERC-4337: Account Abstraction Using Alt Mempool.

• Everything you need to know about Ethereum’s new token standard, ERC-4337.

• Ethereum's ERC-4337 Account Abstraction Smart Contract is Live.

• Ethereum Users May Soon Be Able To Retrieve Lost Private Keys.

• Stackup Brings Account Abstraction to Ethereum with ERC-4337.

• Unpacking ERC-4337.

• Ethereum Says ERC-4337 Deployed, Tested, Beginning Era of Smart Accounts.

• ERC-4337 Quickstart Guide

Table of contents:

1. Governance in Modern Society

2. What Do Corporations & DAOs Seek?

3. Categorizing Growth

4. Collective Participation Principle

5. Governance & Growth in Corporations vs. DAOs

   1. Is the Profit Motive an Efficient Use of Resources?

   2. Is profit growth compatible with the survival of the internal financial economy for DAO collectives & organizations?

   3. Is vertical growth a better allocation of resources?

6. What is the Ideal Structure?

7. Challenging the Status Quo: Society's Evolution Beyond Majority Rule

Governance in Modern Society

We have 2 different societies emerging in modern economies.

• On the one hand, we have a global society of consumers with unprecedented mobility and access to information.

• On the other hand, we have organizations with digital sovereignty (DAOs) approaching to take power from the hands of corporations.

The ever-growing power of the centralized power of information amplifies the radical contrast between the two societies.

The centralized power of information is no more limited to multinational corporations such as Google, Facebook, or Amazon. It is now so pervasive that power & influence is increasingly felt by smaller and smaller players impacting all of our lives.

This power has increased exponentially; many examples exist, but let’s focus on one: the web.

The web as we know it today is in an existential crisis. But it is far from being dead. It is already showing signs of recovery.

This is primarily due to the power shift from corporations to autonomous organizations.

There are two broad categories of organizations gaining this control over information:

1. Autonomous organizations, controlled by algorithms and computers, operated by "runners" or, as the software world.

2. Collective organizations, controlled by members of society, grown mostly on the gig economy and contractual labor.

A diminished web is a wellspring of insecurity for both corporations and DAOs.

The internet, as the core of our digital world, has literally disappeared. Governments and corporations worldwide continue to tinker with theory in ways that change the web's fundamental structure and purpose, making it difficult for individuals to control.

What can we actually do about it? How can we reclaim our digital property through a mesh of decentralized networks and apps? And what would decentralized life look like?

To understand this better, let's take a step back and look at what corporations and DAOs seek.

So, both seek growth and profit, but they go about it differently.

The profit principle drives organizations --> get more and more people involved and monetize their activity to achieve a higher profit.

Companies are organized around managers and stockholders, while employees exist with the sole obligation of fulfilling their roles.

When DAOs reach a specific size and complexity, they have difficulty regulating themselves. So we are in the middle of a transitional moment as a world trying to squeeze the maximum output with the least amount of intellect, effort, and money.

DAOs are driven by the participation principle (explained in the next section) --> get more and more people involved in achieving a larger social purpose and protecting their values of human connection.

So eventually, DAOs will be incredibly efficient because they represent millions of people engaged in mutual aid and cooperation.

How do we categorize this growth?

Let's examine these two types of growth and explore what they could mean for a company looking to further decentralize its infrastructure.

Organically growing a company and DAO has two main paths: social progress through participation and financial progress through profit.

An observation that I have had for a while is the collective participation principle, which can be stated as:

1. Vertically scaling a DAO (creating more divisions and subsidiaries) creates more management layers and is a linear process.

2. Horizontally scaling a DAO (creating new networks, teams, and leagues) creates a more decentralized structure and is a circular process.

Adding to this, by horizontally scaling a DAO in a highly networked, competitive, and information-rich economy, sustainable growth is almost entirely rooted in "peer-to-peer" cooperation.

Hence, for DAOs, the biggest obstacle to both vertical and horizontal growth is the problem of institutional inertia. This happens when every group has a vested interest in the same centralized, coordinated structure and is, therefore, reluctant to adopt non-centralized structures and processes. In this case, decentralized organizations are often viewed as less efficient and 'unprofessional.'

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If you haven’t read about Coase’s Theory of the Firm, you should.

Ronald Coase was a visionary economist who stood out for his independent thinking, rigorous approach, and innovative ideas. His work has a lasting impact on our understanding of the world, as his theories are not only applicable but also provide insightful explanations for the reality we see around us. He was indeed the epitome of a great economist.

The theory of the firm, as proposed by Ronald Coase, asserts that there is a certain type of individual in the workforce known as an "employable person." These individuals are characterized by their ability to be productive and valuable employees within a firm. Still, they lack the unique qualities that would make them stand out or be remembered in history. This is because they are designed not to leave a lasting impact but instead to focus their efforts and skills toward contributing to the success of their employer.

Coase's unparalleled rigor is reflected in his most famous contribution to economics, the Coase Theorem. Despite being written without a single equation, this theorem holds fundamental importance that rivals even the most mathematically complex economic theories.

The Coase Theorem highlights the remarkable efficiency of markets in allocating resources, even in the face of challenges such as pollution.

Coase's clear and concise writing style, combined with his rigorous approach, has made this theorem a cornerstone of modern economic thought.

Coase’s Theory has important implications for the discussion on Governance in Modern Society.

The profit motive in corporations is often seen as the driving force behind their resource allocation decisions. However, as Coase's work suggests that it is not the profit motive per se, but the existence of transaction costs that leads firms to coordinate production and allocate resources within the firm.

In the context of decentralized autonomous organizations (DAOs), transaction costs may be lower compared to traditional corporations, which could lead to a more efficient allocation of resources.

The "participation principle" in DAOs, where growth is driven by increasing participation and cooperation, could also contribute to more efficient use of resources, as long as the institutional inertia that can limit the growth of DAOs is overcome.

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This leads us to the following questions about Governance & Growth in Organizations vs. DAOs:

Is the Profit Motive an Efficient Use of Resources?

What constitutes "efficient use"? It depends on which side of the equation you look at.

For example, big businesses may be efficient in their resource use. At the same time, individuals or people who band together in DAOs may be efficient in their resource consumption.

In terms of resource allocation across collective, corporate hierarchies may be more efficient. For example, if large companies create monopolies, they may use resources more efficiently than small DAOs. However, this efficiency comes at the expense of individuals or people banding together.

According to Coarse’s theory, an employable person is more valuable to their employer when working within the firm rather than trying to sell their skills and abilities in the open market. This is because the firm provides a structure and support system that allows these employees to maximize their potential and be productive. In return, the firm benefits from the efforts and contributions of these employees.

When an individual tries to contribute to the collective as a whole, they make a resource usage of their time and energy, which is purely negative. Individually, nobody is efficient at producing more than Zero; but collectively, most people contribute more than Zero.

Also, when an organization reaches a certain size and complexity, its processes become less and less flexible. This is because large companies typically have thousands of employees who all have their internal ways of doing things, which become comprehensive when the size gets too big.

One point of transparency that emerges from this is that "individualism" and "collectivism" are, in reality, the same — they are just different forms of cooperation and organization.

Is profit growth compatible with the survival of the internal financial economy for DAO collectives & organizations?

In classical economics, "growth without a limit" is a desirable outcome. However, in systems driven primarily by free market dynamics, this often translates to speculation that drives up the value of assets and prices.

In the case of the hyper-accelerated world that is expected to emerge with the advent of Web3, profit growth may no longer mean increased profits.

Instead, it means an upward spiral of crypto asset prices that eventually leads to an inflationary spiral of asset pricing and asset value.

Suppose the community's goals do not include values of wealth accumulation. In that case, another solution may be to use external financial tools to support the internal financial economy for DAOs & organizations.

Is vertical growth a better allocation of resources?

DAOs live in an ecosystem that continually evolves. When the collective size is small, it may evolve in a vertical direction as it grows bigger. However, an evolutionary trajectory may be more suitable for achieving a certain extent. This means that the collective may evolve from independent individuals to a group with many interdependent parts.

How big is big? DAOs that are big enough to be bound by culture and specialization can become too big to fail. However, the size of such an organization should be large enough that it's no longer feasible to maintain both centralized and decentralized governance structures. In other words, the size of an organization should be large enough that it's either centralized or decentralized, but not both. Otherwise, management becomes a limiting factor for the organization's growth, just like an individual.

So, what would be the ideal structure?

The underlying structure of reality matters much more than the participants, something policymakers, executives & collectives need help understanding.

Under the right market structure, a collection of idiots produces a well-functioning market.

-- Nassim Nicholas Taleb

The structure of an organization shouldn't be architectured in a way that fosters inefficiency. The majority of economic production that has ever been produced came from farms and small businesses.

By definition, a community is governed through consensus. Each member of the community has the right to speak and vote. The only requirement is that all members must participate in the decision-making process at the same time.

In the structure of DAOs, individuals should be enabled to collaborate toward a common goal. Ideally, this is a goal shared by everyone in the organization or at least by the majority. Therefore, a set of shared values should enforce the agreement between individuals.

Hence, for DAOs, the leaders of the collective should be those who can provide guidance and leadership to the organization, not necessarily manage and make decisions for the group as a whole.

