DeFi 2.0 | Is Olympus a Ponzi scheme or an innovation? How to ensure and control liquidity at the same time?

The incentive model of OlympusDAO, as well as the strategy of fully controlling its own liquidity, can be considered a masterful incentive design. Importantly, this is a crypto-native model, the way a plug-and-play tool should be.

This article is authorized to be reprinted from ChainNews, with the original title "Is Olympus a Ponzi Scheme or Innovation? Starting from the Masterful Incentive Design Mechanism", original article here

Author: Three Body Capital
Translator: Perry Wang

Olympus is an absolutely fascinating story that blends game theory, incentive design, and a brand-new crypto-native language. It needs to be clear that, as usual, this article should not be construed as investment advice and does not constitute a recommendation for any assets. The standard rules in the crypto space apply: do your own research, make your own decisions, and if necessary, call your friendly banker for paid advice.

For centuries, the market has been seen as the aggregate decisions of market participants, which is correct. However, the market's effectiveness in creating incentives for specific forms of behavior, especially coordinating positive actions, is largely declared a failure.

The price volatility in the crypto space is mainly due to: token liquidity being held by large traders and market makers, also known as "whales." However, they are considered a necessary evil—otherwise, how can tokens of new projects have liquidity, especially when developers want to focus on building rather than market-making?

The incentive model of OlympusDAO, as well as the strategy of fully controlling its own liquidity, can be considered a masterful incentive design. Importantly, this is a crypto-native model, the way a plug-and-play tool should be. This single fact may be more important than any other content in this article.

To reach the summit, we must start from the foot of the mountain.

Olympus: Fundamentals

All cryptocurrency projects have rich documentation and readily available reading resources, and Olympus is no exception. The purpose of this article is to emphasize specific aspects of the project we are interested in, but if you want to satisfy your own curiosity, you should check out the official documentation here.

Based on this, OlympusDAO set out to build native crypto reserve assets.

Simply put, one can easily understand the daunting mission they are facing. In the early stages of the crypto industry, the "base" asset was Bitcoin ── everything was paired with Bitcoin, and the only place in the market where one could invest with a "neutral" strategy was to go long on Bitcoin. The problem was, unlike the situation we are accustomed to now, Bitcoin had greater volatility at that time.

Then, as the Ethereum ecosystem began to flourish, stablecoins emerged ── whether they are centralized like USDT or USDC or decentralized like DAI, they provided an exit valve for the crypto world. Positions could be exited, converted into "stable" assets pegged to the value of the dollar.

The emergence of stablecoins fueled the Cambrian explosion of cryptocurrencies, but the underlying risk always lurking in the background was the dependence on the U.S. government, as the potential value support, pegging, or other reliance on the dollar or its equivalents. In fact, as stablecoin providers increasingly clashed with regulatory bodies, this risk has come to the forefront.

OlympusDAO remains anonymous to date, a powerful testament to the brilliance of a decentralized network. Behind the team is a unique vision: to create a crypto-native reserve asset supported by purely decentralized assets rather than fiat assets. In other words, their envisioned future is not "analog assets" ── the base currency will not be the dollar, and the monetary policy decisions of the Federal Reserve or any other central bank issuing fiat currency will not directly affect its price.

In essence, they aim to assemble a crypto central bank from scratch, accumulating various high-quality crypto-native assets in their asset reserve to support the value of the reserve assets issued by the protocol ── their native token, OHM.

While this sounds like a great idea, the question arises: if OHM is a reserve asset, it needs to be stable, so why wouldn't this crypto token be subject to frequent selling like other tokens?

Secrets: Game Theory

Game theory can be discussed for hours, barely scratching the surface of the most fascinating parts of behavioral economics. Anyone can delve into this field. The key point we need to know here is the application of game theory principles by Olympus, which can be said to be quite clever.

As one might imagine, the language of game theory is very concrete, so we will try to provide a simple explanation of specific terms and their everyday use when needed. First, let's look at the concepts of "strategy" and "equilibrium."

In colloquial terms, "strategy" always implies some complexity, such as military invasion or corporate acquisition. In contrast, the "strategy" used in game theory is a simple, explicit course of action. For example, in the rock-paper-scissors game, a strategy could be: "play paper five times first, then randomly choose rock or scissors," "start with rock, then scissors, then paper, always follow this sequence," or "after the opponent plays paper, I will always play paper next." Of course, most people don’t play the game this way, but economists and game theorists tend to simplify.

Similarly, in everyday language, "equilibrium" often implies some form of balance. In game theory, "equilibrium" is much more concrete: in this state, all participants in the game have no incentive to change their strategy.

Understanding these two terms makes it very simple to derive the game theory result needed to build reserve assets: everyone must buy, believing that everyone else will buy; no one should sell, as selling would result in significant losses.

