Olympus: A masterclass in incentive design

We first came across OlympusDAO and its native token OHM some months ago when we were doing our research on Alchemix, which we wrote about previously. At the time, across crypto twitter, there was also a growing presence of the now ubiquitous (3,3) and its equivalents. At the time we thought it worthwhile to risk some capital on an experiment, bought some OHM and staked it up.

Olympus is an absolutely fascinating tale of game theory, incentive design and a brand new crypto primitive. To be clear, as always, this note is not to be construed as any form of advice or a solicitation to purchase anything. Usual rules apply: do your own research, make your own decisions and if necessary, call up your friendly banker who’s paid to give advice.

Markets have been seen for centuries as the aggregated decision making of market participants, and rightly so. But when it comes to creating incentives for specific forms of behaviour, especially coordination of positive behaviour, markets have largely failed.

The volatility in the crypto space is largely a function of token liquidity being in the hands of large traders and market makers (aka “whales”). Yet they are accepted as a necessary evil – otherwise how will new projects have liquidity in their tokens, especially when developers want to be focused on building instead of market-making?

OlympusDAO’s model of incentives and the strategy of owning their own liquidity is a masterclass in incentive design. Critically, this is a model that is crypto-native. This is what out of the box looks like. This single fact is probably more important than any other takeaway from this piece.  

To take a trip to the summit, we have to start at the very bottom. 

Olympus: the basics 

As with all crypto projects, there is an abundant repository of documentation and reading resources that is readily available, and Olympus is no different. The aim here is to highlight specific parts of the project which are interesting to us, but for the curious (and you should be!) the official documentation can be found here: https://docs.olympusdao.finance/main/ 

At its very base, OlympusDAO set out to build a crypto-native reserve asset.  

Just have a thought about that for a moment and the enormity of their mission becomes clear. In the early days of crypto, the “base” asset was Bitcoin – everything was paired up with Bitcoin, and the only place to go “neutral” on the market was by being long Bitcoin. The problem was that unlike what we’re used to now, Bitcoin used to be WAY more volatile. 

Then as the Ethereum ecosystem started to bloom, Stablecoins came along – whether they were centralised (like USDT or USDC) or decentralised (like DAI), they gave the world of crypto an exit valve. Positions could be exited into something that was “stable”, pegged to the value of one US dollar. 

The emergence of stablecoins led to a Cambrian explosion in crypto, but the problem always lurking behind the curtains was the risk that the US government comes for them, since the underlying values (backed, pegged or otherwise) relied on the use of the US dollar or its equivalents. And indeed, that risk has now come to the fore, as stablecoin providers get into ever more frequent skirmishes with the regulators. 

The team behind OlympusDAO (which to date remains anonymous, testament to the absolute brilliance of the decentralised web) had a singular vision: to build a crypto-native reserve asset, backed by purely decentralised assets rather than fiat. In other words, the future they envisioned was NOT skeuomorphic – the base currency would NOT be dollars, and monetary policy decisions by the Fed (or any other fiat-issuing central bank) would not directly affect prices. 

Put differently, they wanted to assemble from scratch the equivalent of a crypto central bank, accumulating in its reserves all sorts of high quality crypto-native assets which could be used to back the value of a reserve asset issued by the protocol – their native token, OHM.  

That sounded like a great idea, although the obvious question was: if OHM were to be a reserve asset, it would need to be stable, so why would this crypto token not get dumped like every other, every so often? 

The secret formula: Game Theory 

We could go on for hours about the many aspects of Game Theory and we’d barely scratch the tip of the iceberg on what is one of the most fascinating segments of behavioural economics anyone can study. What is key to know here is that the application of the principles of game theory have been, to say the least, ingenious. 

The language of Game Theory is, as one would expect, pretty specific, so where needed we’ll try to provide simple explanations of how specific terms differ from their everyday usage. For starters, let’s look at the concepts of “strategies” and “equilibrium”. 

A “strategy” in colloquial use always implies some sort of complexity, like a military invasion or a corporate takeover. In contrast, a “strategy” as used in Game Theory is a simple, defined course of action, for example in a game of rock-paper-scissors, a strategy could be: “Play paper 5 times then randomly choose rock or scissors”, “always play rock, scissors, paper in this order” or “always play paper after opponent plays paper”. Of course most people don’t play that game in this way, but economists (and game theorists) tend to simplify. 

Likewise, an “equilibrium” in colloquial use tends to signify some sort of balanced state. In Game Theory, an “equilibrium” is actually much more specific: it is a state in which none of the players of the game have any incentive to change their strategy. 