Challenging the Status Quo: Society's Evolution Beyond Majority Rule

Society doesn't change through simple agreements or decision-making methods like voting, committees, or academic conferences. It only takes a small group of individuals with a substantial stake in the outcome to significantly impact the direction of society. This is because there is always some form of unequal balance or distribution of power or resources.

It's important to note that this change doesn't happen through a democratic process or a majority vote. It doesn't happen through lengthy meetings or debates over tea and sandwiches. It's not necessarily the result of a polling process where the general public weighs in.

Instead, the change comes from a few individuals who have a personal stake in the outcome and are willing to put their soul into making a difference. They can leverage the asymmetry in the situation to drive change and move society forward in a new direction.

In conclusion, the evolution of society is not driven by a large group of people coming to a consensus or making decisions through formal processes. Instead, it only takes a small group of invested and motivated individuals to create change to impact society significantly.

Thank you for reading through. Please subscribe below to get regular post updates.

I’d also appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: Twitter and LinkedIn.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

10. Build in Web3 Series: Climate Finance DAO

Hi everyone.

This is an entirely different yet innovative “ZBuild in web3” series I’m trying out here. In 2022, I set out a goal to help bring as many believers as possible to help decode and democratize web3.

While my previous investment & thematic research has been very detailed & specific to a particular target market, I've generously offered as much detail as possible regarding the many primer series, investment, and research thesis on the web3 ecosystem.

Now, the reverse holds as well.

I deliberately chose the term “build in web3” because, in general, most of these articles will explain the working model in more detail. Often people don’t put much thought into how many layers of abstraction we are working with.

The goal is to explain in these posts how each of the web3 solutions will potentially integrate into new & existing business models.

To start things off, below, I've included an outline of a DAO business model focusing on Climate Finance.

Decentralized Climate Finance DAO: Segmenting a Fragmented Green Finance Infrastructure.

A DAO is a decentralized autonomous organization.

A Decentralized Climate Finance DAO is an organization responsible for managing climate finance in a decentralized way.

GOAL: Use blockchain technology to address climate finance transparently and efficiently. The goal behind this DAO is to segment a fragmented green finance infrastructure making it more accessible, efficient & transparent for retail investors like you & me.

FOCUS: Public blockchain infrastructure for carbon markets, green bonds, renewable energy credits, carbon credits, and other environmental assets.

Why is this needed?

1. There's an oligopoly of intermediaries: The responsibility for a targeted environmental offset is often silenced.

2. There's no single marketplace where green assets are traded & monitored independently or according to climate agreements.

3. There's an existing assortment of markets & financial instruments that are responsible for the following:

   1. excess volatility, and

   2. different patterns of rules/regulations which are very hard to follow

The Climate DAO would focus on 4 key points:

1. Measuring & tracking +ve or -ve impact from industries, polluters & dedicated climate projects

2. Per the international climate agreements—issue, trade, regulate & dismiss green assets such as green bonds and carbon credits.

3. Democratize access to green assets through dApps or, if regulations approve, through existing governmental financial institutions.

4. Tokenization of every activity to track & assess spending

Why would this work?

1. For financial institutions: P2P assessment of green bonds, carbon credits along with P2P operations

2. For retail investors (me & you): buy assets in verified GHG reduction activities that have actually taken place.

3. For companies/industries: a cost-effective process of offsetting environmental negligence

4. For economies:

   1. Assess corruption from the ground up.

   2. Double-verify the actions from the ground up.

   3. Raise funds for green projects & invest in viable projects vetted from the ground up.

How would this work?

1. Every family, group, or company using sustainable energy or indulging in green activities will be credited tokenized green credits. The tokens can be:

   1. traded for existing carbon credits

   2. gives access to verify & invest in green projects through DAO

2. Traded tokenized credits get more & more of us involved in making sure environmental obligations are met & observed

3. dApps & DeFi applications will make sure adequate liquidity is available to finance green projects & reward contributors for their work

In 2021, $500B worth of green bonds were issued, but the impact is still negligible. There's no transparency in activities & accountability for negligence.

Advantages & Challenges

The Decentralized Climate Finance DAO would have several advantages over traditional organizations that manage climate finance.

• First, because the Decentralized Climate Finance DAO would be decentralized, it would be much more resistant to corruption and fraud.

• Second, the use of blockchain technology would allow all transactions to be transparent and trackable, further reducing corruption and fraud.

• Third, the Decentralized Climate Finance DAO would be able to tap into a global pool of talent and resources, which traditional organizations often need help to do.

• Finally, because the management of climate finance is done in a decentralized way, i.e., stakeholders are shareholders, it is likely more efficient than traditional methods.

Decentralized Climate Finance DAO could revolutionize how climate finance is managed globally.

To make this happen, however, some challenges need to be addressed.

• First, developing a robust governance model for the Decentralized Climate Finance DAO will be necessary. This will ensure that the organization can make decisions decentralized while still being accountable to its members.

• Second, building trust in the organization's members and the wider public will be essential. This can be done by ensuring that all transactions are transparent and by developing a good reputation through successful initial projects.

• Finally, it will be essential to scale up the DAO to significantly impact global climate finance by giving access to critical climate-hit areas.

If these challenges can be addressed, Decentralized Climate Finance DAO can transform how climate finance is managed globally.

Possible Additional Operational Models to Explore for the DAO

1. Building a carbon credit exchange platform to support an ecosystem of green finance applications on the blockchain along with a Green Assets Protocol. The first use case will be to launch Green Assets Wallet (GAW), a digital wallet for storing and trading carbon credits, renewable energy credits (REC) & other environmental assets.

2. Creating an Ethereum-based accelerator program to select promising projects that want the critical support and resources to succeed. The goal is to improve the dApps and accelerate deployment continually.

3. Creating an Investment Exchange/Crypto-Index fund featuring ETF products (group or pooled investments) based on virtual portfolios. The portfolios are modeled to respond automatically to the underlying market's complex dynamics.

4. Creating a simulated social currency/rewards network on the blockchain. The intention is to see how the global community will react to the incentives and reward system.

Diving deep into the first revenue stream use case:

The first use case will be to launch Green Assets Wallet (GAW), a digital wallet for storing and trading carbon credits, renewable energy credits (REC) & other environmental assets.

The wallet can be integrated with existing exchanges, so it acts as another avenue for buying & selling these assets without worrying about managing the underlying blockchain infrastructure.

GAW will also have real-time pricing data and market analytics tools built into it, making it easier for users to make informed investment decisions when buying or selling their assets.

The next application they are developing is called the ‘Green Assets Protocol,’ which aims at simplifying transactions between buyers and sellers of environmental assets by standardizing contracts using smart contracts on the Ethereum blockchain.

This will eliminate counterparty risk while allowing both parties to track their asset holdings securely in real-time via GAW. Also, a carbon footprint calculator will help individuals & businesses calculate and offset their carbon footprints. The goal is to integrate the application with decentralized exchange platforms so that users can easily buy/sell credits to offset their emissions.

Disclaimer:

Not financial or investment advice. This blog is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any investment decisions. Do your own research.

Thank you for reading through. I’d appreciate it if you shared this with your friends, who would enjoy reading this.

You can contact me here: 0xArhat.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

9. What's the Best Way to Create Value with Selective Data?

Data Collection & Distribution in Web3 is a Significant Challenge

While there is no one-size-fits-all answer to this question, the best way to create value with selective data will vary depending on the specific data set and the organization's goals.

However, some tips for creating value with selective data include identifying key trends and patterns, developing targeted marketing campaigns, and creating custom reports or dashboards.

Especially for a large data set, where analyzing data from different demographics would affect the kind of shared data.

I’ve been thinking about how data can be used to build value at scale.

I have outlined five core assumptions of this design:

If we take these assumptions as accurate, then it follows that to build value at scale, we need to be able to structure data in ways that maximize its value.

These assumptions from my POV suggest that it makes sense to focus on the minor data necessary to meet reasonable minimum goals because token adaption within the retail segment is minimal.

The downside of this approach is that you are not releasing the full potential data to other buyers (who may want to use it differently without tokens).

Focusing on delivering data in exchange for tokens without releasing reconstructions of comparable data to other buyers would limit opportunities for value creation.

Another question that pops up:

Can platforms operating in Data as a Service (DaaS) build a data marketplace on their platform, where aggregators & buyers themselves may use data? (Assuming that the platform has a native token.)

This data marketplace would enforce predefined pricing and supply rules. This turns data into becoming liquid and tradable in real time.

For example, when it comes to data used for machine learning, releasing AI-relevant data is a good idea: Several buyers could use it in more valuable ways.

Regarding the platform's native tokens, there is another aspect to consider.

The challenge, of course, is that there is no one-size-fits-all solution for data architecture. The right approach depends on the specific needs of the business and the types of data involved.

That said, some general principles can be applied in most cases:

1. Simplicity is key: The goal should be to design systems that are as simple as possible while still meeting the needs of the business. This will make it easier to maintain and evolve the system over time.

2. Flexibility is essential: The system should be designed to easily accommodate changes in the types of data being collected and processed and changes in the way the business uses data.

3. Scalability is crucial: The system must be able to scale gracefully as the volume of data increases. This includes both horizontal and vertical scalability.

