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41434931.on-circularity.html
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<p><em>Or how I’ve learnt to stop hating DeFi and love ponzis</em></p><div><hr></div><p>Let me first clarify what I mean by ponzi. As per Merriam-Webster: </p><blockquote><p><strong>: </strong>an investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risks</p></blockquote><p>So maybe not a ponzi, since I wouldn’t call a lot of crypto assets fraudulent in the sense that I don’t think their creators have done anything unethical. And I wouldn’t call crypto useless either.</p><p>Maybe circular? Except circular economy has a completely <a href="https://en.wikipedia.org/wiki/Circular_economy">different meaning</a> in literature.</p><p>How about fiat?</p><blockquote><p><strong>Fiat money</strong> is a <a href="https://en.wikipedia.org/wiki/Currency" title="Currency">currency</a> (a <a href="https://en.wikipedia.org/wiki/Medium_of_exchange" title="Medium of exchange">medium of exchange</a>) established as <a href="https://en.wikipedia.org/wiki/Monetary_system" title="Monetary system">money</a>, often by government regulation. Fiat money does not have <a href="https://en.wikipedia.org/wiki/Intrinsic_value_(numismatics)" title="Intrinsic value (numismatics)">intrinsic value</a> and does not have <a href="https://en.wikipedia.org/wiki/Use_value" title="Use value">use value</a>. It has value only because a government maintains its value, or because parties engaging in exchange agree on its value.</p></blockquote><p>That’s certainly much closer to what I wish to say. Except that its weird to call crypto fiat money when crypto folks often explicitly use “fiat” as a term to separate their made-up assets from everyone else’s made-up assets.</p><p>At this point I might as well explicitly say what I mean.</p><div><hr></div><p>Most base-layer crypto-assets have value primarily due to a circular belief that other participants of the same community will value the asset at a similar or higher price at a future point in time.</p><p>Everything else comes second.</p><p>Bitcoin’s “store of wealth” narrative comes second. Ethereum’s “programmable money” comes second, “value capture via EIP1559“ comes second. As Dogecoin has proved, none of these are necessary conditions for a crypto-asset to have value, although they may certainly help increase it.</p><div class="captioned-image-container"><figure><a class="image-link image2 image2-433-577" target="_blank" href="https://cdn.substack.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2Fab2baa5a-81d3-410b-bc84-ed2c8f049978_577x433.jpeg"><img src="https://bucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com/public/images/ab2baa5a-81d3-410b-bc84-ed2c8f049978_577x433.jpeg" width="577" height="433" data-attrs="{"src":"https://bucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com/public/images/ab2baa5a-81d3-410b-bc84-ed2c8f049978_577x433.jpeg","height":433,"width":577,"resizeWidth":null,"bytes":null,"alt":null,"title":null,"type":null,"href":null}" alt=""><style>
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</style></a></figure></div><p>This circular belief however, is a necessary condition for a crypto-asset to have value. 1559-style value capture does not change this today, as the value capture comes from DeFi, which in turn relies on ETH having value. If ETH’s circular belief weakened and its price halved, DeFi too would crash at the similar pace. Hence as of today, the net effect is that DeFi extracts from ETH, and not the other way around.*</p><p>This can change in two ways however.</p><p>Firstly, DeFi could grow to the size where DeFi casinoes themselves become the primary product of ethereum, and ETH the asset is just a secondary feature that not as many people care for. This wouldn’t be surprising to me, for reasons I’ll soon come to.</p><p>Secondly, some other class of activity could grow on ethereum, one that is less circular in its ability to generate value for ETH. Asset transfers to some extent are already playing this role. Ethereum will continue to be capable of transferring the same number of stablecoins or tokenised bitcoin if ETH halved in value. In practice, however, transfers too will reduce if the sole point of the transfers was more DeFi speculation. If transfers were happening for other reasons - then sure, they’d continue to happen and the gas fees charged on them will help back ETH.</p><p></p><p>*Caveat: It’s not necessarily zero-sum here, DeFi simultaneously grows the number of narratives and memes that people can use to retroactively justify their crypto-asset purchases so perhaps DeFi grows the “narrative pie” more than it eats it from ETH.</p><p>*Caveat 2: Circularity doesn’t mean the pie never grows, there can always be more people entering the system than those exiting - as is happening in practice. It also doesn’t mean the pie must eventually shrink. Circularity however is defined by the beliefs of each actor entering the system - why they are entering and what will allow them to exit.</p><div><hr></div><h3>No, seriously, it’s all circular</h3><p>Just as much as base-layer crypto-assets rely on “up only” chanting and narrative building to increase their value, DeFi relies on volatility events to derive value. Not just DeFi but trading of any asset.