From the outset, Olympus aimed to build an incentive mechanism where anyone participating in this "game" would have a strong motivation to buy and stake OHM, most importantly, to continue holding OHM regardless of market conditions.

If they can truly achieve this, OHM will be able to establish a reputation as a stable and reliable reserve currency in the cryptocurrency world. After all, the reliability of reserve assets depends on the trust of their holders, and trust can only be built over time.

This is the brilliance of Olympus' mechanism design: the staking rewards set surpass the potential USD losses from market fluctuations over a period, effectively eliminating all reasons for stakers to sell their staked OHM. This was achieved in the early days of OHM through an outrageously high 150,000% APY staking reward, which is currently around 8,167% at the time of writing. In other words, at the current price of OHM, buying and staking OHM can almost guarantee stakers a profit in USD terms over a year, unless the value of OHM token drops by more than 98.8%.

Let's provide some numbers: based on the current price of around $881 for OHM, the "break-even" price for staking OHM for a year is $20.20. In other words, at the current price, if you hold on to OHM until the end of the distribution phase currently underway, if the price is above $20.20 after 312 days, you will make a profit in USD terms.

Next, we need to examine what crypto assets are in the Olympus treasury: in other words, what are the reserve assets backing each OHM. This data is readily available on their dashboard.

But first, let's look at some numbers ── the current market value of OHM's treasury assets is $407 million.

Among them, removing assets like ETH and SUSHI that fluctuate in USD value, retaining only stablecoins like DAI and FRAX, for those unfamiliar, FRAX is the largest stablecoin in the AVAX ecosystem, the value of "risk-free assets" in the Olympus treasury is close to $107 million.

The capped supply of OHM is 3,342,369, of which 2,13,676 have been issued. The "book value" of the maximum diluted market price per OHM is $121.20, with $32.07 of that value backed by stablecoin assets.

Comparing this to the "break-even" price of $20.20 for staking OHM for a year, the incentive for holding and staking OHM is quite evident unless all cryptocurrencies face a catastrophic event, holding and staking OHM is a very reasonable choice: returns for OHM stakers are almost guaranteed to rise.

However, there is almost a mind-boggling 9x premium compared to the net asset value (NAV), indicating almost a 9x premium! On one hand, calculating the break-even point is based on the current market price of OHM, which includes the premium and considers the potential risk of price decline thereafter. Furthermore, OlympusDAO's goal is not just to create a static reserve asset pool. In fact, this asset pool can generate revenue, fees from the assets it collects.

Ultimately, if someone believes that cryptocurrencies will eventually go to zero because they will all evaporate, only then, in their eyes, will OHM have no value.

OHM aims to be a pure crypto-native reserve asset. Therefore, to become part of Olympus, the prerequisite is to believe that crypto technology will continue to exist, which is a necessary condition.

So far, we have briefly discussed the project's clever incentive design, how OlympusDAO fundamentally incentivizes OHM holders not only to buy OHM but also to stake and continue holding OHM, disregarding market fluctuations.

Returning to the theoretical language of game theory, among stakers who have no incentive to change strategies when knowing that other stakers have almost no motivation to make any strategic changes, stakers choosing to stake and hold OHM achieve a balanced strategy. The result is a win-win, or a typical payoff of 3,3.

But Olympus' wonder doesn't stop there. Let's move on to the truly interesting part.

Another Major Benefit: Having its Own Liquidity

OlympusDAO is positioning itself as the central bank of the crypto world. Attracting a stable group of "diamond hands" holders who own OHM with zero incentive to sell is one aspect of this mechanism. However, "diamond hands" pose another problem: insufficient liquidity.

If no one wants to sell, the asset lacks liquidity, making it less useful. Therefore, creating liquidity for OHM is essential for trading. However, in the crypto space, creating liquidity usually means handing OHM over to market makers, where the incentive mechanism typically means they only provide liquidity when profitable, choosing to withdraw liquidity when the project needs it most, leading to malicious price fluctuations of the token. Most importantly, without a final buyer. All of this severely undermines OHM's ability to establish itself as a reserve asset.

The solution OHM created for this is to have its own liquidity. This is achieved through the "bonding" mechanism, where large automated market makers purchase liquidity tokens representing shares in Sushiswap's main liquidity pool, as an exchange, to sell OHM tokens from the total nominal issuance at a discounted price, which can be unlocked in stages over a shorter period. Through this method, OlympusDAO ultimately owns most of the liquidity pool for OHM, primarily in the OHM/DAI stablecoin liquidity pool on Sushiswap.

The end result is that the OlympusDAO protocol itself becomes its own market maker, able to commit to providing liquidity regardless of market conditions, thus reducing the volatility of its token price. Liquidity providers who sell their LP tokens receive compensation for purchasing OHM at a discounted price and enter the same incentive structure as any other OHM staker. In this scenario, it's a win-win situation ── sellers of LP tokens can buy OHM at a discounted price compared to the market, and the protocol gains liquidity and assets for its treasury, further increasing the underlying asset value of each OHM.

