Discussing the DeFi economic model: the design and evolution of the incentive model

Written by: Hotcoin Research Institute

The DeFi protocol economic model is designed to enable the DeFi protocol to better achieve its long-term incentive goals while improving the sustainability and market stability of the token. Through continuous optimization and adjustment of the economic model, the protocol can better adapt to changing market and user needs, thereby achieving healthier development.

1. The evolution of the DeFi economic model: from simple to complex economic model design

Many early protocols adopted a simple economic model of mining and providing liquidity, treating tokens as a simple incentive to attract users to participate and pursue short-term profits. However, although this incentive method is direct, it lacks an effective redistribution mechanism. Taking decentralized exchanges (DEX) as an example, when token issuance and all handling fees are directly allocated to liquidity providers, there is a lack of long-term incentives for liquidity providers. This model is prone to collapse when the token value is not supported by other sources, because liquidity providers can easily migrate to other protocols, causing various liquidity pools to collapse one after another.

Over time, DeFi protocols have become more sophisticated and complex in terms of economic model design. In order to achieve longer-term incentive goals, various game mechanisms and income redistribution models have been introduced to regulate the supply and demand of tokens. The economic model and the protocol’s product logic and revenue distribution began to be closely coupled. Reshaping the flow of value through economic models has become the main role of economic models. In this process, the supply and demand of tokens can be precisely controlled, and the tokens can capture value more effectively.

2. Economic model design for different protocol categories

When designing an economic model, we need to clarify the object of the token design. In the field of blockchain, different types of protocols such as public chains, DeFi (decentralized finance), GameFi (gamified finance) and NFT (non-fungible tokens) all have their own unique economic model design points. Therefore, we will explore their design goals and core principles in more detail.

1. Public chain economic model: The economic model of the public chain is affected by the consensus mechanism, but its design goal is always to ensure the stability, security and sustainability of the public chain. Core tasks include effectively leveraging token incentives for validators, attracting a sufficient number of nodes to participate and maintain the network. This usually includes the issuance of cryptocurrency, incentive mechanisms, node rewards, and governance mechanisms to maintain the stability of the entire economic system.

2. DeFi economic model: DeFi protocol expands the concept of economic model, and its economic model involves aspects such as lending, liquidity provision, trading and asset management. Its design goal is to incentivize users to provide liquidity, participate in lending and trading, and to provide corresponding interest, rewards and benefits to participants. In the design of DeFi, the incentive layer is the core, including how to guide token holders to hold tokens instead of selling them, and how to coordinate the distribution of benefits among liquidity providers and governance token holders.

**3. GameFi economic model: **GameFi combines gaming and financial elements to provide financial rewards and incentive mechanisms for gamers. The economic model of the GameFi protocol includes the issuance, trading and revenue distribution of in-game virtual assets. Unlike DeFi, GameFi's model design is more complex because it needs to solve how to increase users' reinvestment needs while also considering the playability of the game mechanism. This results in the appearance of Ponzi structures and helical effects in many protocols.

**4. NFT economic model: **The economic model of an NFT protocol usually involves the issuance, trading and holder's rights of NFT. Its design goal is to provide NFT holders with opportunities for value creation, trading and income to encourage more creators and collectors to participate. This can be divided into NFT platform economic model and protocol economic model. The former focuses on royalties, while the latter focuses on addressing economic scalability, such as increasing repeat sales revenue and raising capital in different areas.

While the economic models of these protocols are each unique, there are also some overlapping and overlapping aspects. For example, DeFi protocols can integrate NFTs as collateral, while GameFi protocols can use DeFi mechanisms for fund management. With the continuous evolution of economic model design, the development of DeFi protocols is relatively rich, and its models are also widely used in protocols such as GameFi and Socialfi.

3. Advantages and disadvantages of main DeFi economic models and representative protocols

If divided according to the business logic of different protocols, we can roughly divide the DeFi economic model into three main categories: DEX, Lending, and Derivatives. If divided according to the characteristics of the incentive layer of the economic model, we can divide it into four models: Governance model, pledge/cash flow model, voting custody "including ve and ve(3,3) model", real income incentive model.

(1) Governance model

A governance model is a protocol or the way in which decisions are made and resources are managed in a protocol. It usually includes rules and processes for power distribution, voting processes, decision-making, proposal submission, and resource allocation.

Representation Agreement:

MakerDAO: MakerDAO is a representative decentralized autonomous organization (DAO) that adopts a decentralized governance model that allows MKR token holders to vote to influence the policies and parameters of the stablecoin DAI.

advantage:

• Decentralization: The governance model allows community members to jointly participate in protocol decision-making, reducing the risk of centralization.
• Transparent and open: Governance models are usually transparent and open, and anyone can view the decision-making and voting process.
• Community participation: Community members of the protocol have the opportunity to influence the development direction of the protocol, which can increase user loyalty and participation.

shortcoming:

• Decision-making efficiency: Decentralized governance can cause the decision-making process to become slow because it takes time to collect votes and reach consensus.
• Attack risk: Some governance models may be vulnerable to malicious attacks or manipulations, especially if currency holders are unevenly distributed.
• Complexity: The design and management of governance models can be very complex and require a significant investment of time and resources from the community and protocol teams.