</p><p>The up only crowd wants people to buy their favourite asset and that’s it. DeFi however wants people to explore the full range of speculation possible on an asset. Inflation news, Covid news, Microstrategy news, regulatory news, everything can have an impact on crypto prices if you meme them hard enough. There may be fundamental drivers for this speculation - for instance a bitcoin mining ban in China might actually reduce the number of Chinese people who will want to buy bitcoin in the future. However speculation is narrative leverage. For every $1 that is going to enter the system at a hypothetical point in the future, there’s $100 of assets changing hands speculating on whether this $1 will enter. </p><p>As always, news that actually impacts people (or hypothetical future people) entering or exit the system is not a necessary condition for speculation to take place. If it did, we’d only have 1-2 major price moves a day. No, people are so desparate to speculate that they will speculate on anything you create. Just create an 8-hour timeframe chart, and lo and behold — you’ll find people speculating on that timeframe. Create a 1-hour chart and people will eventually invent hypothetical news that can move prices in an hourly timeframe. If you meme it hard enough, I’m sure someone can create a coin that has observed correlation with lunar positions as well.</p><div><hr></div><h3>It’s all group belief, so what?</h3><p>Lunar solstices driving prices does not mean all the actors are irrational. If I believe that a lunar solstice will be perceived by others as a reason to push up LUNAR token price, I will want to frontrun them and buy it first. Someone will be successful at this, someone will be unsuccessful at this, what is known is that the price will likely move. Everyone could have information that something is “supposed to happen” and it’ll still happen as it was supposed to like a magical Oujia board, the only question being who lost and who profited.</p><p>Note that it only takes a few people to claim that lunar positions affect LUNAR price in order for everyone else to find it rational to maintain that correlation.</p><h3>I’m a budding DeFi protocol designer, what do I do?</h3><p><strong>#1 Accept that everything is circular.</strong></p><p>ETH is Schrodinger’s ponzi contigent on some future world-changing use cases being built on it. And everything else is just straight up ponzis. Or “circular memetic assets“ if you wanna be more accurate.</p><p><strong>#2 Figure out if you wanna create your own memes or harvest someone else’s.</strong></p><p>Uniswap or Compound for instance are harvesting primarily ETH’s volatility and memes. Uniswap requires less volatility, Compound requires more cause it wants people to trade on leverage. Sushiswap is harvesting a long-tail of shitcoins. Chainlink is arguably in both brackets, creating its own memes as well as some hypothetical value-capture from the memes of a lot of other protocols. Yearn is harvesting laziness. Olympus is creating its own memetics and Rari is harvesting Olympus.</p><p>Permissionless protocols are powerful because they allow you to offload a lot of the hard work of creating memes to a lot of distinct protocols who may each have their own means of doing this. Note however that the memes required for may still be distinct - ETH holders just require long-timeframe ‘up only’ narratives whereas Uniswap requires short-timeframe news that can memetically drive ETH price.</p><p>Creating your own memes is powerful as well because it lets you be in more direct control of what actually matters - user’s attention. It also gives you more freedom.</p><p><strong>#3 Keep your memes flexible</strong></p><p>If an asset is memed too hard to become very specifc things for very specific people, it will be less successful for people who like or are more susceptible to retain other memes in their trading or hodling behaviour. A classic example is Ampleforth, who originally started with calling themselves a stablecoin, which was a success. Then when people realised that didn’t work, they tried pivoting to “an asset uncorrelated to the rest of crypto”. This wasn’t as successful, and they failed to pivot again.</p><p>ETH on the other hand had a very open narrative space, which allowed it to accumulate a very large number of narratives and fictitious drivers of activity.</p><p>Literally any asset can be called a currency - be it OHM or LINK or SAFEMOONCUM22 - don’t meme too hard into value-capture if it comes at the cost of losing the “currency” label.</p><p><strong>#4 Engineer chaos-theoretic behaviour</strong></p><p>Token narratives are naturally chaos-theoretic. It only takes a few people chanting that lunar positions affect LUNAR price in order for to be rational for everyone to create that correlation in a self-fulfilling manner.</p><p>This also applies with pool 2. Being the first user to enter a new ponzi pool 2 feels stupid, until you realise that you just need someone even stupider than you to eventually push up price and let you exit for a profit.</p><p>There may be a lot many other ways to do this, also discussed in the “do I even need a token“ section.</p><p><strong>#5 Keep the narrative goals connected to profit</strong></p><p>Ensure that your narrative is connected to a believable way of accumulating profit for the believer. It doesn’t matter if you’re obscuring other details, it may not even matter if profit is actually realised, it just needs to be believable.