These LP tokens further generate revenue for the protocol as they receive a significant share of the market maker fees from trades. OlympusDAO holds 99.66% of all liquidity in the OHM/DAI currency pair on Sushiswap, making OHM/DAI the largest trading pair on Sushiswap in the past 7 days, generating substantial revenue for OlympusDAO and increasing the total value of its treasury assets:

Solving a Broader Issue

The entire concept of "protocols owning liquidity" has sparked a revolution for many projects striving to stabilize their token prices. For many projects, the founders are developers, not traders, and dealing with price volatility and the subsequent impact on community morale is a major headache for them.

However, they also face the double-edged sword that Olympus must address: how do you simultaneously get the token into as many hands as possible, ensure enough trading liquidity, and ensure that market makers are committed to providing liquidity when most needed, rather than withdrawing at critical moments?.

To some extent, staking projects have been in place for a long time, although during inevitable downturns in the crypto market, staking only alleviates some selling pressure. The controversy surrounding staking is that it removes liquidity from the market during downturns, exacerbating price volatility in crypto assets.

Therefore, while everyone is excited about earning a fortune through OHM staking, we actually believe that the project's greatest masterstroke lies in combining staking with Bonding. After proving the success of the model staking + Bonding, they recently launched Olympus Pro, a platform that allows other protocols to replicate the staking + Bonding setup and offer it as a service, with other protocols only needing to pay a fee. This is called "Protocol as a Service."

This means that other projects can also benefit from the advantages of the Olympus model: controlling their own liquidity, earning fees through their own market-making, and ensuring that their tokens always have liquidity, especially on DEXs.

Currently, five more DeFi protocols are collaborating with Olympus Pro: Abracadabra, Alchemix, Float, Pendle, and StakeDAO. We believe this list will only grow longer in the future.

For Olympus itself, to say they are developing "rapidly" would be an understatement. From the time we started writing this report to when it was completed, Olympus has launched a new version of contracts, with a focus on Bonding, which is not surprising. OHM returns received by Bonders can now automatically stake immediately, meaning any Bond purchased at a discounted price will automatically outperform staking. The more Bonding, the more liquidity, and the higher the protocol's control over liquidity.

Additionally, they have added the ability to tokenize fixed-term Bond tokens into NFTs. Yes, NFTs are not just for JPEG images, they also allow for the tokenization of fixed-term Bond tokens into ERC-20 fungible tokens, creating a more liquid market for Bonds themselves, somewhat resembling the traditional bond market: running Bonds with similar maturity dates are almost equivalent to fungible assets that can be slightly adjusted, while Bonds with specific maturity dates are typically not replaceable by other bonds with different maturity dates.

Similar yet different. Decentralized Bond trading instead of over-the-counter trading? Why not.

Non-analog Assets, Our New Favorite Term

Can this new approach to incentive management change the market dynamics of cryptocurrencies structurally? There is such a possibility. By ensuring good liquidity distribution in all price ranges, reducing the risk of drastic price fluctuations in crypto assets, the range of price changes can be significantly reduced.

However, a fundamental point we want to emphasize is that while such solutions may seem very effective in hindsight, they are practically impossible to implement in the traditional financial world. Traditionally, public companies can conduct stock buybacks and provide incentives for holding shares, such as dividends and ex-dividend dates, but unless every public company starts building its internal trading platform to manage the volatility of its stocks, stock prices are largely controlled by the market.

Furthermore, where is the boundary between "stability" and "market manipulation"? In traditional finance, stabilizing the price after an initial public offering (IPO) is usually allowed to maintain price stability for a limited time. However, if similar operations are carried out after this time window closes, it will attract public criticism and regulatory attention. In the crypto world, using automated market makers like Sushiswap instead of order book-based market making allows the protocol to ensure liquidity and suppress price volatility without actively quoting prices. This method of addressing liquidity shortages in the early days of crypto DEXs has proven to be a graceful, passive, and even profitable means to manage token liquidity.

Additionally, creating slightly dissimilar fixed-income instruments with fixed maturity dates, allowing for high liquidity trading by decentralized traders, helps maintain unusually stable prices, which is almost impossible in the traditional world. Think of the scenes from the movie "The Big Short," where traders start to panic and withdraw liquidity, causing bond discounts to become more aggressive in a day. People can only hope for a mechanism to maintain stability until the end, despite being unprofitable, by continuing to provide liquidity until the end.

In our view, the mechanism design described above is just the beginning of innovative methods, and these methods can only emerge in the crypto world. These methods are not just non-analog assets, i.e., not just crypto versions of existing assets in traditional finance; they are cryptographic solutions built on the crypto-native system. #OnlyInCrypto

We can't wait to see what great ideas the geniuses in the crypto space will come up with in the coming months and years.