THORChain Data Digest: Block Rewards and the Incentive Pendulum. The Keys to a High Yield.
The APYs on THORChain are excellent. You can earn 30% APY on your BTC, an otherwise unproductive asset in defi, and much higher APYs in other pools such as BUSD. Fee revenues make up a portion of this, but in THORChain’s early state of adoption, the two key drivers of these high yields are in fact Block Rewards and the Incentive Pendulum.
Block Rewards currently make up 75% of income to LPs and Node Operators. 721,145 Rune was paid out in Block Rewards from launch of MCCN until the first halt, while just 237,869 Rune was earned in fee revenues.
The Incentive Pendulum is also massively inflating rewards to LPs. Bond wars between Node Operators, coupled with limited caps raises to add liquidity, is consistently forcing THORChain into an inefficient (overbonded) state, boosting APYs to LPs. If you wondered how you were getting such high APYs on pools with tiny trading volumes, this is how.
1. Block Rewards
1.1 Summary of System Income since launch of MCCN: Block Rewards and Fees
1.2 How much volume/users do we need to maintain high APYs when Block Rewards fall off?
1.3 Block Rewards as a Cost to the Reserve
1.3.1 Breakdown of Costs to Reserve by Pool
2. Incentive Pendulum
2.1 The Incentive Pendulum inflating LP rewards
1. Block Rewards
Block Rewards currently make up 75% of earnings on THORChain. This is due to the emissions schedule of Rune, which starts high to bootstrap liquidity to the platform, and will slowly decrease by 1/6th each year over a period of 10 years. The idea is that high initial block rewards will draw users to the platform, but over time as the platform grows, fee revenues will take over as the main source of earnings.
1.1 Summary of System Income: Block Rewards and Fees
System income on THORChain comes from two inputs, Block Rewards and Fees. In figure 1 we can see the breakdown of earnings on THORChain from launch of MCCN to the first chain halt. In the short term, payouts from block rewards are accelerating as the system grows with each churn and caps raise. This is what creates the step pattern in the green graph. In the longer term, block rewards will taper off, following the emissions schedule of Rune.
From about day 50 onwards, block rewards have consistently been higher than fee revenues. Fee revenues have seen two large peaks, 45 and 74 days after launch of MCCN, which were caused by market crashes. Market crashes boost fee earnings as investors rush to stable coin pools to protect their portfolios. This increases volume, and hence fee revenues. While the first spike in fee revenues on day 45 exceeded daily block rewards, the spike on day 74 was easily outpaced by block rewards. This trend of block rewards outpacing fee revenues is likely to continue in the short term, until a combination of tapering Rune emissions and growing THORChain adoption start to reverse this.
1.2 How much volume/users does THORChain need to maintain high APYs when block rewards fall off?
As we have seen, THORChain’s yield is currently coming mostly from block rewards. These block rewards will reduce over time, decreasing by 1/6th each year for 10 years. All other things equal, how much additional fee revenue is necessary to compensate for this, and maintain current APYs? Using data from up until the first halt of MCCN, we can get a fair estimate of this.
A total of 721,145 Rune has been emitted in block rewards. A total of 237,868 Rune has been earned in fees. A 1/6th decline in block rewards meaning a 120,191 Rune reduction in earnings. This will require just over a 50% increase in fee revenues to compensate.
THORChain has seen 105,118,374 Rune total volume across all pools since launch of MCCN. To increase fee revenues by 120,191 Rune, we need a 53,114,511 Rune increase in volume. This translates to an increase in daily average volume from 1,118,280 to 1,683,329 Rune.
Current unique swappers on THORChain is 19,876. Extrapolating from this, THORChain would need to grow by 10,043 users to increase volume sufficiently.
To put this into perspective, Uniswap went from 24,963 users to 57,976 in July alone. Uniswap is only single chain, and it still grew its user count by 132%. Based on this, the goal of 10k users growth for THORChain seems easily within reach.