4. Performance matters: The system should be designed to handle the increased volume and complexity of data without sacrificing speed or accuracy.

5. Security is paramount: The system must be designed with security in mind to protect sensitive data from unauthorized access and misuse.

6. Data quality is essential: The system should be designed to ensure that the data being collected and processed is high quality to be used effectively by the business.

7. Usability is essential: The system should be designed to be easy to use so that it can be used by a wide range of users, from technical experts to non-experts.

8. Maintenance is a necessary evil: The system will require ongoing maintenance, so it should be designed to do this quickly and efficiently.

9. Documentation is essential: The system should be well-documented so that it can be maintained and evolve over time.

How Would the Focus Shift From Releasing Data From Aggregators To Buyers Within Different Operational Segments?

For example, when trading industry-relevant data, a user could decide to trade their data units from others in the network only if that other user has positive feedback from the other users with whom they interact.

This is because I'm considering user privacy into context, which will definitely structure the operational process.

With this feedback, the user — by trading with that other buyer — would have something to offer to his network companies.

Any industry-relevant data enables a new kind of network effect because today, everything is tracked.

For example, data that other buyers in data analysis could use to find profitable product strategies can increase the chance that other B2B players will buy data themselves.

The more data new users generate, the more revenue is generated by the services that sell their data to other buyers. Since the platform & its users can, in essence, control the pricing and supply of data, they can decide exactly where they want to take advantage of the data distribution network.

Therefore, data distribution for multiple purposes may be viable for an initial online data economy.

In the end, it all boils down to the following:

1. Identifying what data is most valuable to your target audience.

2. Use that data to create a unique and compelling offer that your target audience will find irresistible.

3. Promote your offer through channels that will reach your target audience.

This creates value from selective data sharing, which is a critical factor in the success of any data-driven business model. Platforms will have an advantage over traditional data markets because it offers a more efficient way to connect buyers and sellers. In addition, it allows for development of new applications that can be used to monetize data.

Thank you for reading through. I’d appreciate it if you shared this with your friends who would enjoy reading this.

You can contact me here: 0xArhat.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

8. DeFi Lending & Borrowing Primer: Part 1 & Part 2

In case you missed it: Primer Series Part 1: Intro to Lending & Borrowing Mechanics

Deep Dive: CDMs & CDPs

Part 2 of this primer focuses on two primary operating models used by borrowing and lending projects.

(Over) Collateralized:

1. Debt Markets: where the DeFi protocol has both borrowing and lending capabilities (two-sided credit market), and

2. Debt Positions: where the DeFi protocol only allows users to borrow crypto assets (one-sided credit market).

This primer will focus initially on a brief overview of each model and then I provide an in-depth case study on Compound, Aave, and Maker.

Collateral Debt Markets (Compound and Aave)

Collateralized debt markets (CDMs) are DeFi platforms that provide two-sided credit markets via lending pools, essentially a smart contract used to coordinate borrowing and lending among market participants.

The borrowing process for CDMs: a borrower with sufficient collateral submits a loan request with borrowing parameters. When all parameters are confirmed, the loan is executed.

As shown in the figure above, lenders can deposit crypto assets and earn interest income to provide liquidity. Borrowers can deposit collateral in exchange for borrowing & withdrawing a different crypto asset.

Within the lending side, a market for each approved crypto asset creates a liquidity pool, and deposit rates are algorithmically calculated based on supply and demand for the asset.

For example, the interest rate for a particular crypto will increase as:

1. the supply of the asset decreases (lesser deposits) and/or

2. the demand for the asset increases (more borrowings),

and vice versa.

CDMs can also be termed autonomous money markets that reduce the friction often associated with traditional debt markets linked to negotiating interest rates and additional loan terms.

Case Study on Compound— A Collateralized Debt Market Protocol

Transaction Overview

Once a lender’s wallet is connected to the Compound application (link here), the transaction process works as follows:

1. A lender deposits ETH into the ETH pool, which is then available for other users to borrow at a variable rate.

2. The lender receives a cETH

3. To close the position, the lender then exchanges cETH back into the protocol to recoup both the principal deposit and accrued interest.

Note: ‘cETH’ is an interest-bearing ERC-20 token used to record ownership within a given market.

On the borrowing side, a user must supply cETH as collateral to borrow USDC from the lending pool. Thus, the process works as follows:

1. The borrower must first deposit ETH into the lending pool.

2. The borrower simultaneously mints a proportionate amount of cETH.

3. The borrower then deposits the cETH as collateral for a loan.

4. At this point,

   1. the borrower withdraws USDC from the lending pool based on the collateralization ratio specified.

   2. Interest payments are then automatically added to the borrower’s outstanding debt balance, which is paid when the borrower wants to retrieve the ETH deposited by them as collateral.

5. To close the loan at any time, the borrower repays the outstanding ‘USDC + Interest‘, which unlocks the collateral.

   1. Each deposit is assigned a collateralization ratio, and more volatile cryptocurrencies have higher collateralization requirements.

   2. If the loan becomes under-collateralized (i.e. if the value of the ETH falls below the predetermined threshold ) and the borrower does not quickly top up the collateral, the position is liquidated directly on the open market at the current market price to fund the outstanding debt balance.

What are cTokens?

After supplying crypto into the pool, a lender automatically receives ‘cTokens’, which are ERC-20 tokens representing the type and amount of assets deposited. There is a different type of cToken for each market, such as ‘cETH’ for ETH or ‘cDAI’ for DAI.

Each cToken can be viewed as proof of a deposit that essentially tokenizes the user’s ownership stake within a given liquidity pool based on the proportion of funds added relative to the total supply.

As mentioned before, rather than receiving periodic interest payments, interest income automatically accrues to a lender through the variable exchange rate between cTokens and the underlying crypto asset.

The number of cTokens owned by a user doesn’t change. Still, each token becomes convertible into a more significant amount of the underlying pool of assets as borrowers pay interest. A lender can withdraw funds from the pool at any point by converting cTokens back into the underlying asset at an exchange rate that increases or decreases over time as borrowers pay interest back into the platform. This is the mechanism by which interest income is distributed to lenders.

For instance:

Let’s assume there are 50 ETH in the ETH pool and 2500 cETH in circulation. I deposit 20 ETH (total of 70 ETH) into the pool and receive 1000 cETH at the current exchange rate (i.e., ~50 cETH/ETH).

After I deposit the ETH, the protocol automatically mints the number of cETH needed to reflect my ownership (i.e., ~28% = 1000 cETH/3500 cETH) of the ETH pool.

Over the next few months, there are no new deposits, but borrowers pay 3 ETH in total interest payments to the lending pool.

As a result, the ETH market consists of 73 ETH but there are still 3000 cETH outstanding, so the new exchange rate is 41.1 cETH/ETH.

Thus, now I own 1000 cETH, which can be redeemed for ~24.33 ETH.

The primary benefit of cTokens is improved capital efficiency and market liquidity.

I, as a lender, can earn interest income while simultaneously deploying cTokens across other DeFi applications, such as decentralized exchanges or other lending protocols. This means that in addition to earning a yield on the deposited crypto assets, I can also use cTokens to further participate in DeFi protocols, such as providing liquidity to a DEX or engaging further with other lending & borrowing protocols.

Rather than paying a transaction fee for each periodic interest payment, borrowers & lenders are only required to pay transaction fees when opening or closing a position. From the protocol’s perspective, interest payments are also retained within the lending pool rather than being immediately distributed to user wallets, which improves market liquidity.

FAQ

1. Can lenders simply buy more cTokens to increase the interest they earn? No, cTokens cannot be purchased on an open market as cTokens can only be minted and held by lenders as long as they provide liquidity to the shared pool of that particular crypto asset.

2. How will borrowers and lenders benefit? Borrowers receive interest income from cTokens that can be converted to the underlying crypto asset. Lenders turn their unique insights on borrowers into direct profits by receiving cTokens that they can convert to the underlying crypto asset. Also, by minting cTokens, lenders:

   1. earn interest through the cToken’s exchange rate, which increases in value relative to the underlying asset, and

   2. gain the ability to use cTokens as collateral.

3. How does this relate to lending/borrowing on other decentralized lending platforms? *cTokens represent assets in a loan that are supplied by the lenders. Based on the borrowers' ability to repay the loan, lenders are rewarded for their deposits as such borrowers and lenders do not directly compete with each other.

Interest Rates Support Market Liquidity and Stability

Since Compound lends collateral assets to borrowers, lenders assume liquidity risk when supplying capital to a lending pool (also referred to as protocol risk), essentially the inability to withdraw the principal deposit amount and/or interest income.

Unlike traditional credit markets where there are intermediaries such as banks, rating agencies, and so forth to hedge liquidity risk, Compound or any other DeFi protocol does not establish these hierarchies. This lack of objective and structured methods for mitigating liquidity risk introduces the potential for unpredictable liquidity events such as bankruptcy and illiquidity.

Compound does not guarantee liquidity to lenders or borrowers, but each lending pool must maintain sufficient liquidity such that assets are available for withdrawal at all times.

Reserves are an easy way for lenders to deposit their crypto assets with attractive interest rates and allow borrowers to create a hedged portfolio from Compound borrowing pools. Since compound does not have direct control over the reserves, so the collateral deposited while borrowing from a pool is designated as safe. This increased efficiency allows users to borrow more and lend more, with borrowers having more liquidity.

