A Beginner's Guide to Seigniorage Protocols

Hey there! Welcome back to the IGIN newsletter. Thanks to the 9 new IGIN readers that have joined us since our last issue. That puts us at 252 people who can now impress their friends with their knowledge of web3, the creator economy, and the internet.

Congrats. You get it now.

You truly are embarking on a journey here.

You can't learn web3 in a day. Or a week. Or even in a month. This space is complicated. I realize that with some of these concepts we go over, no matter how well I explain them, you'll need to spend some time around this ecosystem to truly grasp what's at play here. However, the goal is for you to begin to take those first steps along that path. 

We've already learned about the basics of Defi... and the power of stable coins... and even the power of a protocol-owned-liquidity model with Olympus. So you're on you're well on your way.

Let's keep the momentum going.

Today we are going to dive into another type of project type that has emerged in the DeFi space — seigniorage protocols (it's pronounced "seen-your-adge"... at least I think so).

I've gotta give you a heads up here. The mechanics of these type of projects can be tough to digest, so take your time while reading. Luckily I won't be throwing you straight into the deep end. We've got a fun little analogy I created to help you follow along. Good luck out there readers. I'll see you on the other side.

Let's dive in...

• Seigniorage Explained (with an analogy)

• Tomb Finance

• Tomb Forks and Beyond

Seigniorage Explained

To understand the mechanics of these seigniorage protocols, we're gonna head back to our favorite IGIN analogy — pudding.

The Economics (as an Analogy)

Imagine a world in which we use snacks as currency. There's an entire market full of various snacks, each with fluctuating values. Now let's dial in on one of these snacks in particular, vanilla pudding. 

So in this hypothetical world, everyone wants more pudding. There's many ways people can go about earning more of our beloved pudding. We have access to all of your classic DePi (decentralized "pudding" finance) opportunities: staking, lending, farming, etc. However, this can only earn you 5-30% APR (your annual pudding rate). Those rates sound great for most, but we always want a little extra pudding yield...

So in comes the creation of a seigniorage project. Let's call this project, Pudding Cup Finance.

The goal of this project is to essentially become a pudding-printer, and in this world pudding is money (so a money-printer).

How can Pudding Cup Finance do this? Well, they are going to create their very own snack, chocolate pudding. The value of this new snack is going to be pegged to the value of vanilla pudding. Ideally, at any given time, one chocolate pudding cup will be worth just about one vanilla pudding cup (1 cPC = 1vPC).

Ok. Buckle up. This is when the pudding economy gets a bit more complicated.

Our friends over at Pudding Cup Finance decide its time to set up the building blocks for this project. They build their own pudding factory, and they set up their three key assets to make up this new pudding economy. 

• Chocolate Pudding Cups

• Plastic Cup Machines

• Empty Plastic Cups

Let's start by discussing chocolate pudding cups. So the goal here is for Pudding Cup Finance to continuously bring more chocolate pudding cups onto the market. However, there is a rule in place. Their factory is only allowed to produce more chocolate pudding cups if the value stays above peg. Recall that the price of chocolate pudding is pegged to the price of the traditional asset, vanilla pudding. So if vanilla is worth $5 per cup, we need chocolate to be worth slightly more than $5 per cup in order for them to increase the supply. While the value is above peg, this increase in supply will encourage the price to move down, closer to the price of vanilla pudding. 

Why? Well let's think back to basic supply and demand. If supply goes up, price typically goes down. So if we want the price of chocolate to mimic that of vanilla, we have to follow this "price vs. supply" rule. If we were producing pudding while the price was below peg, the increase in supply would be making the price difference larger — a.k.a. not what we want.

Now that we understand we are increasing supply when the price is above peg, we need to discuss the inverse situation. What happens if the price is below peg?

You guessed it... we have to decrease supply. Less supply should lead to an increase in price— a.k.a. bringing the value back above peg. 

Pudding Cup Finance has a solution. If the price of chocolate pudding is below the price of vanilla, you can "give" your pudding cups back to the pudding cup factory. They will get rid of that pudding, taking it off the market and lowering the supply. 

Your incentive in this exchange — you receive empty plastic cups in return for giving up you chocolate pudding. Wait... why would you want empty pudding cups in exchange for your chocolate pudding cups? 

The first reason is that it helps the chocolate pudding ecosystem...but let's be honest — as much as we might want to claim that we're here to help the community, our underlying goal is always to make more pudding. Because pudding is money in this world.

So, in order to incentivize people to take pudding off the market, the factory offers a juicy bonus on the backend of this deal. If you trade for empty plastic cups when the price of chocolate pudding is below peg, you get to redeem these cups for extra chocolate cups when the price is back above peg.