1.3 Block Rewards as a Cost to the Reserve
In figure 2 we can see the balance of block rewards as a cost to the reserve, against its share of income from fees. I also include Impermanent Loss Protection (ILP) in this graph, which is the other regular cost to the reserve. The dashed lines show costs. The blue dashed line is the block rewards, and orange dashed is Impermanent Loss Protection (ILP). The solid green line is fee income to the reserve.
The first thing that stands out is that ILP payouts are trivial compared to block rewards. A total of 721,145 Rune has been paid out in block rewards since launch of MCCN, but just 11,516 Rune has been paid out in ILP.
The second trend that stands out is that income to the reserve from fees is consistently higher than ILP pay-outs. This is encouraging to see, and gives us a glimpse into the long run income vs expenses for the THORChain reserve, once block rewards have reduced. ILP payments peak 45 and 74 days after launch, which coincides exactly with peak earnings to the reserve. This is because both ILP and fee revenues follow largely the same pattern, peaking in market crashes.
You can find a detailed breakdown of ILP payouts and fee revenues on THORChain here:
The tldr from these reports is that both ILP and fee revenues accelerate massively in market crashes. For ILP, fear in the market is the main driver of ILP payouts. In periods of market greed, the average ILP payout is just 43.9 Rune per day, but in periods of market fear this increases to 646 Rune. A fearful investor is much more likely to bite the bullet and cash out the ILP. At the same time, market crashes are also some of the best periods for earning fees in THORChain. This is because volume to stable coin pools massively accelerates as investors rush to protect their portfolios. These two competing factors balance out, and allow income to the reserve to consistently keep pace with system expenditures.
1.2.1 Breakdown by Pool
Out of curiosity, I had a look at each pool individually to see if any was a net liability to THORChain, i.e. ILP payouts for that pool were greater than fees generated for the reserve. I thought perhaps some of the smaller pools with little trading volume would be net negative, but to my surprise not a single pool was a liability. It appears that fee revenues and ILP payouts are closely correlated. You can see a full breakdown of each pool in figure 3 (if a pool is not included, it is because it has paid out 0 ILP).
2.1 The Incentive Pendulum is massively inflating LP rewards
The Bond Wars between Node operators, coupled with limited caps raises to add liquidity, is consistently forcing the incentive pendulum into an inefficient state. This is massively inflating LP earnings.
The optimal state for THORChain is to have bonded capital match pooled capital. In this efficient state, 67% of system income (block rewards + fees) go to Node operators, and 33% goes to LPs. The game theory of the incentive pendulum should create an equilibrium at this efficient state, and this is what I expected to see in the data. When the system is overbonded, the incentive pendulum swings to favour LPs. Earnings increase past the 33% equilibrium, encouraging Nodes to move some of their bonded capital to pools, and bring the system back into balance. Similarly, if the system is underbonded, LP earnings decrease, Node earnings increase, and the opposite effect should occur.
However, to my surprise, we see a very different story playing out in practice. In figure 4 we have how earnings should look when the system is in an efficient state. In figure 5 we have how earnings look in reality. Not only is the earnings split vastly different from the efficient 67% to 33% split, but LP earnings are in fact consistently higher than node earnings. Since launch of MCCN, 534,278 Rune has gone to LPs, while just 424,736 has gone to nodes. This is a split of 44% to 56% in favour of LPs. The inefficient state of the incentive pendulum has contributed an additional 214,606 Rune to LPs, which is a large part of why APYs have been so high on THORChain.
APYs on THORChain are great, but this is not currently due to THORChain’s trading volume. In this early stage of MCCN, high APYs are coming from two main factors: block rewards and the incentive pendulum. Block rewards make up 75% of all system income, and will continue to outpace fee earnings in the short to medium term. The incentive pendulum is also inflating APYs for LPs. The bond wars between Nodes, coupled with limited caps raises to add liquidity, are forcing THORChain into an overbonded state. This in turn boosts rewards for LPs.