Author: 0xMingyue Wu on Blockchain
As described in the official documentation of Aerodrome, Aerodrome Finance is the next generation of AMM, aiming to serve as the central liquidity hub for Base, combining a powerful liquidity incentive engine, voting lock-up governance model, and user-friendly experience[1]. Since the launch of the Aerodrome protocol on August 31st, the protocol has attracted nearly $200 million TVL within just 24 hours, and the annualized compounded yield of $AERO liquidity mining is close to 1000%. According to Defillama data on September 2nd, the total TVL of Base chain on September 2nd is $379 million, while the TVL of Aerodrome is as high as $196 million, accounting for 51.7% of the total TVL of Base chain, which can be said to have occupied half of the Base’s “territory”. What “magic” mechanism enables a Dex to achieve such tremendous success in such a short period of time? This article will start from Ve(3,3) (the core mechanism of Aerodrome), and provide an in-depth introduction to the core mechanism of Aerodrome, the generation of the flywheel, and the development prospects.
1 Game Theory and Flywheel: Ve(3,3)
The Ve(3,3) mechanism originated from Solidly, a protocol created by Andre Cronje, the co-founder of Fantom, but due to design flaws, the protocol is already in a “failing” state. Velodrome, the largest Dex protocol on Optimism chain, has improved the flaws of Solidly protocol, and Aerodrome inherits the latest features of Velodrome V2. The core mechanism of Aerodrome, Ve(3,3), can be divided into two parts: Ve&(3,3). Ve comes from Curve’s veCRV model, and (3,3) comes from OlympusDAO’s 3v3 game. The combination of the two attempts to balance the holders and traders in the supply, bringing more protocol revenue to projects (especially initial ones) that join the Ve(3,3) protocol, while improving the efficiency of reward distribution when leasing liquidity[2]. The following sections will introduce the ve and (3,3) mechanisms respectively.
1.1 veNFT, the evolution of veCRV
ve stands for Voting Escrow, which is the process of staking Curve’s governance token CRV for VeCRV to receive more rewards as an LP. It was first introduced by Curve to strengthen incentives for long-term token holders.
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In the Aerodrome protocol, there are two protocol tokens: 1) $AERO and 2) $veAERO. $AERO is the protocol token used to reward liquidity providers, following the ERC20 standard. Locking $AERO can obtain $veAERO. $veAERO is wrapped in veNFT, which is based on the ERC721 standard (also known as NFT). The quantity of $veAERO obtained from locking $AERO is determined by the locking time of $AERO (following a linear correspondence). The longest locking time is 4 years, and locking for 4 years can obtain a 1:1 ratio of $veAERO. Similarly, if locked for one year, only 1/4 of the locked $AERO quantity can be obtained, and if the locking time is very short (such as one week), only 1/208 of the locked $AERO quantity can be obtained. After the locking time expires, users can retrieve all their locked $AERO.
Aerodrome will emit a certain amount of $AERO every week, and holders of $veAERO will vote to decide which liquidity pool $AERO emissions will go to.
1.2 (3,3) Game
Derived from the (3,3) game theory of OlympusDAO (originating from Nash equilibrium theory), this term comes from the standard notation in game theory used to describe an important characteristic of games: the strategies and payoffs of game participants. In this notation, the first number in parentheses represents the number of strategies available to the first participant (usually the actor), and the second number represents the number of strategies available to the second participant (usually the opponent).
In the Aerodrome protocol, all protocol participants have three choices for the $AERO they receive: 1) provide $AERO liquidity; 2) lock $AERO and receive $veAERO for long-term holding; 3) sell $AERO. To simplify the multi-person game, the following figure shows the different behaviors of two Aerodrome protocol participants and their corresponding profits.
Figure 1.1 Aerodrome (3,3) Game
The first number in parentheses represents the profit of participant 1, and the second number represents the profit of participant 2. The larger the number, the higher the profit, and negative numbers indicate losses. The figure above is drawn based on the author’s understanding and does not come from official documentation.
