Next Gen Tokens

Introduction

The Mutual Fund celebrated its centennial last year. These were the crown jewel of fintech in their day and they predate the SEC which is a good reminder that fintech innovation was entirely possible before the SEC graciously stepped in to protect all of us. Mutual funds gave investors price exposure to an entire sector through a simple passive investment. It’s an early example of using the same bookkeeping system we use for ownership of companies for more abstract financial intentions.

Then in the 1990s Tradfi invented ETFs. These were more tax efficient than mutual funds because buyers could treat income as capital gains and redeem the shares for in-kind assets (not a taxable event) but most importantly they were natively tradable on the stock exchange throughout the day rather than indirectly through the fund company or brokers after market close. Taxes deferred allow you to compound more money. Paying a lower tax rate effectively increases your yield compared to dividends. Fairer redemptions protects the peg and leads to a healthier asset for buyers.

The benefits of these changes are undeniable and due to them ETFs have experienced explosive growth. Since their inception ETFs have been gobbling up an ever larger share of the economy. In the early 1990s at the advent of the ETF, mutual funds accounted for around 20% of the NYSE total market cap. Today, mutual funds and ETFs together account for around 40%. This is in addition to the market cap rising from 36.7% of US GDP to a staggering 208%. This shows just how much fundamental value there is to a financial wrapper around even the simplest financial intent. It’s a game changer.

In Tradfi when you wrap these things with their own identifier and make them tradable they call it a Structured Product. In Defi, we call it a token. You can make your own in just a few minutes. If you’re willing to put in more work you can make tokens that express sophisticated financial intents. The more sophisticated tokens today offer the same benefits ETFs brought to the stock market but they wrap yield-bearing, self-compounding, leveraged strategies that anyone, anywhere in the world can access with nothing more than a swap or deposit. You no longer have to resort to writing smart contracts to execute flash loans or recursive looping like this. Uniswap v1 didn’t return a token. Uniswap v2 did; and I attribute its dominance today to this simple fact. The simple act of creating a token for each LP enabled the liquidity farming boom of 2020.

In the same way ETFs are eating the stock market, tokens are going to eat Tradfi. [1][2]

What I’m perhaps most excited about is tokenization. So I think Robinhood is uniquely positioned at the intersection of traditional finance and defi. We’re one of the few players that has scale both in traditional financial assets and cryptocurrencies. What that means for us is bringing real assets on crypto technologies and giving people access to real world productive assets using crypto rails where they benefit from liquidity and the other advantages of that technology. What that means is equities, private investments, and more should be brought onto crypto technology to unleash the true power of the crypto revolution.

Vladimir Tenev – CEO Robinhood

We believe the next step going forward will be the tokenization of assets. That means every stock, every bond will have its own CUSIP. It’ll be on one general ledger. Every investor, you and I, will have our own number, our own identification. We could rid ourselves of all issues around illicit activities about bonds and stocks… But the most important thing, we could customize strategies through tokenization that fits every individual. We would have instantaneous settlement. Think about all the costs of settling bonds and stocks but if you had tokenization everything would be immediate because it’s just a line item. So we believe this is a technological transformation for financial assets.

Larry Fink – CEO Blackrock

Those are not random crypto influencers. Larry Fink is the head of one of the largest asset management firms in the world. If ETFs and Mutual Funds can reach 83% of US GDP, tokens which do all of that and more can surpass that number. This basic fact gives tokens over a 20 trillion dollar addressable market cap even if all we accomplish is vampiring ETFs onto blockchain rails to add blockchain superpowers. Tokenization is a multi-trillion dollar value-add to the world. And which ledger do you think is going to be the “one general ledger” that all of these stocks and bonds will run on? The chain that goes down when there’s a memecoin launch? A corporate chain without credible neutrality? I don’t think there’s much doubt.

Next Gen

A major wave of tokenization is coming and it isn’t going to stop at replicating Tradfi. Tokens are going to be composed into powerful products that Tradfi has no parallel for. We have already reinvented most Tradfi machinery on-chain. You can profit from accurately predicting any type of price movement you can imagine; up, down, sideways, or like a toddler with a crayon. All of this is built on more technically sound infrastructure backed by more math and fewer counterparties. This covers everything from decentralized exchanges, to rate-stripping protocols, to options protocols.

The next wave of tokens are going to exist as higher level abstractions that wrap financial intentions for both more convenience and capital efficiency. They will enable you to use leverage while still being able to sleep at night. They will make our governance designs more resilient. They will package an entire financial strategies such as an insured leveraged position in a single wrapper. Here’s just a smattering of ongoing innovation that I’m aware of.