</p><p>Ampleforth’s example of “asset uncorrelated from the rest of crypto“ is an example of a meme that doesn’t clearly tie itself to a profit goal - this is something you should not be doing.</p><p><strong>#6 Figure out your churn rates and timeframes</strong></p><p>Think about which timeframes of activity you are primarily trying to attract. As always, don’t perfectly lock yourself into one frame if you don’t have to, but there’s no harm in prioritising one. Think in terms of user attention and what drives it.</p><p>Think in terms of which user brackets profit and which ones lose - you ideally want the people more vulnerable to being infected by your meme to make profit at the start, in order to further lure them in. You also don’t want to generate too much profit for too few actors right at the start, this reduces the benefits you can provide everyone else. If you’ve played <a href="https://play.google.com/store/apps/details?id=com.miniclip.plagueinc&hl=en_IN&gl=US">Plague Inc</a> you know that everything that spreads needs its perfect infectivity to terminal effect ratio. Terminal effect here being profit or death.</p><p>Meme coins don’t need to counterbalance profits with losses while theyre in up only stage, however you may eventually find that you need someone to eat losses so that someone else profits. Try to concentrate the losses to few people and spread the profits to many at the start, to reduce the number of people being pushed away from your ecosystem. Once matured you could always engineer a major loss event across the entire ecosystem to balance out all the previously promised profits - although again, with meme coins this isn’t often even necessary.</p><p>Liquidity is powerful because it travels through timeframes - allowing market activity in one timeframe to subsidise activity in a different timeframe.</p><p><strong>#7 Be creative with tokens</strong></p><p>A lot of my previous steps sounds like they’re referring to a classic meme coin, this is not necessarily the case. A lot of it is applicable to all sorts of activity, be it engineering more dex trading, or a pool2 pool3 system, or something unique like Olympus. Anything can be memed, it can be an LP token, it can be a bond, it can be a staked token or a fourth-order derivative.</p><p>In fact, tokens aren’t even necessarily for speculation, they’re just a convenient and popular abstraction for it. Ethereum has no native notion of “tokens” - tokens are in fact mappings between addresses and single integer balances (A → b) where A retains the right to edit b or delegate this edititing right to a contract. (Which in turn gives you atomic swaps and AMMs and so on.) Contracts can be so much more creative - they can be multiple integers, they can be bit counters or state machines, and each of these can be imbued with its own unique meaning. For instance I could create an ERC20 or an NFT that flips between “red” and “blue” every time it is transferred, with a 1 in a million chance of turning “golden” in a transfer. Or I could create an NFT that doesn’t have a single owner - in fact it has a king, a priest and a vizier - all of whom together interact via complex rules to elect a new king, priest and vizier.</p><p><strong>#8 Create different forms of activity for different user brackets</strong></p><p>For instance in a leveraged setup, you have liquidity providers, you have stablecoin lenders, you have the people with leveraged exposure and you have MEV-optimising liquidators. In a pool1 pool2 pool3 setup you have different user brackets entering each pool.</p><p>The more different classes of users you are able to attract, the better it is for your product. It doesn’t even matter whether those users are critical to it at a purely financial level, they will likely still help at a narrative level. For instance NYAN or CARBON on arbitrum had no apparent financial need for a pool1 at all when pool2 is what generates profit for the devs, however the large amount of TVL attracted in pool1 may have acted as a narrative driver to push up prices in pool2 as well. Similarly MEV-optimisation of liquidators doesn’t seem like it’ll directly impact your lending protocol, until it attracts a lot of users studying your code who may also end up using your protocol or find other weird quirks in it.</p><p>Try to push the smart people into activity that does not eat too much into the profits of the rest. Note however the distinction between smart people and smart activity. Moving LUNAR in line with lunar solstices or BTC in line with each block reward halving isn’t necessarily smart activity, but it may still be conducted by smart people.</p><p>Also even smart people can make dumb moves if the protocol is sufficiently optimised for it. Think of all the people who bought too strongly into the value-capture meme as a way to value DeFi tokens without realising everything also strongly correlated with ETH price or the attention drivers mentioned above in this post. Or the people who believe that ethereum reinvents governance or finance or fair launches or whatnot. There’s certainly some truth to the fact that ethereum may have positive forms of impact, but it is easy to oversell the impact of any given event by tunnelling people into a collective attention space where memes spread better than the truth.</p><p></p><p>P.S. If you’re a budding protocol designer who found this article useful, please write to me on twitter or discord. I may not respond immediately but I would like to stay in touch long-term.</p>