The probability of a black swan event would involve a scenario where lenders try to withdraw more funds than are currently available.

From the previous example:

If I was the first lender to deposit 30 ETH into the ETH lending pool and a day later, Ryan pledges collateral in the form of a different crypto asset and withdraws 20 ETH from the lending pool. So now, the lending pool only contains a total of 10 ETH.

I would be unable to withdraw my full deposit until Ryan repays his loan of 20 ETH with interest.

In this context, each lending pool must maintain sufficient liquidity. One great feature of Compound is that its interest rate algorithm is designed to incentivize a healthy market liquidity level. Therefore, a ‘bank run’ event is improbable.

• The interest rates for both borrowing & lending are primarily driven by the utilization rate (i.e., the percentage of deposits on the platform that has already been lent out) within each market (i.e., borrowing demand compared to total supply).

• As the liquidity for a particular crypto asset in the market decreases (& utilization rates increase), the platform automatically increases the lending and borrowing interest rates, incentivizing users to lend crypto assets and repay outstanding debt + interest.

• Conversely, during periods of high liquidity (and low utilization rates), the platform automatically decreases interest rates such that lenders are encouraged to withdraw deposits or borrow other crypto assets.

According to Compound’s whitepaper, this formula describes the platform’s borrowing and lending interest rates.

• Borrowing Rate = Base Rate + (Utilization Ratio * Multiplier)

• Lending Rate = (Borrow Rate * Utilization Ratio) x (1 - Reserve Factor)

• Utilization Ratio = Borrowed Assets / Supplied Assets

The loans on any CDM protocol are always overcollateralized, and so is the case with the loans borrowed on Compound. Hence, there’s very little probability that the utilization rates exceed 100% because borrowers always have sufficient interest income to fund the lending rate. While market conditions influence utilization rates, the remaining interest rate parameters are determined by Compound Governance, including:

1. Base Rate: Minimum borrowing rate assuming there is no demand for the asset.

2. Multiplier: Expected change in utilization levels.

3. Reserve Factor: % of the interest on borrowed funds held by the protocol.

Rather than allocating the entire interest payment to lenders, Compound collects a part of the revenue in an insurance pool to cover any future defaults.

For example, a borrower’s collateral may be insufficient to fund their outstanding debt if a loan becomes under-collateralized due to an extreme and sudden price movement. In this scenario, lenders are repaid using the assets from the reserve pool.

Another great example of a CDM protocol is AAVE. I have already briefly written about it here: How is SavingBlocks Optimizing DeFi in its Business Model

Aave: A CDM Lending & Borrowing Protocol

Quick Points:

• Aave, built on top of the Ethereum blockchain, is a DeFi lending protocol that allows users to lend or borrow crypto assets via liquidity pools.

• Aave has a governance token called Aave which allows holders to vote on governance issues of the protocol.

• Lenders deposit cryptocurrencies into liquidity pools and earn interest on the cryptocurrencies.

• Meanwhile, borrowers deposit cryptocurrencies as collateral to receive a loan in another cryptocurrency.

• Aave currently has liquidity pools for over 15 ETH-based assets such as USDT, DAI, USDC, GUSD, LINK, BAT, UNI, and much more.

Similar to Compound, when a user deposits their crypto assets into any of the Aave liquidity pools, the lender receives “aTokens” (similar to the cTokens) in exchange.

For example, if the user deposits 100 ETH tokens into the Aave liquidity pool, the user receives 100 aETH tokens that can be exchanged for the underlying collateral. As an ‘aToken’ holder, the lender receives interest. If there is more borrower demand for that token than lenders’ supply, then interest rates would move higher and vice versa.

The holders of AAVE (the native cryptocurrency of the protocol) also benefit from not being charged a fee when taking out a loan denominated in Aave and borrowers that post Aave as collateral get a discount on fees.

Aave offers several new features, including:

• Multiple lending pools Aave supports multiple lending pools. Each pool consists of its own collection of tokens with independent interest rates and liquidity levels, which helps the protocol mitigate potential contagion risks.

  1. For example, the Ethereum AMM Liquidity Pool was the first liquidity pool launched on Aave and allows Uniswap or Balancer liquidity providers to deploy “LP tokens” as collateral.

  2. The interest rates and other market dynamics within the AMM Liquidity Pool are separate from other pools on Aave.

• More stable borrowing rates: Risk-averse users can borrow funds from Aave’s lending pools at a more stable interest rate. Importantly, these rates are regular (not fixed) as the protocol may adjust the borrowing rate given extreme market conditions, and lending rates are continuously variable.

• Credit delegation: One offering on the Aave platform allows a lender to extend an unsecured loan to a known counterparty. The lender takes the credit risk, dictates which borrowers are eligible for participation, and sets the terms of the loan using a smart contract.

  1. For instance, Edouard can deposit an approved crypto asset into the Aave Protocol in exchange for ‘aTokens’.

  2. But instead of designating the aTokens as collateral to receive a loan, Edouard can set up a Credit Delegation Vault (CDV) and earn additional interest by “delegating” a line of credit to Diego with predetermined loan terms such as the borrowing limit and interest rate.

  3. Once delegated, Diego can use Edouard’s assets as collateral to withdraw funds from Aave.

  4. Since Diego does not deposit collateral, Edouard cannot enforce repayment, and the loan is therefore backed by trust.

• Flashloans: An unsecured loan where the borrower receives and repays the loan in a single, multi-step transaction. In most cases, Flash loans are typically used to execute arbitrage transactions, refinance debt positions, and optimize returns across various dapps. But in general, Flash loans represent a three-act play: 1) receive a loan, 2) do something quickly with the loan, and 3) repay the loan.

  In Aave, borrowers with no collateral can take a flash loan. In a flash loan, the smart contracts have rules that the borrower must pay back the loan (with a small fee of ~0.09%) before the transaction ends, or else the smart contract will reverse the transaction as if the flash loan never happened in the first place. As a result, neither Aave nor the user takes any risk.

Flash Loans Use Cases

Users that take out a cryptocurrency flash loan can use it to buy an asset, sell the cryptocurrency, and then return the original amount in the same transaction while pocketing the profit.

Use cases for flash loans include arbitrage and debt refinancing.

Arbitrageurs can use flash loans to take advantage of price differences between markets to make a profit without putting up any collateral. Meanwhile, borrowers can use flash loans to take advantage of differences in lending rates on various lending protocols.

For example:

• Suppose the borrower has an existing loan at Compound with a 10% interest rate but wants to refinance the debt at Cream or Notional Finance, which offers a 5% interest rate.

• In that case, the user can take out a flash loan and repay the loan in lending protocol A and then borrow at lending protocol B at 5%. After receiving the proceeds from lending protocol B, the user can pay off the flash loan at Aave.

• This flash loan occurs within the time it takes for an Ethereum block to be added to the chain, which is about every 15 seconds.

It is also worth noting the AAVE protocol recently launched a new upgrade, Aave V3, which includes new features, including cross-chain interoperability, improved capital efficiency, and new risk management capabilities. In January 2022, Aaave released Aave Arc for institutional investors.

Aave Arc (Aave Request for Comments)

• Aave’s product for institutional investors to address security, fraud, and money laundering risks in the DeFi ecosystem creating new lending and borrowing pools exclusively for institutional investors.

• Strict KYC procedures need to be followed, both on the borrowing side as well as the lending side. Furthermore, Aave implements anti-money laundering and antifraud compliance through an established third-party service provider.

• These measures enhance risk mitigations for institutional investors and lead to a positive feedback loop with higher institutional participation in these exclusive liquidity pools. The platform supports bitcoin, ether, Aave, and USDC.

(Over) Collateralized Debt Positions (CDPs)

CDPs are lending platforms that offer (over)collateralized loans via a single-sided marketplace. The borrower’s experience is similar to CDMs such as Compound or Aave.

The user deposits a cryptocurrency as collateral in exchange for a different crypto coin. But the back-end tech is designed differently. A CDP-based system does not create an AMM (autonomous money market) but is based on the economic design of a decentralized stablecoin.

Playing with Analogies

• CDMs act like banks: where cash by depositors is lent out to borrowers,

• CDPs deposited funds are locked in a vault to backstop the issuance of a newly minted stablecoin (e.g., DAI).

  • These fresh stablecoins are then provided to the borrower as an overcollateralized loan, with the protocol setting an interest rate.

  • In order to get the initial deposit/collateral back, the user must repay the loan with interest in full.

  • By periodically changing the interest rate, the protocol ensures the proper flow of funds to maintain the stablecoin (e.g., DAI) peg at $1.

As you can see below, a borrower can draw liquidity in the form of newly minted tokens (usually stablecoins) without relying on other market participants.

Case Study: Maker

The value proposition for the borrower is the ability to maintain exposure to collateral assets while improving liquidity with DAI, which can be sold for cash or deployed across DeFi applications.

Rather than lending the deposits themselves, Maker locks the collateral in a smart contract and leverages its borrowing and saving products to support the growth and stability of the DAI stablecoin.

Transaction Overview

A user can access the Maker protocol through the Oasis app.