Think of it as a pudding bond. You loan some pudding to the factory. Eventually you get paid back with interest.

There is a key risk here. If the project ever hits a situation in which it can never get the price back above peg, you'd be stuck with your empty plastic cups. No one will buy those off of you, so if you're a pudding cup beginner, maybe leave this to the advanced pudding players. 

Alrighty. Time for the last piece of the puzzle — Plastic Cup Machines. This answers the main two questions, you've probably been puzzled over.

1. Who gets to keep the new chocolate pudding going into the market?

2. How am I gonna get those sweet pudding profits that I've been chasing?

Basically, the pudding factory is equipped to produce the actual chocolate pudding, however, they need the community to provide the machines that make the plastic cups. So if you buy yourself a machine, you can "stake" it in the factory. The factory will then take the plastic cups you produce, fill them with the chocolate pudding and send them back to you as rewards... but only when the price is above peg of course :) 

Boom! Just like that, we've made it to pudding paradise. 

With the power of seigniorage, Pudding Cup Finance just created a whole new snack-asset, and this asset is going to give you returns at a much higher rate than your standard DePi opportunities.

Snack foods are slightly less flexible than cryptocurrencies as far as explanations go, so to help complete the picture, let's to a quick recap but with a real seigniorage project...

Tomb Finance

If you want to know about real seigniorage projects, Tomb Finance is the place to start. This is by far the largest and most impactful project of this type in the DeFi space right now. Let's connect what we've learned with our pudding example to Tomb.

As you can see above, $TOMB is pegged to the $FTM token, the native token of the Fantom blockchain. This network is one of the fastest growing networks in the web3 space currently, so it makes a lot of sense that we would want to increase our ownership of the FTM token. That's the asset that we want to mimic through seigniorage. (Notice how all three tokens are priced in $FTM in the picture above. You can see that when this screenshot was taken, $TOMB was below peg [worth less than 1 $FTM] )

Tomb Finance wants to keep the value of $TOMB (chocolate pudding) at just above the value of $FTM (vanilla pudding).

If the value of $TOMB is above $FTM, it is considered above peg. That means the protocol can create new $TOMB tokens. These tokens will be paid out to anyone who owns $TSHARE and stakes it in the protocol (lending the cup machine to the factory). 

If the value of $TOMB is below $FTM, it is considered below peg. That means the protocol needs to work on raising the value of $TOMB in order to restart the factory. Users can purchase $TBOND by exchanging $TOMB tokens, thus taking them off the market.

The keyword here is "bond". That is very fitting word for your understanding of this asset. It is a loan given to the protocol by users. This creates a debt that must be repaid with "interest" by the protocol once back above peg — in essence, exactly like a traditional bond.

Now for the last piece of the puzzle. (I left this out of the pudding analogy because it doesn't quite translate to snack talk super well.) It's about time we mention liquidity. If $TOMB really wants to be considered a value equivalent to $FTM, the assets must be liquid. This means you should be able to easily exchange between the two. 

In the world of decentralized finance, users are the ones who provide liquidity between tokens. Users can simply purchase equal values of both $TOMB and $FTM and create a liquidity pair on a decentralized exchange. In return, you will receive an LP-token, which acts as your blockchain receipt showing that you own that liquidity. This is what allows other people to swap between the two tokens.

(If you need a quick refresher on liquidity pairs and decentralized exchanges, read this.) 

To incentivize users for providing liquidity, Tomb Finance allows you to stake you LP-token in the protocol and earn $TSHARE. In pudding terms, this is like providing chocolate and vanilla pudding cups to a shop so people can swap between them. In return you get a plastic cup machine (the analogy is a bit weird, but the concept is solid).

Alright. Now let's add this liquidity pair to the mix... Take this next paragraph slow.

A user wants to increase their exposure to $FTM. To do so, they can purchase an equal amount of $FTM and $TOMB tokens. They use these tokens to provide liquidity and receive LP tokens. They then stake these LP tokens in Tomb Finance. They are now continuously earning $TSHARE rewards from the protocol, regardless of if the price is above or below peg. (Liquidity pair rewards are not dependent on the peg, because the increase of $TSHARE on the market does not effect the $TOMB price directly.)

Now that the user has earned $TSHARE rewards, they can claim them and stake them to begin receiving $TOMB rewards (our $FTM equivalent). If they wish to, they could then split these new $TOMB rewards into a $FTM-$TOMB liquidity pair and the cycle continues on. The more you compound rewards, the more you earn..

So why would you go through all this work?

Simply put— you'll be earning multiples higher reward rate on your $FTM/$TOMB compared to traditional $FTM staking or lending rates. At the time of writing this, you could earn 56% APR on your liquidity in the form of $TSHARE rewards...

