Welcome, subscribers! Thank you for subscribing. What will be shared today and the days ahead are alpha from our Economics Design's researchers.
Please keep these mails secret and do not share them with any one because these alpha are confidential. Enjoy your reading.
TLDR below. This is not financial advice.
Catch the episode on YouTube
In this article we will have a look at the economics of value creation. It consists of three main things: the purpose of a market, value in a market, and economic balance. We also analyse the model of Vesper Finance, a portfolio management protocol, and look at six ways in which Vesper can transition from short-term growth objective to long-term growth.
Purpose Of A Market
A market is a space for buyers and sellers to come together to trade and transact. The market is not owned by anyone and is just a space for people to come in and trade. Examples of some public markets are countries, farmer’s markets, listed companies, etc. Examples of a private market are small little Facebook groups or it could be small online social media groups that you create with your friends.
In any ecosystem, be it a country, a market or a video game, the key asset of transfer is value. Value can be captured in forms of goods (i.e. barter trade of cheese for yogurt), in forms of common currency to be used in later dates (i.e. sovereign currency to be used to pay taxes) or in internal tokens, currencies (i.e. in-game currency for in-game activities) and NFTs (i.e. representation of digital assets).
A core thesis when you talk about value creation in a market is that it helps in long-term growth. What does that look like? It looks like GDP growth, tokens value accrual. How does it help? It helps people accumulate more value, hence wealth, in the market. We get wealthy because value is created.
Value creation is system-specific, it occurs when new assets are minted, new users join the system or long-term productivity gains are achieved. In a country, that could be intellectual capital created from a start up. In a token-ecosystem, that can be new protocols and tokens minted in the ecosystem.
Long-term productivity happens when productive, not merely financial, resources are attracted into the ecosystem that can contribute to the future growth. This can be compared to population growth in a country and investing in intellectual capabilities of the population.
This naturally creates inflationary pressure. The key to balance is the 2 types of inflationary pressures — both asset inflation and currency / price inflation.
First, you have value being created, followed by value being distributed to the different people in the game, and then value being realised.
Once value is realised, you have more capital to create more value. Long story short, what we are doing in token economics and economics in general is that we are trying to understand value; how value is created, how it is distributed, and how it is realised. This is not something too far from your economics 101.
In economics 101 instead of value, we look at goods and services being created, distributed, and consumed. Here these goods and services are just tokenised. And they are just a representation of value. At the end of the day, token economics is about understanding that a token captures value. It could be any kind of value, but it captures an intrinsic value within your system, and then we design economic policies to allow the value to run itself in this little closed-loop cycle.
Balancing The Value Cycle
When we are creating value, it is not realised immediately as it has to go through a value distribution process. When we talk about value creation we are talking about long-term growth. What does it look like in 5, 10 or 15 years, and how can that value be realised through this entire process.
Value distribution is the next step in this game. This step is a bit more immediate so this is where we look at short-term growth, inflation, and the general metrics that represent or signify that your ecosystem is growing.
You have this thing called nominal value and real value. We want to figure out what is the real value accrued to the different active users in any particular ecosystem. When they have enough capital being accrued then they can continuously create additional value.
As an economist, you have to figure out how to balance the long-term growth, short-term growth, and real value accrual to your active users. It is very easy to skew to one side.
For example one of the things that we see quite often is that projects are giving a lot of token inflation to the entire ecosystem which is value distribution or short-term growth.
It is not wrong, as in different stages of your ecosystem you need different kinds of incentives in place, and that is normal. What we want to do is figure out how to balance between giving a lot of inflation to get everyone involved, but at the same time think about long-term growth so that there is capital and value being realised which can be reinvested into the protocol for long-term growth.
Case Study: Vesper Finance
Disclaimer: we helped Vesper Finance in this value creation plan for its long-term growth.
Vesper is a portfolio management protocol. Users deposit tokens and get some of the native tokens in return. Let us say you put ETH in, then it helps you to figure out how to optimise your ETH returns and they give ETH back to you and at the same time, you also get $VSP which is their internal token.