Once a wallet is connected to Oasis, the borrowing process works as follows:

1. The user deposits ETH into a “vault”, which is a smart contract that locks the collateral and records the $$ value of the deposit.

2. The user then receives DAI based on the specified collateralization ratio. Put another way, the borrower receives an overcollateralized loan in DAI that must be repaid in the future.

3. The borrower repays the outstanding debt (initial amount + accrued interest) in DAI to unlock the previously deposited collateral, i.e., ETH.

For example

Suppose Ryan deposits 12 ETH into a Maker vault with a collateralization ratio of 300%.

As of today (12 Nov 2022), 1 ETH is worth ~$1200; Ryan deposited ~$15,264 worth of ETH, which allows him to mint up to ~8900 DAI.

But Ryan is bright and mints less than the maximum limit to provide a buffer before a potential margin call in the event that he gets liquidated. So, Ryan mints ~5000 DAI.

• Ryan's liquidation price for the loan of 5000 DAI is $728.

• *If he had borrowed 8000 DAI with a collateralization ratio of 190%, his loan’s liquidation price would have been $1,122.*

• So the buffer of ~$372 gives him more time to capitalize on his investments with the loan. There’s also a liquidation penalty invoiced directly to incentivize vault owners to avoid liquidation. This penalty fluctuates with the overall debt of the vault.

Interest payments then subsequently accrue on Ryan’s loan based on a variable interest rate, which is actively managed by Maker governance to drive the price of DAI toward its peg (vs. Compound, where interest rates are determined by supply and demand).

And rather than paying interest periodically over a predetermined term, Ryan can close the debt position at any point by repaying the principal + accrued interest.

Maker’s DAI & How the Platform Maintains Its Peg

How is a one-sided credit marketplace more successful & profitable than a two-sided credit marketplace such as Compound or Aave?

There are two primary factors responsible for the success of the Maker protocol:

A. Supporting the $1 Peg: Three factors support & maintain the stability of DAI:

1. The DAI savings rate (DSR),

2. Stability fee to maintain the supply of DAI, and

3. A limit on the supply of DAI against the collaterals.

B. (Over) Collateralization: By overcollateralizing the loans within vaults, Maker protocol hedges its loans against the volatile nature of crypto.

Let’s dive into each in more detail.

A. Supporting the $1 Peg

DAI is an ERC-20 token, like many stablecoins that trade on the open market. As we saw with Luna-Terra, all stablecoins are subject to heavy fluctuations around their $1 peg.

Like many stablecoins:

1. the demand for DAI is spread across its activity on various DeFi platforms or just a desire for a DeFi user to hold a comparatively stable (safe haven) asset

2. the borrowing activity predominantly drives the supply

Hence, the Maker Protocol leverages three primary strategies to maintain the dollar peg:

1. Stability Fees

The stability fee manipulates the supply of DAI and, in turn, helps maintain DAI’s $1 peg. This fee ranges between 0.3%-0.75% between various collateral assets.

1. When the demand is low (DAI is trading below $1), Maker’s governance increases the stability rates to incentivize borrowers to repay the debt, reducing the supply of DAI outstanding on the open market and putting upward pressure on the price of DAI.

2. Contrarily, when DAI trades above $1, Maker’s governance decreases stability rates to incentivize market makers to open a Maker vault, which increases the supply of DAI outstanding and puts downward pressure on the price of DAI.

2. DAI Savings Rate (DSR)

The Maker protocol guarantees a stable value for its DAI stablecoin. To make DAI an inflation-resistant currency, it doesn’t rely on central banks or governments to ensure its stability.

Instead, DAI’s stability is assured by providing users with a variable interest rate, DSR, in exchange for depositing DAI into the protocol.

DSR manipulates the demand for DAI as MakerDAO votes on a lower or higher DSR to influence holders to sell or buy DAI on the open market.

DSR is funded with a percentage of borrower interest payments.

Identical to how a bank charges a higher interest rate on loans than what it offers for the customer’s cash deposits, Maker’s protocol inflows must always be greater than the protocol outflows.

Interest Payments >> DAI Savings Rate (DSR).

Maker Protocol’s DSR differs from Compound or Aave’s as it is not a lending contract, and no party on the other end is borrowing the DAI tokens. The purpose of the DSR is to protect the dollar peg of the DAI stablecoin.

3. Collateralization Ratio (CR)

A CR is a debt ceiling constraining the total supply of DAI available for issuance against different collateral assets. If your loan on the vault reaches its liquidation price, the new DAI cannot be minted until outstanding debts are repaid. Maker’s governance adjusts the debt ceiling of various collateral assets to maintain supply based on current demand levels.

B. (Over) Collateralization

Given how volatile the crypto markets have been lately, the value of collateral locked within vaults must exceed the value of debt outstanding (as measured by the total supply of DAI).

Like Compound, MakerDAO loans are therefore over or sufficiently collateralized based on a predetermined collateralization ratio, typically in the 150% to 200% range, depending primarily on the collateral volatility and borrowers’ risk appetite.

If the collateral value falls below the collateralization ratio, the borrower must

1. repay the loan in DAI or

2. deposit additional collateral.

Otherwise, the protocol incentivizes network participants referred to as “keepers” to scan loans eligible for liquidation. A keeper can sell crypto collateral to repay the loan in DAI and close the borrower’s debt position.

In doing so, the keeper earns a “liquidation penalty”, a fee deducted from the borrower’s collateral and calculated as a percentage of outstanding debt (~10% to 15%). After applying the liquidation penalty, the remaining collateral is returned to the borrower.

It is worth noting that keepers tend to be (sometimes) automated bots that constantly monitor open vaults. It is my understanding that MakerDAO currently manages most keepers, but the long-term goal would be to transition toward more community management.

Further, the MakerDAO Treasury assigns a portion of stability fees towards a backup pool to cover future bad debts referred to as “protocol debt”.

For instance, if the value of a borrower’s collateral decreases below the debt outstanding before the liquidation, the position may be closed at a loss such that MakerDAO assumes protocol debt. In this scenario, the protocol uses funds from the reserve pool to fund the DSR.

If the backup pool is inadequate to fund new protocol debt, there are 2 primary solutions:

1. Auctioning newly minted MKR tokens in exchange for DAI stablecoin, which subsequently pays off the protocol debt. Consequently, the value of the MKR token is diluted.

2. Shutting down the protocol to ensure that all DAI holders and vault borrowers adequately receive the net value of assets to which they are entitled. This might only be done in a severe attack or a hack, as we saw with the BNB chain a few weeks ago.

Thoughts & Remarks

L1s are the primary roadmap for the financial applications of web3. Furthermore, the concept of interoperability enables powerful new capabilities to be layered on top of previously developed protocols, creating unique and more complex dApp ecosystems and co-dependent value-creation flows.

Indeed, "protocols" are becoming synonymous with "dApps" in DeFi.

With their open-source nature, dApps are essentially building blocks that can be combined to create robust protocols. This provides an incentive for protocols to innovate continuously and for dApps to increment in complexity rapidly, accelerating the pace of innovation in DeFi.

One potential for the non-linear evolution of DeFi dApps is that communities can leverage other protocols' innovations, which could cause DeFi to evolve faster than other disruptive business models.

Another is that it becomes challenging to pick winners because a protocol could develop a highly useful dApp that is subsequently improved upon by other developers who fork off with incremental advancements that supplant earlier iterations of the protocol.

While this model may make it harder to determine who the winners are, it does optimize the pace of innovation. This may explain the high velocity of improvement we have seen in DeFi. Also, we have regularly seen that the multi-sided platforms have a fundamental disconnect between their needs and the needs of the protocols they employ.

Before the merge, we saw data transmitted across thousands of blockchains with very high costs, gas fees, and network latency. We're collectively spending billions on scaling blockchains, yet individual L1s remain too small for security needs. And blockchains built on top of other chains are not optimized for their network latency. They need to build their network on top of them.

A handful of projects largely dominate the DeFi industry and its coin market capitalization. Because of this centralization (FTX, Celsius, BlockFi, etc.), it has become increasingly tricky to passively observe and evaluate the projects themselves and the changes they propose to the world. DeFi is still very much an ecosystem of beginners. Still, it is becoming expensive to the point where it becomes more reasonable to evaluate and understand the protocols they choose to build.

Most regulated financial infrastructure today still relies on legacy banking infrastructure. This has unfortunate consequences resulting from the separation of systems created by legacy banking:

• payments (settlement),

• clearing and settlement (funds to move money), and

• the custody of funds (assets).

Financial services are siloed and segregated into various parts, and the talk of DeFi is about the current and near-future evolution of smart contracts: a technology that is 5 years old but is in its nascent stage.

Part 3 of this primer series will focus on Key Performance Indicators to assess & understand Lending & Borrowing protocols and dApps.

Thank you for reading through. I’d appreciate it if you shared this with your friends who would enjoy reading this.

You can contact me here: 0xArhat.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

Check Out:

1. List of CDPs

2. List of Lending Protocols

DeFi: Crypto Use Case Operated to Create Actual And Valuable Utility

After what happened the last few months with Celsius, 3AC, and now FTX, DeFi lending & borrowing models have gained meaningful traction in a short period. This primer provides a comprehensive view of lending & borrowing within DeFi.