Yield Bearing Indices

Yearn Finance pioneered pooled auto-compounding positions in 2020. These were passive instruments that didn’t require the gas-intensive claim, sell, deposit loops we had become accustomed to at the time. But even today, it takes regular monitoring and adjustments to maintain a high yield rate on platforms like Yearn or Beefy. This is the opposite of convenient, it makes my tax accountant hate me, and also makes me pay a lot more short term capital gains than I’d otherwise be able to.

The less sovereign but convenient answer to this inefficiency is managed indices where a fund manager does that work for you. The more manual form of this is Morpho Vaults or something like hyETH that wraps them in a token. The more algorithmic form of this is something like Tokemak’s Autopools. Either way, someone is defining a set of investment opportunities as a policy to the vault and then pushing money around Defi in a yield seeking fashion so you don’t have to while wrapping all that work into a token so you aren’t incurring taxable events as it happens. So far these only deal with correlated assets because managing IL has been an industry headache in the past but nonetheless these are very nice tools that still have capital controls to prevent the centralized rug risk of a traditional fund manager while offering a layer of convenience, gas reduction, and capital efficiency.

Leverage Tokens

Leverage platforms in Defi are powerful but the leveraged positions within them are usually untokenized. This is because the UX flow usually goes like this:

• Deposit your collateral(s).
• Open a leveraged position.
• Valhalla or Liquidation. (Remember kids, leverage is dangerous).

The deposit transaction is usually separate from the leveraged transaction because there is a good variety of things you can use that collateral for on the leverage platform. Separating these steps improves flexibility. However, not outputting a token on deposit is unfortunate because… well go read the Introduction again .

So, while this flexibility is good it comes at the cost of capital efficiency. It would make sense then for at least a few of the most common leveraged positions to be put into token wrappers when that full flexibility isn’t needed. And that’s what Index Coop is doing. They are creating leveraged ratio tokens to bring the benefits of tokenization to this common financial intent. Underneath it’s basically just using the 2x long asset to borrow and sell the 1x short asset from Aave. They proactively manage the borrow position to maintain the 2x leverage. Think of it like someone wrote a token wrapper, ETH2xBTC and BTC2xETH, around these specific DefiSaver positions. You could achieve the same effect using perpetual futures, however:

• Your tax accountant might hate you and you’d be reporting any gains from things like funding rates as income instead of capital gains.
• Funding rates on perpetual swap platforms are usually higher than money market borrow rates.
• Funding rates are more reactive to shortages than money market rates so you can experience some horrific rate spikes.
• There’s no liquidation protection on the perpetual swap. People can and do get painfully liquidated on these platforms all the time.
• You would have to learn perpetual swap platforms which are a lot more intimidating than dexs.

Overall, it’s a simple system that makes leverage much more accessible even if it does come with the overhead of actively managing the leverage.

Delta Neutral

A normal person investing in assets enters a position by buying the asset and then exits the position by selling the asset. Here in web3 fewer of us every year qualify as normal. You see, market selling means you have to sell, which means you need liquidity to sell into, you are creating taxable events, etc. A less considered alternative to market selling is to buy a 1x short position somehow. If you hold both then as the asset price rides the famous crypto roller coaster the long would make money and the short would lose the same amount of money or vice versa. The result is zero change wrt whatever your short it redeemable in. Monetarily it’s very similar to selling the position as long as you can exercise the put. A position that is not subject to price volatility is called delta neutral.

There’s a few fun advantages to this. As mentioned above, it might allow you to defer a taxable event on the asset being sold until long term capital gains would kick in which is useful even if the option comes at a premium. In addition to this, what if the token you would be selling was interest bearing? By continuing to hold it you continue to collect interest. As long as the interest on the long exceeds the cost to borrow or premium on the put you’re now profiting from a carry trade. I wrote about a different variety of a carry trade a few years ago which may be worth revisiting to see how it has played out. There’s a few other facts worth noting here as well.

First, while I did say to buy a 1x short position, you are going to almost certainly use the long position as a collateral to borrow and create a 1x short position. This saves you from needing to come up with more capital. If you use a money market to execute the max short you can walk away with the stablecoins but you probably can’t actually get to a delta neutral position due to LTV (loan to value) caps. This is still a nice option but there are risks I talk about in the post linked above. Otherwise you can use a variety of leverage platforms to get that LTV up to 100% and actually be delta neutral but you won’t be able to withdraw the stablecoins.