...and if you staked those $TSHARE, you could earn an additional 2438% APR in $TOMB rewards while the system is above peg. It is important to note that these APR's are dependent on the price of the tokens. While writing this piece, $TOMB has been below peg for about 10 days now. Because of this the price of $TSHARE is currently suppressed. This means the APR is higher because you can purchase the same $TOMB printing capability for less. The takeaway... the APR fluctuates. It is not constant.

If all that manual compounding seems like too much work for you, there is always the option to deposit your LP into an auto-compounding protocol such as Reaper or Beefy. They'll do the dirty work for you and sell your rewards back into the LP tokens. 

One reason this system is so attractive to investors is you avoid one of the arch nemeses of liquidity providing — impermanent loss. This is when you lose out on potential gains because a change in relative value between assets in a liquidity pair change. It's too complicated to truly explain the math behind it, but the important takeaway is you shouldn't experience much impermanent loss on a stable pair. A $FTM-$TOMB pair ideally should stay very stable because of the peg design of the system (1$TOMB=1$FTM). Just another bonus to this seigniorage strategy.

There's one last thing that often confuses new users in seigniorage protocols. These projects operate with a time component called an epoch. Tomb operates under a 6-hour epoch, which equates to 4 epochs/day. Basically, the "factory" will either be "on" or "off" during each epoch. At the start of each new epoch, the average price (TWAP) of $TOMB during the last epoch, is reviewed. 

If this value is above 1.01 (meaning on average, 1 $TOMB is worth at least 1.01 $FTM during an epoch), then the project can print new $TOMB tokens during the next epoch. If this value is below 1, users will be able to purchase $TBONDs. If the $TOMB value lands between 1<$TOMB<1.01, that epoch will neither print new tokens, nor will it allow users to purchase $TBOND. It is in a neutral state. In the figure above, the bottom line is the peg (1$TOMB=1$FTM). The green line is the 1.01 mark. Each time the epoch began above the green line, the protocol printed new tokens. In between the lines, nothing happened. Below the bottom line, the protocol begin selling $TBOND tokens.

Tomb Forks and Beyond

Although Tomb was not the first of these type of projects, it has definitely cemented itself as the premier seigniorage protocol in the DeFi space. Similar to the situation with Olympus, this led to a ton of projects making their own version of $TOMB. We call these "forks". 

As with all big forking trends, some projects are better than others. I'd wager that only a select few will survive long term. However, I think one of the biggest positives that forks bring about is innovation. Tomb popularized this model, but when you have hundreds of projects launching to compete in the same space, they are forced to innovate if they wish to attract any investors.

For example, what should protocols do if they are struggling to get back above peg? The team at Kitty Finance, a seigniorage protocol with tokens pegged to $AVAX and $MATIC, had an innovative solution. They added a new mechanic where you could earn their version of the "empty cup machine", $CAT, by staking their version of bonds. So basically they doubled your incentive to purchase bonds while below peg. This makes it much more likely that the community will act to help restore peg. They also added a staking pool for their $CAT token which reduces sell pressure on that token when the system is below peg. 

Systems like these are what can help differentiate between good forks and bad forks. It doesn't guarantee success, but it surely gives the project a boost.

It is important to note that these projects are highly susceptible to the actions of the community. There is a right and wrong way to interact with these protocols when it comes to helping the health of the protocol. One large selloff could tank the price of the pegged token on smaller projects and make it very difficult to get back to peg. So choose your project carefully. The stronger the community, the more likely the collective users will strive to keep the money printers printing.

As with every new trend in DeFi, these projects will teach us more and more about how the future of digital currencies may work. We will make mistakes. We will hopefully learn lessons. And hopefully most of us will make some profit along the way.

An oft used phrase in the web3 space is "Money Lego's". Every time we experiment with a new token system, we unlock a new type of money lego that future projects might use to build an even better and more innovative product than before.

Who knows what this seigniorage system might inspire down the line... maybe someone will finally figure out how to grow money on trees. Blockchain trees of course...

Thanks for reading! We hit 250 subscribers! That's awesome. I might've slowed down on my release schedule a little bit recently, but I promise I'm still working behind the scenes to pump out some great content to you whenever I can.

As always...send this to someone you know who might find it interesting. You might even say that my subscriber count is below peg, and I'm gonna need some help from my community to help get me push that number up some 😉

-Levi

P.S. The second way to get my subscriber count above peg is to buy me a drink. It can guarentee it will inspire me to write some more. I'm sure you know what button to press...

I do my best to explain how it all works in these letters, but I won't be able to outline all of the risks. So if you read this and want to get involved, make sure you do your due diligence. For full transparency, I am involved in some of the tokens mentioned in the writing. This letter is not financial advise.