A deep dive into the DeFi DEX enabling cross chain liquidity
Before we drill into the details, it’s worth taking a step back to appreciate the privacy landscape we are currently navigating. Contrary to what some may believe, decentralization is not about finding sneaky ways to hide your wealth or assets – it is about your rights as a user being equal to those who set up the infrastructure of the system.
Say you’re an investor that wants to exchange native BTC for ETH in a decentralized way. To achieve that, right now, you’d have to go through multiple exchanges, wrapped tokens and expensive gas fees all the while trusting a third party to execute your transaction. What if you could get rid of all of that and instead rely on smart contracts that are instant, trustless and permissionless?
With its groundbreaking cross-chain liquidity infrastructure, THORChain allows for multiple layer-1 token exchanges across siloed blockchains such as Bitcoin, Ethereum and BNB.
What is THORChain?
If you’re new to THORChain and haven’t read our previous article in which we introduced the basics of the blockchain, here is a quick recap of the important points:
- THORChain is a layer-1 blockchain built on the Cosmos SDK and Tendermint.
- RUNE is the native chain’s token.
- It functions in a similar way to Uniswap, a popular decentralized exchange (DEX).
- What sets THORChain apart is that it caters for multiple blockchains.
As a point of reference, Uniswap recently surpassed a lifetime cumulative trading volume of $1 trillion. However, since the protocol is fundamentally smart contract logic built on top of Ethereum there is a constraint which limits the scope of swap functionality to ETH and ERC-20 tokens. This means that you cannot exchange tokens outside of the Ethereum network.
Key Ecosystem Stakeholders
Throughout this article we will refer to four key stakeholders who are defined briefly below:
- Swappers – use liquidity pools to swap assets.
- Liquidity Providers – add liquidity to pools and earn rewards termed liquidity fees.
- Node operators – provide bonds (i.e. RUNE) and are economically incentivized to secure the network.
- Traders (arbitrageurs) – monitor and rebalance pools with the intention of making profits.
DEX vs CEX – THORChain’s decentralized model
As we’ve established, THORChain’s infrastructure is different to the classic centralized exchange (CEXs) model we see today such as Binance, Coinbase and FTX. The Greymatter Research report highlights three key differences below:
- Fair distribution of fees to liquidity providers (LPs):
Instead of using a central limit order book (CLOB) as a means to achieve asset price discovery and accompanying asset swaps, the protocol uses an AMM model called Continuous Liquidity Pools (CLPs).
- Incentivising trustlessness:
Keys are distributed and delegated across a set of nodes (currently there are circa 100 nodes, with a target of 120) instead of the exchange being the trusted intermediary and handling private key management. In order to transmit funds, the system requires consensus from two-thirds of the node operators. Additionally, the node operators are incentivized to operate in favor of the protocol since the penalty for breaking the rules, whether it be due to negligence or dishonesty, is to slash the deposited collateral (bond).
- Substantive asset backing:
The native RUNE token exists as the base pair between all asset pools.
Who is behind THORChain?
THORChain was conceptualized in 2018 by a team participating in a Binance Dexathon (decentralized exchange coding competition).
The platform has no official CEO, founder, or director. The creators of THORChain are semi-anonymous because they did not want to create the ‘Jesus Effect’ that we have seen with many other DeFi projects. To ensure that the infrastructure remains decentralized, the governance vision is for THORChain to be run and owned by the community.
Now that we’ve cemented our foundations, it’s time to look into the mechanics of how THORChain works, starting with the RUNE token.
RUNE Token Utility
The native RUNE token has two primary uses:
- Liquidity Pool Token:
The token is staked in the various liquidity pools (it acts as the base pair) and allows traders to swap between different asset pools using RUNE as a hidden intermediary.
LPs are susceptible to impermanent loss, but the protocol offers impermanent loss protection on a sliding scale of up to 100 days for symmetrical deposits. This means that after day 1 the LP would have 1% insurance protection, on day 2 they would have 2% insurance protection and so on up to full coverage after 100 days.
- Collateral (bond)
The token can be put up as collateral by nodes to ensure network security. The bonded RUNE is kept inside the Asgard vault where it cannot be accessed by the THORNodes. If the node operator acts in bad faith against the network by stealing the funds in the vault, their RUNE will be seized and because they will lose 1.5x the value of what they stole, it is not economically attractive for them to do so.