This brings me to the second useful fact. The cost to short crypto is usually less than the cost to long due to the industry being generally bullish over the years. Case in point, this is why that icETH token is still making money years later. This fact is dead obvious if you looking at the funding rates on perpetual swap platforms. When this line is above zero, it means you can get paid taking a short position.

Combined, you are now in a position where you are making money on both the collateral and the short of your delta neutral position. That is just wild. So instead of selling your crypto, invoking a taxable event, and making stablecoin yield you can enter a delta neutral position, forfeit the profit from price appreciation, but retain collateral + funding rate yield while deferring a taxable event on the crypto collateral for as long as you like.

An astute reader will be asking themselves what is preventing someone from just buying crypto and entering such a position immediately from stablecoins? Nothing at all. You can do exactly that. If you do this with ETH you are giving up the stablecoin yield which is most likely sourced in some way from US treasuries in exchange for yield from staking + funding rate. This can be advantageous in certain macro environments such as when fed interest rates are low and it’s a risk-on environment with a lot of demand for leverage so the funding rates are high.

Of course someone has already tokenized this idea so you don’t have to manage the short position yourself and worry about brief fluctuations in the LST peg or funding rates. For a delta neutral position the most natural denomination is in whatever you are delta neutral to. This is going to most commonly be USD so the token wrapper around this position is itself a stablecoin.

This leads us to a new paradigm for stablecoin design. Consider stablecoin designs to date. How do they protect their peg in order to be stable? I see three basic mechanisms in play all of which lead to problems constraining adoption.

1. Redeemable reserves. These have the hardest peg but are ultimately only as strong as the underlying asset they are redeemable for. Stablecoins such as USDC are backed by treasuries and redeemable for USD so they are subject to government default/control. Furthermore, Circle can just blacklist your address. Stablecoins backed by USDC such as FRAX inherit this problem. LUSD/BOLD are backed by redeemable ETH collateral which leads to a hard peg but the redemptions force borrowers to maintain terrible LTV ratios which limits adoption.
2. Dynamic rates. USDS/DAI and similar coins are all borrowed into existence. They retain their peg by manipulating supply and demand of the token using variable interest rates. This leads to two problems. First, the interest rates are usually subject to governance intervention which is fallible. Second, it can depeg for weeks before interest rate changes can force holders to restore the peg.
3. Revenue. Tokens like alUSD are backed by revenue from the collateral assets. This has proven to provide a relative weak peg and we regularly see tokens like this multiple percent off their peg. This is not a hallmark of a stablecoin and obviously limits their adoption as a token to hold for stable value.

Some tokens combine more than one of these approaches. For example crvUSD combines both reserves and programmatic adjustments to interest rates.

Contrast this with a stablecoin wrapping a delta neutral position which I’ll call dnUSD which could be backed by any interest bearing collateral for which there is enough depth in options/perpetuals markets for any like-kind asset.

1. Unlike USDC, Circle can’t blacklist an address. dnUSD isn’t derived from USD in any way and therefore wouldn’t be affected by the US government defaulting on US treasury bills or seizing the underlying reserves.
2. There is no need for a DAO to set or manipulate rates. The only rates are the collateral rate (e.g. staking) and the funding rate both of which are set by wider market forces that are difficult to manipulate.
3. Like LUSD this should be redeemable for the underlying but without the terrible UX to borrowers and LTV inefficiencies. This creates the necessary stability for adoption as a stablecoin.
4. Unlike borrowed stablecoins which are limited to scale with the demand for leverage, dnUSD adds revenue from the collateral. This enables to scale beyond the 0 funding rate line as far negative as the interest from the collateral. This is mathematically more scalable.

So what started as a way to potentially defer a taxable event to reduce tax obligations led to potentially the best pattern we have seen for a truly decentralized stablecoin once we wrapped the position in a token. That’s actually rather profound.

Timelock Tokens

Protocols often benefit from duration commitments from their users. For governance tokens duration commitments help to align voters with the long term success of that protocol and it helps to lower the TVL volatility within LPs from liquidity locusts as crypto prices and rates change dramatically on shorter time scales. We implement these duration commitments as timelocks. Typically these timelocks either return no token at all e.g. veCRV (but we like tokens), return an NFT (token but no liquidity or price data), or people use liquid lockers like Convex or StakeDao to a create a token where there would otherwise be none.

There are a few things I think we can improve compared to liquid lockers. First, assets unlock (become available for sale) according to their lock time and not according to the needs of the protocol. This can lead to systemic but avoidable risks when large players unlock and exit all at once. Second, there’s a bunch of unnecessary maintenance in frequently relocking your position. Third, the liquid locker token itself handily defeats the point of a duration commitment from users. The above concerns can be addressed by some subtle changes to the timelock design.