The purpose is to understand that the technology and strategy fortifying DeFi borrowing/lending models may eventually prove transformative despite a lack of market maturity.

As many have mentioned over the years, the most significant advantage of DeFi is that it enables anyone, anywhere, to participate. By refraining from traditional intermediaries, DeFi has significantly reduced the barriers to entry and the cost of participation for those who still do not have access to several financial instruments & services in the TradFi world.

Just as the Internet was arguably the first large-scale application of connecting computer technology, DeFi is already arguably more impactful than blockchain, crypto and the concept of web3 combined.

DeFi is Far From Being Mainstream, But the Momentum is Gradually Building

The premise that blockchains will disrupt traditional financial services rests on the idea that people will be empowered by access to previously unavailable financial services due to high barriers to entry. I believe that broader retail adoption of DeFi-based borrowing and lending will likely take quite a bit of time and is unlikely to impact consumer lending in the near term.

The entry barrier is high as users have to invest time and energy to get into the industry— and that’s before considering the money in TradFi, where depositing, managing & transacting money is among the least enjoyable things you can do.

Reasons include:

1. Risk profiles and risk appetites (e.g., most tradfi users are opposed to online lenders)

2. Lack of regulation in the lending space (decentralized lending is virtually unregulated)

3. Scarce liquidity, i.e., credit loss, hacks, liquidity crunch, etc., where major CeFi institutions such as FTX, Celsius, BlockFi, and many more have perished.

4. The narrow range of use cases and limited visibility into what the crypto assets are, among other things.

While each point has tremendous potential to be productized & monetized, most of the problems we see today result from these puzzle pieces falling into place at different rates.

However, it’s possible that as borrowers have more ways to benchmark the cost of borrowing and lenders have more ways to benchmark the return on lending, the extended ecosystem of DeFi retail investors may be more inclined to leverage crypto assets. Such platform interest income may help fuel the growth of decentralized lending protocols.

With adoption, these barriers should disappear, and actual mass adoption will hopefully result from better consumer education, competition, availability, and scalability. Put simply, DeFi would become more attractive, more user-friendly, and more transparent.

There are a large number of inherent challenges and uncertainties in figuring out:

1. how to on-ramp to the crypto world,

2. what accounts and wallets to set up, where to purchase altcoins,

3. how to transfer coins,

4. determining which coins are legitimate, how to engage with DeFi platforms,

5. risks of borrowing/lending/staking, and – probably most importantly –

6. how to secure your assets.

Many of these challenges exist in traditional finance because there is less competition, existing infrastructure, and institutional support. But with 20-80x return, you can’t ignore the potential and promise of DeFi.

So I expect that DeFi protocols will and should primarily focus on these three challenges:

While other protocols will focus on privacy, fungibility, or driving the user experience.

As an unprecedented amount of talent migrates to blockchain-focused businesses, it’s just a matter of time before most of these issues get resolved. As more legacy financial services providers embrace digital assets, onboarding becomes more effortless, bringing the masses to DeFi without having to open a new account.

As the different exchanges/wallets expand their available tokens, access expands, reducing the steps needed to explore beyond the relatively narrow list of assets available on many more mainstream exchanges. As more devices come equipped with cold storage options, the need for access to private keys is reduced, further increasing access.

The ecosystem continues to grow, and so with it, the need for scaling solutions. Ultimately, I believe that the “data network” which powers the future of the decentralized web will be, and is already, one of the largest computer networks.

So it’s only a matter of time until it becomes the most decentralized and resilient network on the planet.

Before I discuss borrowing & lending, I want to touch on the existing security problem in DeFi.

Security is absolute, and it’s a race against time. There are already many crypto projects that are advancing multiple approaches, but the ultimate goal of all of them is to replace legacy protocols with blockchain.

First of all, let me give you my definition of security.

Security is a digital asset’s refusal to change hands for insufficient value.

This general problem causes millions, if not billions, of dollars in yearly damages. And unfortunately, it appears to be wildly under-addressed in the crypto space.

Many projects aim to prevent security breaches with multi-sig wallets and voting systems. But a multi-sig wallet doesn’t solve the theft problem; it only reduces the chances of theft. And voting systems (even those based on smart contracts) require human operators.

The level of competition for personnel, training, and funding is so high that the odds of doing a fundamentally better job are minuscule. And the reality is that the best tech for securing digital assets is people. So if any crypto project is going to solve the security problem, it has to figure out a way to layer people on top of its tech.

The Impact on Legacy Lenders Should Build as New Lending Protocols Evolve

One of the innovations of DeFi is the access it gives borrowers to relatively inexpensive liquidity secured by financial assets while allowing them to maintain complete control of their borrowed funds. While most traditional banks enable customers to take out margin loans, the proceeds must be used to purchase securities in an account where the lender has custody of the assets.

Some wealthy individuals can secure liquidity against investments through their bankers, which is largely unavailable to the average retail investor. Individuals can also borrow against current pension savings, but the process can be cumbersome and come with several limitations that reduce the appeal.

By contrast, DeFi lending protocols enable borrowers to receive tokens borrowed against existing positions in an over-collateralized loan that any retail investor can then use for any purpose— whether it’s to buy a different digital asset or convert to fiat currency to do things like pay for a new car, a house or pay down debt.

The emerging DeFi industry has allowed lenders and borrowers to transact securely and efficiently acrossDeFi'snetworks worldwide. DeFi’s market value will be fertile ground for attracting crypto investors as it grows.

Because the protection collateral gives lenders against default (or risk of bankruptcy), secured loans are inherently less risky than unsecured. They tend to cost borrowers less than unsecured loans in terms of interest rates. While there haven’t been many signs that DeFi is being used to take proceeds off-chain to pay other debts, as holdings of digital assets grow, this seems inevitable, given the inherent cost advantage of secured lending vs. unsecured.

DeFi Borrowing & Lending Protocols Are Disruptive

DeFi borrowing & lending protocols are one component of the application layer of the broader crypto/blockchain ecosystem. As of November 2022, borrowing and lending are among the largest DeFi categories, with ~20.8B of total value locked (TVL), representing ~30% of the DeFi market share.

Suppose you are new to the world of DeFi. In that case, there are four primary value propositions for retail investors across the DeFi borrowing and lending space— especially when compared to TradFi services.

These Include:

1. Composability and potential for rapid evolution: The open-source nature of DeFi projects tends to be the building block of more complex applications. As each piece improves, the applications for it grow. Invariably, new requirements are generated, which makes that piece work better. Many open-source ventures, especially in DeFi, begin with a concept and build an application on top of that concept. This provides an incentive for protocols to innovate continuously and for dApps to increment in complexity rapidly, accelerating the pace of innovation in DeFi. This composability has a couple of interesting implications.

   1. One is the potential for non-linear transition in the capabilities of linked dApps, as users can leverage the innovations of others, which could cause DeFi to evolve faster than other disruptive business models.

   2. Another is that it becomes challenging to pick winners because a protocol could develop a highly useful dApp that is subsequently improved upon by other developers who fork off with incremental advancements that supplant earlier iterations of the protocol. While this model may make it harder to determine who the winners are, it does optimize the pace of innovation.

2. Lower operational costs. It takes several days to process a bank loan; borrowing & lending dApps provide 24/7 access to debt markets where users can instantly borrow or lend tokens with the available liquidity (i.e., loans can be repaid or withdrawn at any time). Additionally, since the underlying protocol automatically processes principal and interest payments, these applications benefit from much lower overhead costs than tradFi. However, ignoring network throughput and capital limitations, it is possible that this operating model could be infinitely scalable.

3. Enhanced operational models. The crypto ecosystem is often critiqued for its anonymity and the potential for fraud and money laundering to thrive. Still, I believe the reality is the opposite; with high transparency, they will ultimately make the space easier to regulate than legacy financial services. For instance,

   1. The exact collateralization ratio of a given protocol is publicly available, and the protocol is constantly monitoring each borrower's health by actively tracking the value of the collateral.

   2. Another benefit of this transparency is that it makes it easier to see how decisions on DeFi protocols are made because the logic is lodged on a public blockchain, which is very different from tradFi, where the rationale behind lending decisions is often opaque.

   3. Any person or organization can theoretically audit DeFi protocols in real time so that users can identify and avoid potential financial scams, harmful business practices, money laundering, and other undesirable behaviors. ZackXBT is known to expose several financial scams, which are all possible because of enhanced transparency. Check out his investigations.

4. New capital-raising capabilities: Many DeFi protocols employ innovative tokenomics that enable builders to quickly deploy large lending pools at a relatively low cost. This is mainly done by incentivizing the lenders through issuing native tokens that usually come with some rights to either income or voting power on the protocol.

   1. Since these tokens cost nothing to create,

      1. if the protocol ultimately fails to gain scale, the cost is zero for the capital borrowed, but

      2. if it does achieve scale, the cost is the share of ownership given away.

   2. The returns for early liquidity providers to DeFi lending protocols can be significant, making it relatively easy to get the capital needed to establish a credible protocol.

The Use Cases of Today Have Defined The Roadmap For The Future.

A common question for someone beginning in DeFi relates to “who is actually participating in overcollateralized crypto credit markets?” The answer is primarily crypto-focused traders and investors.