Each node must bond a 2:1 ratio of RUNE to staked external assets (BTC, ETH, BNB). For every $1 of BTC pooled, there must be $2 of RUNE bonded by the nodes to provide security.
The Incentive Pendulum – how does this work?
The optimal state of the THORChain network exists when for each $1 of an external asset in the system, $3 of RUNE is locked up alongside it. This means there is 50% RUNE bonded by nodes and 25% RUNE matched with 25% external assets by the LPs.
If there is too much capital in liquidity pools, the network is unsafe and vulnerable to attack. If there is too much capital bonded by nodes, the network is inefficient.
Naturally, the ebbs and flows of the capital markets alters this ratio.
When the 2:1 ratio breaks down and the value of staked assets becomes greater than the value of bonded RUNE securing the network, the node operators receive a larger share of system income to incentivize them to bond more RUNE to secure the external assets in the liquidity pools.
This mechanism is referred to as the ‘Incentive Pendulum’ and aims to distribute capital across nodes and LPs in the desired 2:1 ratio described above.
The investment case for THORChain
To appraise THORChain’s potential, let’s go back to first principles: supply and demand. Our analysis includes some hand-picked metrics – let’s start with 5 demand side factors.
1. THORChain DEX Volume
There is a fundamental mechanism in place which enables the protocol to thrive. To start, there is demand for decentralized exchange services and users are willing to pay a fee to swap layer-1 tokens in a trustless and permissionless manner. Hence, there is a profit motive which drives LPs to provide liquidity. As such, the actual swap volume determines the APY that can be earned by the LPs.
Across the last couple of months, the swap volume averaged at around $25m per day, which would equate to a monthly volume of $750m:
Currently, UniSwap processes significantly more transactions, with Coin Gecko reporting $1b in volume per day during the month of May. To put these figures into perspective, centralized exchanges such as Binance can process $15b per day.
This indicates that traders continue to prefer centralized exchanges over DEXs. However, this could gradually change as the UI and UX of platforms improve combined with a greater awareness of the advantages of using DEXs.
It’s worth noting that even if swap volume were to fall over the coming bear market, node operators are still able to earn RUNE through token emissions.
2. Income Earned by Nodes & LPs
Income available to nodes and LPs consist of liquidity fees generated from token swaps & block rewards (also referred to as token emissions).
According to Delphi Digital analysis, from Q4 2021 to the end of Q1 2022, on average 15% of the total revenue originated from liquidity fees generated through cross-chain swaps and the rest was made up of block rewards. Hence, the majority of fees (approximately 85%) earned by nodes relate to the block rewards.
Most L1 networks such as Bitcoin and Ethereum, typically have organic fees (not block rewards) making up 1-5% of total revenue, putting THORChain in a good stead.
Further, the liquidity fees share of total revenue has been generally consistent, possibly due to the inelastic demand for unwrapped cross-chain swaps.
Liquidity providers earn one third of the system income, with the rest being earned by the nodes to compensate them for taking on the most risk. To be a node, you need to bond at a minimum 300k RUNE which equates to roughly $480k at the time of writing.
3. Node count
As there is a legitimate demand for THORChain’s service offering, nodes and LPs are incentivized to acquire RUNE to enable the upkeep of the network and make profit in the process.
The native token is intrinsically baked into both the liquidity provisioning of the protocol and the economic security model that allows the system to function.
The graph below shows that the number of nodes has progressively increased and is now above 100. This illustrates that there is a growing demand for RUNE tokens by nodes to participate in the ecosystem.
It’s promising to see that the node count is rising, however it’s worth noting that collusion risk is always a present factor. Although the distribution of power is deliberate and careful, one cannot be entirely sure that the network will always be collusion free.
4. APY as a KPI
Another useful metric to help gauge the attractiveness of providing liquidity is the yield obtained from the different liquidity pools.
Throughout 2021, the average APYs on BTC, ETH, and BNB pools were 16%, 18%, and 35% respectively — which is strong for high-quality crypto assets.
However, at the time of writing, the yields for the three largest THORChain assets have dropped to 2%, 7% and 8% respectively.