The internal native token $VSP is used for two reasons:
Value creation: Instead of value creation in terms of protocol value distributed to the users of the protocol, we are thinking of something a bit more long-term. How do we reinvest in the protocol, how can the protocol continuously grow and how can the protocol continuously accrue value to create value for anyone that comes into the space.
Value Distribution: This is where we have $VSP token. Value accrual and token inflation is the mechanism to distribute the value created.
Value Realization: Value then is realised through the platform fees returns of the users.
What Has VSP Been Doing So Far?
What Vesper has been doing so far is that they have been focusing very much on value distribution and you can see that in the entire token allocation in the system. Right now a lot of the different platform fees being accrued are being converted to tokens and redistributed back to the active users and hence there is value realization.
One of the things that could be improved in the entire scheme of the game is to shift the conversation and shift the plans towards long-term growth or value creation. Value creation could be, for example, treasury management, partnership management, different kinds of operations, better marketing, better UI/UX, etc.
Vesper is now moving the conversation and plans towards long-term growth and looking at how do we shift economics towards continuously creating value in the long run.
This Is Done in Six Ways:
These are the six methods the Vesper DAO has voted a yes on.
1. Reduce The Withdrawal Fee
When withdrawal fees are reduced, it helps people to move funds towards asset pools with higher returns. That is a form of value creation. Thus, the withdrawal fee will be reduced for people swapping asset pools within the Vesper protocol.
2. Increasing The Yield Fee
Taking the other asset management protocols as benchmark, the yield fee to the protocol can be increased to be more competitive. This also provides better cashflow to shift towards long-term growth and sustainability.
3. The Fee Allocation
Since Vesper is currently focusing on short-term growth, the protocol fees are currently being distributed to all users. Right now, to develop long-term growth, Vesper will start accruing value for the future products available and the future users. Then fees will also be generated and allocated to this segment of the space which can be marketing, operations, partnerships, etc.
This is similar to how companies behave in Web 2.0. The difference is that now the community is able to better decide where and how to distribute this protocol owned value, for future growth.
4. Replenish VSP Reserves
Looking at past data, we, Economics Design, found that VSP reserves help to increase user behaviors towards adding more capital into the protocol. What we want to do is for a portion of fees being generated to be allocated to replenish the VSP reserves. The protocol currently has a budget for it and we are just extending the budget for a couple more years, hence long-term value creation.
In this process, together with fee allocation (above) and treasury management (below), the protocol can achieve its growth strategy with time.
5. Multi-Currency Treasury
Treasury is kind of like insurance in a protocol. In its current state, the Vesper treasury exclusively holds VSP. Whilst that is great to increase utility, this courts potential risk through a lack of diversification. Thus, in the approved proposal, Vesper will increase its allocation to other tokens, but still retain its VSP position. This is to minimise the drawdown of treasury funds. This strategy will only impact the allocation of new funds and will not touch existing VSP holdings to avoid excessive sell pressure.
The previous methods help to increase value creation. This is to reduce risks while creating value.
6. Treasury Maintained Through An Algo
The DAO has also approved the implementation of an algo-trading strategy for allocating new additions to the treasury. The strategy will determine if assets should be allocated to stablecoins or a specific allocation of other tokens (ETH, UNI, LINK, and VSP) to minimise the drawdown of treasury funds. Simply, it just switches between keeping it in stablecoins and keeping it in the native multi-currency treasury. This helps to balance any kind of shocks in the space.
The purpose of a market is to be a space for buyers and sellers to come together to trade and transact. The value cycle is a three step process where value is created, distributed, and realised. An economist has to figure out how to balance the long-term growth, short-term growth, and real value accrual for active users in the market to achieve economic balance. As much as we look at value creation and growth, we also need to be mindful of risk mitigation.
Listen on podcast if you prefer audio version.
TLDR: The purpose of a market is to be a space for buyers and sellers to come together to trade and transact. The value cycle is a three-step process where value is created, distributed, and realised. An economist has to figure out how to balance the long-term growth, short-term growth, and real value accrual for active users in the market to achieve economic balance. Vesper is a portfolio management protocol that is now moving the conversation and plans towards long-term growth and looking at how do we shift economics towards continuously creating value in the long run.