From a borrower’s perspective,

a user can commit crypto holdings as collateral in exchange for a loan denominated in a different crypto asset.

There are three main reasons why a borrower would seek an overcollateralized loan:

1. Increased yield: As a depositor can maintain exposure to capital appreciation of the collateral assets while simultaneously deploying borrowed assets across yield-generating dapps or other investment strategies,

2. Liquidity requirements: As a token holder (e.g., someone who owns ETH, etc.) can source liquidity from the protocol without selling the underlying holdings, which would trigger a taxable event, and

3. Increased leverage can double down and construct a levered long or short position as a token holder.

The most common borrower is the sophisticated retail or institutional investor who deposits a volatile crypto asset as collateral (expecting the token value will remain stagnant or increase) in exchange for a loan denominated in another asset. This second asset is often more stable and is more suitable for generating yield/liquidity.

From a lender’s perspective,

The lender can deposit their crypto into a shared pool of assets in exchange for interest income.

With traditional bank interest rates at historic lows, many investors and traders seek ways to earn higher yields. DeFi credit markets provide an efficient method for crypto “HODLers” i.e., crypto holders intending to hold their positions indefinitely to increase returns on idle assets that are otherwise left idle.

For instance, a lender can deposit a stablecoin into a protocol such as Compound or Aave and earn a ~1-3%+ variable APY.

Recent Increase In Institutional Adoption Are Promising, but There Are Many Hurdles Still to Overcome

Several institutions, such as Paypal, Blackrock, JP Morgan, etc., play a growing role in DeFi as they roll out strategies to participate in this emerging space.

If you’d asked me a couple of years ago about active institutional adoption, it would have seemed far off because of the difficulty of forecasting liquidity and managing risks in crypto marketplaces.

But, as more liquidity providers and financial instruments such as options & derivations come into play in DeFi, we see the institutional adoption curve steepening.

I still believe that most financial institutions are in the “discovery” phase of DeFi, but face more considerable adoption hurdles related to stringent regulatory oversight and reporting requirements.

It’s also important to note that the requirements of institutions to adapt to DeFi can be mapped from the:

1. research,

2. pre-trade compliance, and

3. the best execution to monitoring, reporting, and custody.

Over the last two years, there has been an explosion in products and services in all these categories, with capital flooding in to build the necessary DeFi infrastructure, which is a great sign for the DeFi ecosystem.;

Deep Dive: Lending & Borrowing Mechanics

In part 2 of this primer series, I will dive deep into two primary operating models used by borrowing and lending projects:

(Over) Collateralized:

• Debt Markets: where the DeFi protocol has both borrowing and lending capabilities (two-sided credit market), and

• Debt Positions: where the DeFi protocol only allows users to borrow crypto assets (one-sided credit market).

Part 2 of this Primer contains a brief overview of each model and an in-depth case study that examines the inner workings of specific protocols leveraging the different models: Compound, Aave, and Maker.

Read Part 2 of the Primer Series here: Deep Dive: Compound, AAVE & MakerDAO.

Thank you for reading through. I’d appreciate it if you shared this with your friends, who would enjoy reading it.

You can contact me here: 0xArhat.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

7. Centralizing Blockchain Ecosystems

There is no question that there is a strong element of centralization that has increased blockchain adoption. But is there some potential to collaborate the activity between various L1s?

As the number of blockchains & dapps grows, the need for interoperability increases. Interoperability allows blockchains to “talk” and exchange value or information.

• Imagine being told that you can use your BoA account to send money to someone else's account in the same bank and not to someone else whose account is in another bank.

• Imagine having the freedom to simultaneously use the benefits of the network effects of TikTok and the brand partnership model of Instagram without having to create two separate accounts.

Within the crypto ecosystem, the individual L1s act as silos. They lack interoperability. Users can’t move their native coin from one chain to another.

Hence, the most obvious step after Decentralization is Distribution. This would stabilize the thesis of centralization in web3.

Here Comes the Bridge

A bridge protocol allows a blockchain to interact with other blockchains.

A bridge protocol improves the overall ecosystem by:

• Allowing interoperability between chains

• Increasing usability

• Enabling easier access to a broader set of users

• Reducing costs

• Improving security

• Enhancing user experience

• Improving interoperability between protocols

• Enabling better data portability

• Enabling easier access to data (for example, uploading data to the host, downloading data from the backend)

• Enabling applications to reduce the cost of transactions (for example, by decreasing the need to query individual blockchains)

• Enabling blockchains to compete with existing payment networks (for example, by decreasing the cost of exchanging value/information in/between (e.g., PayPal, PayTM, wire, bank, etc.))

Also, it's important to note that, despite the recent hype, these bridges are still in early development. The teams behind these projects improve the technology and user experience. However, as money changes hands, users need to be confident that this technology will work.

I have personally seen (dApp) founders test their tech in two ways:

1. Integrate the technology directly into their products: Users can then buy and use the service within the dApp between different L1s or L2s that prove the value of the technology,

and/or

1. A technical white paper with some degree of "white box" analysis can be used to prove the value of the underlying concept if the protocol works on a consensus mechanism.

Here’s an example of a bridge protocol in action:

A bridge protocol is like a smart contract that enforces the rules of payment and data sharing between them.

1. First, a user needs to send some $USDC from Solana to Ethereum. A bridge protocol allows users to use their Solana (Phantom) wallet to broadcast a transaction to the Metamask wallet.

2. The Phantom wallet signs a transaction that includes information like:

3. The transaction's destination address (wallet address). Other metadata about the transaction (for example, the transaction's quantity, price, gas price, etc.)

4. Before sending the transaction to the wallet, the Solana chain requires the Ethereum chain to satisfy the conditions specified in the smart contract. These conditions can be anything: data or money.

5. Above, this relates to the transaction's destination address and gas fees.

6. The receiving blockchain (Ethereum) checks that the transaction's destination address matches the issuer's address. For example, if the addresses match, the receiving blockchain signs the transaction and broadcasts it to the relevant blockchain.

7. The wallet receives the signed and completed transaction and issues its own transaction (similar to the original transaction on Solana) to the new blockchain wallet to complete the payment.

8. In this way, the bridge protocol enforces the rules of payment between the chains to ensure the transaction is valid.

Try it out here: portalbridge.com/#/transfer at Portal from Wormhole

Conclusion

In essence, the protocols need to make data that matches your situation available to the other blockchain. The protocol must be confident that the smart contract won't be exploited to provide the data for the wrong blockchain.

There is no question that there is a strong element of centralization that has increased blockchain adoption. Bridge protocols could be used as a method to aid the consensus mechanism for sharding and other concurrent solutions. It’s only a tiny fraction.

Not to mention that Bridges are the most vulnerable dApps out there. It’s still a long way to go. But I still believe there are many opportunities for this type of collaboration, especially between those with excellent engineering talent and backend infrastructure.

Thank you for reading through. I’d appreciate it if you shared this with your friends who would enjoy reading this.

You can contact me here: 0xArhat

Share on Twitter.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

6. Understanding User Dynamics in DeFi

Let me show you how user dynamics affect any DeFi platform you use.

In DeFi, three factors determine the motivation for a user to use that said platform:

1. Participation cost: Do I need to hold the native token or incur a participation cost to meet potential trade counterparties (i.e., to join the community)

2. Transaction motive: How many tokens do I need to hold and/or stake (which depends on platform liquidity) to get a voting share of the platform?

3. Investment motive: How can I leverage my participation cost to benefit from the expected (increased/decreased) future token price? This motive splits the community into two parts: short-term & long-term HODLERS.

This split is a crucial factor to consider because this determines the kind of investment strategies users use on the platform.

With this, the platform achieves two important things:

1. It allows for interesting dynamics (e.g., HODL, variable speculators) within the platform.

2. It allows for the platform ecosystem to self-regulate. (e.g., adaptive governance, boundaries b/w investment strategies, etc.)

Currently, most platforms lack this motive due to

1. the implicit (lack of) participation cost (e.g., high token price on any excellent performing asset pair, undefined governance or roadmap, etc.), or

2. the unrealistic (lack of) investment motive (e.g., ETH/USD parity, strict tax regulations, etc.), which leads to the concentration of funding over the platform; users that are often termed as "whales".

Trading platforms rely on strong investment incentives to attract users. The speculative nature of the market allows investors to borrow on one token and recoup their investment with abnormal % returns in a short time.

This is not always realistic in a DeFi setting.

Another form of restricting profitability is a capital risk, i.e., $10k/user is too much to invest in the marketplace to realize a substantial return. Too big of a network effect to allow a beginner to create a product whose integration requires specialized implementation.

DeFi platforms must balance network effect with more technical implementation (e.g., smart contract adaptation) needed to create value for the user.

As we advance, we will see more crypto uses cases as a currency for value transfer. However, it will be more for payments and less as a speculative asset.

The hope is to enter a new economic era in which speculation is replaced by production, and research gives way to testing.

To summarize:

New user adoption exhibits an externality on others, but the investment motive also introduces an emphasized situation where two things improve or worsen in the existing user base.

The inverse is significant enough to form a network effect.

The strong network effect triggers the declining network cost, which in the long term impacts the attraction of long-only investment in the ecosystem.