There are two parts to this, both of which can be designed in a variety of ways. On the first part, decoupling from a pure time-based unlock requires some kind of new system parameter. Unlocks could still be a function of time but multiplied by an adjustable rate. This rate could be managed by governance or self-adjusting like interest rates in money markets like crvUSD based on something like the percentage of the supply locked in governance or distance from target liquidity depth. The idea is to make it easier for people to exit when the system is healthy and has what it needs and harder to exit when the system is under duress. I always prefer more intelligent and algorithmic solutions to naïve ones and this is an easy way to achieve that. Let’s call this dynamic timelocks.

The second part is the mechanism of the unlock itself. With the veCRV model your voting influence decays to 0 over time but your entire position unlocks at the end of the timelock. People don’t like this so they mostly use liquid lockers so they can exit when they want to. However the liquidity on liquid lockers is illusory in practice (CRV liquid lockers depegged almost 50% at the end of 2024), it adds a middleman protocol that extracts value from the base layer and ultimately gains governance control over it, and it would rather seem to defeat the point of a duration commitment from users if users can exit at any moment without penalty. Rather than having users sell an illiquid position, what if they could just buy their way out of the timelock? Practically this may sound equivalent to losing 50% to exit on your cvxCRV position but there are several differences. For one, where does the lost value go? In the current model it goes to whomever buys the token and waits for the repeg. In the case of an official exit penalty though it could go to the protocol as revenue rather than a third party. This compensates all the holders who held through the drop rather than just the people who bought the bottom. Second, it could effectively have infinite liquidity depth compared to liquid lockers today and it could achieve that without having to pay extra yield to LPs for the liquid locker token. So, fewer middlemen, better value capture to the protocol, and more deliberate control over exiting.

How do we implement this? Well it’s not hard to imagine a rage quit function on your veToken position that implements the penalty. The penalty could be adjusted to implement a dynamic timelock. This is pretty weak on the tokenization front though. An alternative design being developed by Alchemix is to emit a new token called Flux that you can burn to unlock your locked tokens. This tokenizes and therefore monetizes the timelock itself. It’s a bit like rate stripping. What I find very interesting about this design is you can just leave everyone “max locked” all the time so it removes a whole lot of bookkeeping on-chain tracking the individual positions and it removes all the maintenance relocking transactions from the system. To combine this with dynamic timelocks you just change the rate at which Flux is emitted by the system so you can manage the amount of unlock overhang at any given time. And there’s no particular need to maintain liquidity depth on the Flux token like there is on something like cvxCRV/CRV. It’s a definite step forward.

Permissionless LRTs

In my restaking post I said I’d like to see a “Rocketpool for LRTs.” What does this mean? Well, imagine you are a home staker today with some excess bandwidth and disk space on your Ethereum validator and you want to sell this extra capacity to EigenDA. How do you get someone to delegate to you? In EigenLayer the capital provider has to first deposit their LST then they have to select a node operator and delegate that deposit to them. As a node operator, how does someone discover you and why do they trust you? You’re probably on page like 100 of the EigenLayer node operator listings and even if someone searches the dregs there’s not a whole lot of metadata about these node operators on the EigenLayer listing that someone could use to vet you. You are beneath the profit margin bar of an LRT protocol like Etherfi to be worth vetting. So you either delegate capital to yourself which defeats the point of the system or you don’t get to participate. Either option excludes smaller operators from participating but that strongly centralizes the node operator set for AVSs of all kinds which is a pretty unhealthy outcome.

To change this we need to invert capital deployment from a push model like EigenLayer uses to a pull model like Rocketpool uses. Rather than a capital provider delegating directly to a node operator, the node operator requests delegation from a pool of funds. This way the node operator doesn’t need to be discovered which is obviously better for smaller operators you’ve never heard of. When the node operator requests delegation though, why do capital providers trust the node operators not to do something malicious? For centralized LRTs (all of them today), the LRT team serves as a risk underwriter in selecting curated node operators and AVSs to delegate capital to. What’s the parallel here? Well, usually the node operator will have to have something at stake equivalent to the RPL stake a Rocketpool node operator has to provide.