As shown in Figure 1.1, based on the different actions of the two protocol participants regarding the $AERO they receive, there are a total of 9 possible outcomes, which can be broadly classified into 3 categories: 1) cooperation between both parties, where they lock the received $AERO or add $AERO liquidity to earn more tokens; 2) one party acts maliciously, i.e., one of the protocol participants sells the received $AERO; 3) both parties act maliciously, a typical case of “mine-sell-dump,” where both participants sell the received $AERO until the protocol is no longer profitable. For outcome 1) cooperation between both parties, both participants contribute positively to the protocol, improving the protocol’s TVL and participation, and together they receive more $AERO; for outcome 2) one party acts maliciously, the malicious actor gains temporary profits from selling tokens, while protocol contributors (liquidity providers/lockers) incur losses; for outcome 3) both parties act maliciously, all protocol participants participate in the protocol using the “mine-sell-dump” method, quickly selling the tokens they receive, resulting in the rapid depreciation of the protocol’s value. In Aerodrome, the “shovel” for mining (i.e., the token used to provide liquidity) is usually a token related to the protocol, which means that the interests of liquidity providers will also suffer losses when the value of the protocol goes to zero. Therefore, for outcome 3) both parties acting maliciously, the editor of this article believes that they cannot benefit.
In reality, real markets are often formed by countless protocol participants working together, which is more complex than the game between 2 protocol participants. For almost all ve(3,3) protocols, especially some ve(3,3) protocols without a background, the “mine and sell” mode leading to outcome 3) of market forces is the most common, only those “star” projects that have gained sufficient market participation and have balanced points moved to outcome 1) cooperation between both parties, which is also a dynamic balance that changes with the participation of new market participants.
1.3 Viewing the Ve(3,3) Core Participants’ Interest Game from the Prisoner’s Dilemma
When a ve(3,3) protocol short-term proves its value and accumulates a large number of lockers, the game has quietly changed. At this time, both liquidity providers and lockers have upgraded to “stakeholders” of the protocol. For the complex market composed of multiple protocol participants, this section will classify all core players of the protocol into two categories: 1) Liquidity providers of $AERO; 2) Holders who have long-term lockups of $AERO. The different behaviors of these two categories of members will also determine the fate of the protocol, as shown in the following figure.
Figure 1.2 Prisoner's Dilemma between Aerodrome Liquidity Providers and Lockers
The first number in parentheses represents the profit situation of participant 1, and the second number represents the profit situation of participant 2. The larger the number, the more profit is made, and negative numbers indicate losses. The figure above is drawn according to the author’s understanding and does not come from official documents.
As shown in Figure 1.2, the different behaviors of these two core participants will also lead to three completely different results: 1) Win-win; 2) One party gains; 3) Both parties lose. 1) Lockers cooperate with liquidity providers, and lockers guide the newly emitted $AERO to liquidity providers who make positive contributions to the protocol. Liquidity providers either lock up the newly obtained $AERO or continue to provide deeper liquidity, and the protocol develops positively, improving its fundamentals, resulting in a win-win situation for both parties; 2) Either lockers or liquidity providers act maliciously, such as lockers directing the emission of $AERO to malicious MEME tokens, or liquidity providers selling all of their obtained $AERO, which benefits the malicious actors and leads to the long-term value of the protocol being reduced to zero; 3) Both lockers and liquidity providers act maliciously together, causing the fundamentals of the protocol to deteriorate rapidly and the value of the protocol to quickly drop to zero.
This situation is similar to the “Prisoner’s Dilemma”. For individual liquidity providers or lockers, the most rational choice they can make is to act maliciously. At this point, the Nash equilibrium point[3] in this game is the point where the entire system incurs the greatest loss, and the equilibrium point is far from Pareto optimality[4].
How to break the “prisoner’s dilemma”? From the perspective of lock-up holders, the ve(3,3) protocol usually establishes a whitelist mechanism at the protocol level to prevent lock-up holders from acting maliciously; from the perspective of liquidity providers, the protocol usually provides lock-up rewards to liquidity providers. When liquidity providers obtain a larger amount of locked assets and become the main force of lock-up holders, the game between liquidity providers and lock-up holders is no longer a zero-sum game. Liquidity providers will make greater contributions to the protocol for their own interests. At this time, the Nash equilibrium point is transformed into the Pareto optimal point that maximizes the interests of the protocol.