(2) Pledge/cash flow model

The staking/cash flow model is an economic model in which users can lock (stake) their assets in order to receive stable cash flow or income over a period of time. This model usually encourages users to hold and support the protocol for the long term, while also providing a stable source of financing and liquidity for the protocol.

Representation Agreement:

DeFi lending platforms, such as Aave, allow users to pledge cryptocurrency assets to obtain loans for assets such as stablecoins, and they also receive a portion of the borrowing interest as income.

advantage:

• Provide stable income: The staking/cash flow model can provide holders with predictable cash flow or income, which helps attract people who hold and support the protocol for the long term.
• Increased liquidity: This model encourages users to lock assets in the protocol, increasing the liquidity of the protocol and helping to provide more lending opportunities and transactions.
• Incentives to hold and participate: Users are motivated to hold and stake assets to earn additional benefits, which can increase protocol loyalty and participation.

shortcoming:

*Risk: Pledged assets are usually exposed to price fluctuations and smart contract risks, and users may lose part or all of their assets.

• Complexity: The staking/cash flow model of some protocols may involve complex rules and conditions, which may not be user-friendly enough.
• Market dependence: Cash flow is often dependent on the overall success of the protocol and market conditions, and if the protocol is not robust or the market moves poorly, cash flow may be reduced or interrupted.

(3)ve bidding hosting model

Ve voting custody is a governance model in which token holders obtain governance rights by staking or staking tokens and participate in the decision-making and governance process of the protocol.

Representation Agreement:

Curve is a typical representative of this governance model, adopting the ve and ve(3,3) models to give token holders governance rights. Users can vote in "Gauge Weight Voting" with their veCRV to determine the distribution ratio of CRV in each liquidity pool for the next week. The higher the distribution ratio of the pool, the greater the CRV reward, and it is easier to attract sufficient liquidity. .

advantage:

• Decentralized decision-making: The voting custody model enhances the decentralized nature of governance, and most decisions are decided by a joint vote of token holders.
• Long-term participation encouragement: Users need to lock or pledge tokens to encourage them to hold them for a long time and actively participate in protocol governance.
• Improve protocol security: Increasing the threshold of governance rights can improve the security of the protocol and reduce the risk of malicious manipulation.

shortcoming:

• Voting instability: The voting escrow model may lead to voting instability as tokens may be unlocked or withdrawn, leading to volatility in governance decisions.
• Manipulation risk: Some token holders may attempt to manipulate governance votes, especially where a small number of tokens control the majority.
• Complexity: For novices, the voting escrow model may be complicated and require understanding of the staking and locking conditions of different tokens.

(4) Real income incentive model

The real income incentive model is an economic model mechanism that aims to reduce the cost of protocol subsidies by rewarding real users for their participation, and encourages users to pledge or lock tokens to obtain token rewards. This model emphasizes user loyalty and engagement while increasing the complexity of rewards through unlocking thresholds.

Representation Agreement:

Camelot's core incentive goal is to encourage liquidity providers (LPs) to continue to provide liquidity. The incentive mechanism ensures the smoothness of transactions and helps LPs and traders share the profits generated. The real revenue of the Camelot protocol comes from the fees generated by the interaction between traders and the pool. This is the true revenue of the protocol and the main source used by the protocol to redistribute revenue. In this way, Camelot ensures the sustainability of its economic model.

advantage:

• Reduce protocol costs: By unlocking the threshold, the real revenue incentive model reduces the cost of protocol subsidies, making the protocol more attractive.
• Incentivize real users: Users need to stay engaged to receive token rewards, which encourages active participation from real users.
• Enhance protocol inclusivity: Due to the complexity of real revenue calculation, the real revenue incentive model is more attractive and can attract more users to participate.

shortcoming:

• Complex earnings calculation: Since rewards need to meet unlocking thresholds, actual earnings calculations become complex and difficult to predict.
• May lead to inactive users: If users leave the system, they will lose token rewards, possibly reducing activity.
• Requires user education: Users need to know how to participate in staking or locking, which may not be user-friendly enough for novices.

4. Summary of the evolution of DeFi economic model

As DeFi protocols continue to develop and innovate, many protocols have improved their economic models. The core of these improvements is the introduction of a game mechanism to redistribute a portion of profits and enhance the stickiness of users in the entire ecosystem. This process has even led to the emergence of vote-buying values and various composite platforms. On the other hand, the economic model mechanism also introduces additional token rewards to promote the operation of the entire ecosystem and attract more traffic and funds.

Taken together, these mechanism improvements make tokens no longer just a simple medium of value exchange, but a tool for capturing users and creating value. By redistributing profits, it can not only increase user activity and stickiness, but also encourage users to actively participate through token rewards and promote the development of the entire system. The evolution of this economic model helps build a more attractive and sustainable DeFi ecosystem, providing more value and opportunities for users and protocols.

The continuous evolution of economic models helps build a more attractive and sustainable DeFi ecosystem, providing more value and opportunities for users and protocols, realizing the vision of financial innovation, decentralized governance and community participation, and promoting the future Changes in the financial system. Therefore, understanding the development of these economic models will become an integral part of entering the cryptocurrency community. As technology continues to develop and the community continues to grow, DeFi will continue to lead the wave of financial innovation and provide more inclusive and innovative financial services to the world.