However, this is going to be a lot more complicated than it is just for ETH staking. Rocketpool has had multiple years to settle on the appropriate fee split and collateralization rules for just one type of service and yet they are still undergoing dramatic redesigns in their tokenomics to change these dynamics today. So how do you manage all the collateralization rules, fee split rules, and build liquidity on an LRT so it’s actually liquid when there are going to be hundreds of AVSs instead of just ETH staking and when the risk appetite of capital providers is so diverse? I propose that instead of trying to wrangle everyone into a single LRT under a single DAO you’ll need a marketplace of many LRTs that can fight for mindshare. Right now, with the centralized LRTs there are about half a dozen different points on risk spectrum that have representation and the policy of the risk underwriting for each team is entirely opaque. I’d prefer a system where anyone can build their own LRT that represents their risk profile, where hundreds of points can be represented, and which can evolve with this rapidly expanding space.

Mellow is building this. You should be hyped.

Insured Position Tokens

As an industry we keep hoping that institutions are coming. Evidence strongly indicates that they are but one sure thing that they will need before they can plug capital into Defi markets is insurance. Tradfi insurance companies have an inherent conflict of interest because the claims assessor works for the insurance company. It would be a shame if institutions were forced into adopting Tradfi insurance markets just to enable investing customer funds in web3 protocols. However, web3 insurance systems are a nightmare.

In my Depin post I wrote about the mechanics and dangers of subjective consensus oracles. I conclude there that as long as we use money as our Sybil resistance mechanism such oracles will always devolve into money seeking rather than truth seeking machines. This is a big problem when we can’t use a court system as a fallback against corruption within the platform and that corruption is impossible to remove via some type of zkproof.

The obvious answer then is to build a new oracle system that can fall back to the court system within a pre-agreed jurisdiction at higher levels of dispute when the lower tier optimistic oracles fail. This is basically the “do no harm” design that would produce a system at least as resilient as Tradfi insurance companies today. In most cases the oracle could resolve a truth and resulting payouts using optimistic mechanisms on chain. If the initial optimistic oracle fails the oracle could fall back to a UMA style oracle. If that in turn is also disputed the money could be held in escrow by a trusted third party that would act under the orders of a court within a pre-agreed jurisdiction. At each stage disputes would become orders of magnitude more expensive and undesirable.

“Do no harm” doesn’t mean we couldn’t fix things along the way otherwise. For example:

• We could solve the conflict of interest of a claims assessor working for the insurance company by using an institutional digital identity/account recovery system and simply forbidding addresses under a shared parent umbrella from serving as multiple parties in the same oracle.
• We could use AVS systems for any on-chain parties so there are economic penalties for failing to perform work on time or honestly if it is successfully disputed.

Once we have the ability to assess truth using a court system fallback the next thing we need to fix is the UX and billing structure. Web3 insurance policies at the moment are billed as a variable APR on the capital insured. Due to variable rates the insurance policy cost is unpredictable and it can cost more than the profit in Defi on the position which is obviously a problem. Insurance policy purchasers are accustomed to either annually adjusted rates or at the very least non-variable APRs so they can make informed longer term business decisions. This requires rebuilding the market for insurance policies in web3.

Lastly, of course we want to combine the insurance and the yield bearing position together inside a new token that automatically pays the insurance out of profits without requiring extra action from the policy purchaser. In addition to the obvious tax benefits of being able to pay the insurance fees using non-taxable income this can guarantee insurers get paid which lowers risk and therefore insurance rates. It can also enable better billing models because the insurance policy cost can now vary based on the performance of the yield bearing position so offering insurance that can’t cost more than the profit of the yield bearing position would be possible. In summary, compared to current systems we can provide better tax structure, less financial risk to policy buyers, real consequences to dishonestly, and fewer conflicts of interest. What’s not to love?

Conclusion

After 50 years of digital innovation the results from Tradfi are disappointing. They still haven’t made a unified ledger for both dollars and securities. Counterparties are everywhere, extracting fees at every step of everything. Fraud is rampant and trust in these institutions is rapidly declining. The playing field is purposefully undemocratic and tilted against the common investor and increasingly they know it.

Blockchains change all of this. We start with a set of blockchain superpowers which offer benefits so undeniable that adoption of this technology is inevitable. Fraud at the accounting layer becomes impossible. Reconciliation becomes unnecessary. Settlement becomes instant. Then we inherit a culture of democratic access to opportunity. We create permissionless systems with less friction, fewer counterparties, fewer fees. Lastly we layer on a spirit of innovation. Tradfi innovates on the time scale of decades; we innovate at the timescale of months. We developed all the financial tools of Tradfi in about 10 years instead of 400. Now we are set to create new, more accessible, more transparent, more capital efficient structured products that wrap our financial intentions into tokens. In Tradfi, you have to apply for permission to innovate. In Defi, you’re actually free. And that’s how we’re bringing decades of financial innovation every year.

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