2 The Operation of the Flywheel: The Upward Spiral and the Death Spiral
In the previous section, we explained the game theory of the ve(3,3) protocol. So what “magic” allows the Aerodrome protocol to attract 200 million US dollars TVL in just one day? In this section, I will explain the “flywheel” mechanism of Aerodrome.
2.1 The Flywheel Effect and the Secret of Attracting Funds
The name of the flywheel effect comes from the mechanical field of the flywheel. A flywheel is a rotating device that becomes more difficult to stop or change direction as its rotational speed increases. In business, this concept means that once a company or organization establishes some competitive advantages, these advantages will accumulate and strengthen like a rotating flywheel.
In Aerodrome, the fundamentals of the protocol (TVL, trading volume, and the total amount of external protocol bribes) and the protocol token $AERO constitute the two levels of the flywheel. Imagine when the price of the protocol token $AERO rises, liquidity providers earn more income, and they will provide more liquidity; liquidity depth optimization and increased trading volume lead to increased protocol revenue, and more people choose to lock up $AERO to obtain protocol income; the protocol’s popularity increases, and more external protocols participate in the operation of the protocol. And all of this (fundamentals) will continue to drive the rise of the $AERO token, and the value of the protocol will show an upward spiral, as shown in the figure below.
Figure 2.1 Aerodrome forward flywheel (price positive feedback)
On August 31, when Aerodrome officially launched, the Aerodrome team provided nearly 7% emissions of $AERO to the $AERO-USDC pool through its control of $veAERO. Due to the extremely small amount of $AERO in circulation on August 31, when the first $AERO transaction occurred, $AERO was priced. At that time, due to the huge lp (liquidity provider) income and the extremely small lp pool, the lp APR (not APY, APR is non-compound annualized) of the $AERO-USDC pool reached as high as 10,000% (this number is seen by the author, theoretically because of the very small pool and high rewards, APR can be higher). At this time, due to the huge income from liquidity provision, $AERO became scarce, and liquidity providers bought more $AERO to provide liquidity, thus driving up the price of $AERO. The rise in the price of $AERO enables liquidity providers to earn more income, and the forward flywheel is thus generated. In just one day on August 31, the Aerodrome protocol attracted 200 million US dollars TVL, occupying a significant portion of the total locked value on the Base Chain.
2.2 Rising Spiral and Death Spiral: How to Break It?
When Aerodrome attracts attention with its rising spiral, it is worth considering when this spiral will end. We all know that money does not appear out of thin air, so what is the flow of money in this mining feast (earning $AERO rewards by providing liquidity)?
Since the $AERO tokens earned by providing liquidity are linearly emitted, the circulating $AERO in the market will gradually increase. When it reaches a critical point, smart market participants will find that as the depth of the $AERO-USDC liquidity pool increases, the profitability of liquidity mining is no longer attractive. At this point, these market participants choose to sell their $AERO, leading to a decrease in the price of $AERO. When the selling pressure and buying pressure reach a balance, the upward spiral is broken, and the price of $AERO no longer rises. At this point, the income of the $AERO-USDC liquidity pool also stops changing. As more $AERO is released over time, when the selling pressure exceeds the buying pressure, the price of $AERO will fall, leading to a downward spiral, as shown in the figure below.
Figure 2.2 Aerodrome Negative Flywheel (Price Positive Feedback)
There are currently many ve(3,3) tokens in the market that are in a downward spiral, one example being the CHRONOS protocol on Arbitrum, as shown in the figure below. Its project token $CHR has fallen from the opening high of $1.81 on May 4th to the current price of $0.0168 in 4 months, a decrease of 99%.