Liquidity fees are derived from trade volume, thus, as we enter a bear market the number of swaps naturally declines, which results in lower yields across the board.
5. TVL as a leading indicator
At its peak, the TVL reached $549m, which indicates future potential when the market eventually turns around again. The composition of this liquidity primarily relates to BTC, ETH and BNB.
For comparison, Trader Joe, Avalanche’s largest DEX peaked at $2.5b and REF Finance (DEX) on NEAR topped out at $277m.
At the time of writing, the TVL of non-RUNE assets in all liquidity pools was fluctuating around $160m, meaning the market capitalisation of RUNE must be at least 3x (i.e., in the region of $480m) due to the 3:1 ratio of RUNE to non-RUNE assets discussed above.
The optimal state ratio sets RUNE’s deterministic market capitalisation, anything in excess of this is market speculation.
The chart below illustrates the shift in market sentiment from Q1 to Q2 of 2022 as more LPs decided to remove non-RUNE assets from the blockchain amidst challenging market conditions.
In terms of price action, in a market downturn, it is unlikely that there will be much speculation on the price of RUNE. During the bull market, the price reached a significant speculative premium of $21 in May 2021, however, the token is down more than 90% from its peak along with the rest of the market.
Now, let’s consider the supply side factors.
RUNE has a maximum capitalisation of 500m tokens. 40% of this total supply (200m RUNE) is non-circulating – formed of vested seed/team allocations and reserves.
The reserve emits block rewards, Impermanent Loss Protection Payments and, in extreme cases, may compensate network participants for their losses. At present, the reserve is in a strong position by holding $2B worth of tokens.
Approximately 30% of the circulating supply is voluntarily locked in bonds and pools. Bonded and pooled RUNE is productive as it is used for security and swaps respectively.
Liquid Supply Curve
The below graph details that the RUNE token supply is programmed to be released in a gradual manner across various categories, such as team and investors. This is important as sudden spikes in supply can cause downward pressure on token price.
RUNE Token Emission Curve (inflation)
In terms of the annual inflation rate (token emission schedule), the system rewards early behavior by distributing RUNE from the Protocol Reserve. It gives out 1/6 of the Protocol Reserve each year. The system aims to reach 2% annual inflation after 10 years and it is assumed that blocks are created every 5 seconds, and 6.3 million are created per year.
There is an expectation that over time, the fees distributed to nodes and LPs will originate as a higher proportion from fees than block rewards.
In addition to the above investment case, there are few exciting developments in the pipeline worth keeping an eye out on:
1. THORFi – Think DeFi on THORChain
Chad Barraford is the author of this innovative system. THORFi is the next biggest milestone on THORChain’s journey, which will introduce a number of novel products including no liquidation lending/borrowing, and single-sided fixed yields (ie. earn BTC on BTC). The design of THORFi is out of the scope of this article but those interested can take a look here. A start-up called Lendscape is leading the way in designing the front-end of this new system.
2. New Chain Integrations:
Cosmos Hub, Avalanche, L2s, and many others are amongst the chains that will be integrated in the near future. With each chain integration, we will likely see the amount of RUNE in pools going up along with the deterministic RUNE price.
3 . More wallets:
In order to interact with THORChain you need a wallet that has a compatible integration. As this a crucial prerequisite for THORChain’s success, wallet integrations will be a top priority for devs in 2022 and there is a strong expectation that all major wallets will eventually integrate with THORChain.
Bear market aside, there isn’t a more exciting time to be involved in DeFi especially when a project presents such strong fundamentals. For one, the RUNE token is well-integrated into the THORChain ecosystem and the token economic design reasonably ensures that the value of RUNE increases with the growth of the ecosystem.
The consensus from industry experts is that we are moving towards a multi-chain future. If you think of each chain as being a major global city, each one has its own unique characteristics. Whether you pick London or New York is down to personal preference. In a similar vein, users will migrate to the chains that suit their individual needs, from building communities, to staking, trading and investing.
THORChain is on the right side of a growing shift that is gathering momentum. They are the first movers in the multi-chain liquidity aggregation space and are providing the infrastructure to enable permissionless and trustless token exchange.
We imagine that in this multi-chain future, THORChain is well-positioned to play an important role in reshaping the ways in which investors and users interact with the blockchain