Thank you for reading through. I’d appreciate it if you shared this with your friends who would enjoy reading it.

You can contact me here: Arhat Bhagwatkar.

Share on Twitter.

My previous research:

1. Decoding & Democratizing web3

2. P2E: A shift in gaming business models

3. Stablecoins: Is There Hope?

4. Unlocking the Potential of Decentralized Data

5. Primer on L2 Scaling Solutions

SavingBlocks is a DeFi-powered crypto fintech giving everyone safe & easy access to DeFi savings - to a mobile savings app live on both app stores (Apple & Google). They recently graduated 1st from the cohort in the Founder Institute (the largest accelerator in the world based in Silicon Valley) and three technology partnerships with top-tier companies for bank custody, digital asset custody, and identity verification.

I have had the pleasure to work with the founders, Edouard & Diego, as an Advisor over the past few months on the SavingBlocks platform from the ground up, discussing, testing backend DeFi investment strategies, and envisioning DeFi into the core of SavingBlocks.

Let’s look at how.

How is SavingBlocks Optimizing DeFi in its Business Model?

The founders of SavingBlocks believe that the broader retail adoption of blockchain-based DeFi services is gradually increasing and is unlikely to impact consumer spending in TradFi in the near term.

Reasons include:

1. the only gradual legitimization of digital assets as an investable asset class,

2. unmanageable UI/UX for many dApps relative to legacy financial services providers,

3. the lack of regulatory safeguards to protect consumers and regulatory clarity that would attract more new entrants/capital,

4. narrow range of use cases and limited visibility into what those are.

One of the innovations of DeFi is the access it gives investors to relatively inexpensive liquidity secured by financial assets while allowing them to maintain complete control of their funds. While most traditional banks enable customers to deposit money or take out margin loans, the proceeds are used to purchase securities in an account where the lender has custody of the assets. The value of the currency is already lost within the different processes a bank takes with your money in the bank to generate returns.

Hence, SavingBlocks is focused on creating financial products that

1. leverages new technological capabilities (NFTs),

2. *are easily understood (user-friendly UI, check here), and*

3. provides value to owners of digital assets (5% fixed interest on your fiat deposits).

To give you an overview of what use cases SavingBlocks look into while reinvesting retail deposits, I’ve narrowed it down to the following case study.

What are the Use Cases Today, and How Will the Market Evolve in the Future?

A common question relates to who is actually participating in overcollateralized crypto credit markets. We believe the answer is primarily crypto-focused traders and investors.

From a borrower’s perspective, a user can commit crypto holdings as collateral in exchange for a loan denominated in a different crypto asset.

There are three main reasons why a borrower would seek an overcollateralized loan, including:

1. Increased yield, as a depositor can maintain exposure to capital appreciation of the collateral assets while simultaneously deploying borrowed assets across yield generating dapps or other investment strategies,

2. Liquidity requirements, as a token holder (e.g., someone who owns ETH, etc.) can source liquidity from the protocol without selling the underlying holdings, which would trigger a taxable event, and

3. Increased leverage can double down and construct a levered long or short position as a token holder.

The most common borrower is the sophisticated retail or institutional investor who deposits a volatile crypto asset as collateral (expecting the token value will remain stagnant or increase) in exchange for a loan denominated in another asset. This second asset is often more stable and is more suitable for generating yield/liquidity.

From a lender’s perspective, a user can deposit their crypto into a shared pool of assets in exchange for interest income.

With traditional bank interest rates at historic lows, many investors and traders seek ways to earn higher yields. DeFi credit markets provide an efficient method for crypto “HODLers” i.e., crypto holders intending to hold their positions indefinitely to increase returns on idle assets that are otherwise left idle.

For instance, a lender can deposit a stablecoin into a protocol such as Compound or Aave and earn a ~1-3%+ variable APY.

SavingBlocks uses platforms such as Compound & Aave and invests in diverse liquidity pools (stablecoin focused) that ensure that the 5% fixed interest rate is met for all users on SavingBlocks.

Let’s understand how the borrowing and Lending mechanics work in Compound & Aave.

A Deep Dive into Borrowing & Lending Mechanics

There are two primary models used by borrowing and lending projects, including:

1. collateralized debt markets (CDMs), where the protocol represents a two-sided credit market with both borrowing and lending capabilities, and

2. collateralized debt positions (CDPs), where a one-sided protocol allows users only to borrow crypto assets.

Within lending, there is a market for each approved crypto asset, and interest rates are algorithmically calculated based on the supply and demand for the asset.

• For instance, the interest rate for a particular coin will increase as the supply of the crypto decreases (fewer deposits) and/or the demand for the asset increases (more borrowings).

• In this context, CDMs are autonomous money markets that reduce the friction associated with traditional debt markets related to negotiating interest rates and other loan terms.

A Case Study on Compound

Transaction Overview

Once a lender’s wallet is connected to the Compound application (link here), the transaction process works as follows:

1. A lender deposits an approved crypto asset into the pool, which is then available for other users to borrow at a variable rate.

2. The lender receives a “cToken”, an interest-bearing ERC-20 token used to record ownership within a given market.

3. To close the position, the lender then exchanges cTokens back into the protocol to retrieve both the principal deposit and accrued interest (which are withdrawn from the lending pool).

Interest Rates Support Market Liquidity and Stability

Since Compound lends collateral assets to borrowers, lenders assume liquidity risk when supplying capital to a lending pool (also referred to as protocol risk), essentially the inability to withdraw the principal deposit amount and/or interest income. Compound does not guarantee liquidity to lenders or borrowers, but each lending pool must maintain sufficient liquidity such that assets are available for withdrawal at all times.

A Case Study on Aave

Founded in 2017 by Stani Kulechov, Aave is another popular CDM platform based out of London, UK.

Aave offers several new features, including:

1. Multiple lending pools: Aave supports multiple lending pools. Each pool consists of its own collection of tokens with independent interest rates and liquidity levels, which helps the protocol mitigate potential contagion risks.

   1. For example, the Ethereum AMM Liquidity Pool was the first liquidity pool launched on Aave and allows Uniswap or Balancer liquidity providers to deploy “LP tokens” as collateral.

   2. The interest rates and other market dynamics within the AMM Liquidity Pool are separate from other pools on Aave.

2. More stable borrowing rates: risk-averse users can borrow funds from Aave’s lending pools at a more stable interest rate. Importantly, these rates are regular (not fixed) as the protocol may adjust the borrowing rate given extreme market conditions, and lending rates are continuously variable.

3. Credit delegation: One offering on the Aave platform allows a lender to extend an unsecured loan to a known counterparty. The lender takes the credit risk, dictates which borrowers are eligible for participation, and sets the terms of the loan using a smart contract.

   1. For instance, Edouard can deposit an approved crypto asset into the Aave Protocol in exchange for ‘aTokens’. But instead of designating the aTokens as collateral to receive a loan, Edouard can set up a Credit Delegation Vault (CDV) and earn additional interest by “delegating” a line of credit to Diego with predetermined loan terms such as the borrowing limit and interest rate. Once delegated, Diego can use Edouard’s assets as collateral to withdraw funds from Aave. Since Diego does not deposit collateral, Edouard cannot enforce repayment, and the loan is therefore backed by trust.

4. Flashloans: an unsecured loan where the borrower receives and repays the loan in a single, multi-step transaction. In most cases, Flash loans are typically used to execute arbitrage transactions, refinance debt positions, and optimize returns across various dapps. But in general, Flash loans represent a three-act play:

   1. receive a loan,

   2. do something quickly with the loan, and

   3. repay the loan.

It is also worth noting the AAVE protocol recently launched a new upgrade, Aave V3, which includes new features, including cross-chain interoperability, improved capital efficiency, and new risk management capabilities.

Conclusion

DeFi means anyone, anywhere, may participate in investments. This is a significant advantage over banks. It is no longer just a developing and visionary concept and is being championed by forward-thinking technologists and entrepreneurs worldwide.

By renouncing traditional intermediaries, DeFi significantly reduces the barriers to entry and the cost of participation. Investing in a DeFi project means one does not have to go through a bank and make time-consuming, tedious, and frustrating phone calls/personal visits to ask for a loan.

Further, unlike traditional lending, there is no counterparty risk, so if one defaults, the entire debt is taken over by the system. In essence, DeFi is changing how the world behaves by opening up more financial opportunities to more people in better ways.

Just as the Internet was arguably the first large-scale application of connecting computer technology, DeFi is already arguably more impactful than blockchain and crypto combined.

By initially investing in Stablecoins (USDC & USDT), the provenance and reliability of investments stay transparent. SavingBlocks ensures you do not lose your investment and can withdraw your deposit anytime.

If you have any questions, feel free to reach out to Edouard, Diego, or me, and we’ll be happy to assist you to come onboard SavingBlocks.

Disclaimer:

SavingBlocks does not only reinvest deposits in Compound & AAVE.

In the coming weeks, we will dive deep into more articles that give you a view of how SavingBlocks investment strategies return a positive surplus yield.

Complete transparency, as promised.

The articles will illustrate some of the well-known DeFi protocols SavingBlocks use for its detailed investment strategies. We’ll dive into more case studies on Yield Farming on DEX pools, Lending to companies on-chain, and many more.