Figure 2.3 $CHR Token Price Candlestick Chart
Although Aerodrome has a seemingly reliable team and cooperation with Base, its token $AERO may still have difficulty escaping the downward spiral. How to break this downward spiral? In fact, Velodrome, the parent protocol of Aerodrome, has already provided an answer, and the core of this answer is to increase the lock-up rate and firmly bind the interests of protocol participants with the development of the protocol. Since the launch of the Velodrome protocol on June 1, 2022, with the outstanding business capabilities of the Velodrome team and the cumulative total of 7 million $OP tokens provided by the Optimism Foundation, the lock-up rate of the protocol has remained high through various bonus activities. According to statistics from the official Velodrome Discord[5], on September 2, the lock-up rate of the protocol was still as high as 79.03%.
3 ve(3,3) Development Plan: Regain the Rising Spiral
For the core health indicator of the ve(3,3) token – lock-up rate, this section will discuss some methods that allow the protocol to increase the lock-up rate and regain an upward spiral.
3.1 Provide Lock-up Rewards
Providing a one-time reward to protocol lock-up holders is the simplest and most aggressive approach, as Velodrome did. Since its launch in June 2022, the protocol has provided nearly 15% lock-up returns to new protocol lock-up holders through funding from the optimism foundation. From the current perspective, Velodrome has been successful, with its TVL on the optimism chain exceeding all star protocols like Uniswap and Curve.
3.2 LaunchLianGuaid: Empowering Lock-up Holders
When I speculated in June this year why Binance did not list the token of the star project Velodrome on the Optimism network, a co-founder of Velodrome’s team surprised me with a sentence in Discord: When some centralized exchanges expressed their desire to list the $Velo token and seek cooperation with the team, the team’s response was: We welcome you to list $Velo, but we won’t provide support. At first, I was puzzled by the team’s behavior, but later I understood this: The price manipulation by CEX often attracts a large number of short-term speculators into the protocol. They will not participate in the operation and game of the protocol, but only participate in price speculation. However, for the ve(3,3) token, price speculation is fatal – price speculation leads to an increase in circulating tokens and a decrease in lock-up volume, which means the death of the protocol when it enters a downward spiral after the price starts to fall from a high level.
This also made me realize the grand narrative of the ve(3,3) protocol. A successful ve(3,3) protocol firmly holds the pricing power in the hands of the protocol, which can serve other protocols and act as an alternative liquidity solution. It is a new type of impermanent loss compensation scheme that uses protocol tokens to provide liquidity providers with returns. When the market environment is good, it will have a new coin listing venue that rivals mainstream CEX – LaunchLianGuaid.
ve(3,3) provides certain protocol token rewards to liquidity providers, which enables ve(3,3) DEX-like protocols to have the inherent ability to list new coins – newly launched protocols do not need to hire any market makers, they only need to import ve(3,3) protocol rewards into their token’s liquidity pool, and users will provide liquidity to the pool. Here, the ve(3,3) protocol can also empower lock-up holders through LaunchLianGuaid, thereby increasing the protocol’s lock-up rate and improving its health.
4 Summary and Outlook
This article starts from the ve(3,3) mechanism and introduces the inherent principles of the upward spiral and downward spiral caused by the ve(3,3) game mechanism. It also provides some methods to solve the downward spiral of the protocol. The vision of ve(3,3) is so grand, and different ve(3,3) protocols often make slight modifications to its mechanism. Due to limited energy and ability, there may be errors and incomplete descriptions in this article. Readers are welcome to provide valuable feedback.
I have learned from different channels that there are still many participants in ve(3,3) protocols who do not know how to maximize their profits by participating in such protocols. Moreover, there are already many external protocols thriving based on the ve(3,3) protocol, such as Sonne finance, Tarot, Extra finance, fbomb, USDR, etc. I still hope to write an article on how these protocols have developed and grown based on the ve(3,3) protocol, as well as the current status of their development. Stay tuned!
References
[1]https://aerodrome.finance/docs[2]
https://www.oklink.com/academy/zh/2022/01/27/hot-ve33-curve-olympus/[3]
https://zh.wikipedia.org/wiki/%E7%BA%B3%E4%BB%80%E5%9D%87%E8%A1%A1[4]
https://zh.wikipedia.org/wiki/%E5%B8%95%E7%B4%AF%E6%89%98%E6%95%88%E7%8E%87[5]
https://discord.com/channels/967319632530767924/993229082538029187/1147532036328923286
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