With those two terms in mind, the game theoretical outcome that is needed to build a reserve asset is quite simple: Everyone has to buy, in the belief that everyone else will buy; and no one should sell, because they will lose out on huge gains if they sell. 

The goal of Olympus from the outset was to set up incentives such that anyone that was approached with the prospect of participating in this “game” would have a compelling incentive to purchase, stake and most importantly HOLD the OHM tokens regardless of market conditions. 

If they were able to do that, then OHM would be able to build up a reputation as being a stable, reliable reserve currency in the crypto world. After all, a reserve asset is only as reliable as the trust its holders have in it, and trust can only be built up over time. 

And that’s where the brilliance of Olympus shows: by setting up staking rewards that more than outweighed – over a period of time – the potential dollar losses from market moves, the incentive structure effectively removed ALL reason for any stakers to sell their staked OHM. This was done by rewarding staking using a ridiculously high APY of north of 150,000% in OHM’s early days, and currently around 8,167% as of time of writing. Put differently, at the current price of OHM, purchasing and staking OHM over a 1 year time horizon would leave a staker at least better off in USD terms unless the value of the OHM token fell by more than 98.8%. 

Let’s put some numbers to this: at OHM’s current price of around $881, the “breakeven” price for OHM that’s staked over a 1 year period, backdated to their available runway for OHM distribution of 312 days, is $20.20. In other words, at the current price, if you stick around till the end of OHM’s distribution phase (that it’s in now) if the price is above $20.20 in 312 days, you’re better off in USD terms.  

The next thing we need to look at is what the Olympus treasury contains – in other words, what is the value of each OHM backed by. The data is readily available on their dashboard here: https://app.olympusdao.finance/#/dashboard 

But here are the numbers – the market value of OHM’s treasury assets currently sits at US$407m. 

Of this, removing assets like ETH and SUSHI whose USD market value fluctuates and only keeping DAI and FRAX (for those unfamiliar, FRAX is the leading stablecoin on the AVAX ecosystem), leaves the “risk free” value of the treasury at just under US$107m.

With a maximum total supply of 3,342,369 OHM (of which 2,13,676 are currently issued), the “book value” of each OHM at prevailing market prices at maximum dilution is $121.20, of which $32.07 of value is tied to stablecoin assets.

Compare these to the $20.20 “breakeven” price of OHM from staking over a year and it becomes quite clear why, barring an absolute cataclysm that shuts down all of crypto, it makes sense to hold and stake OHM: the total USD account value for a staker of OHM is all but guaranteed to go up.

But what about the premium to NAV, it’s an insane premium of almost 9x! For one, the breakevens calculated are based on the prevailing market price of OHM which contains the premium and bakes in the potential risk of prices moving down from here. Moreover, the aim of OlympusDAO isn’t simply to create a static pool of reserve assets. It is, in fact, revenue generative, generating fees from the assets it picks up.

Ultimately, if one believes that crypto is going to zero because it’s all vapourware, then OHM is irrelevant.

OHM is built to be a pure crypto native reserve asset. Thus, it is a necessary precondition that to qualify as part of the addressable market for Olympus, one must believe that crypto is here to stay.

So far, we’ve touched lightly on how ingenious incentive design allows OlympusDAO to intrinsically incentivise OHM holders to not only buy OHM, but also stake and hold OHM through market volatility.

To go back to Game Theory parlance, an equilibrium strategy is found where stakers choose to stake and hold, in the knowledge that other stakers have little incentive to do any different. The outcome is win-win all around, or in typical payoff notation, (3,3).

But it doesn’t stop there. Now for the really fun part.

The benefits of owning liquidity

OlympusDAO is setting itself up to be the central bank of the world of crypto. Getting a stable set of “diamond hand” holders that stake up OHM and have zero incentive to sell is one thing. But “diamond hands” create a different kind of issue: illiquidity.

If no one wants to sell, then the asset isn’t liquid and isn’t of much use. So, liquidity needs to be created for OHM to be tradeable. However, in the world of crypto, creating liquidity typically means handing OHM to market makers who are incentivised to only provide liquidity when profitable to do so, while withdrawing liquidity when it is most needed, leading to vicious price moves. Most importantly, there was no buyer of last resort. All of these would severely undermine the ability of OHM to establish itself as a reserve asset.

The solution that OHM created to this was to own its own liquidity. It does so by “bonding”, offering to purchase liquidity tokens representing shares in liquidity pools of the big automated market makers (mainly Sushiswap) in return for selling OHM tokens for the total notional at a discount which vests over a short period of time. In this way, OlympusDAO ends up owning large proportions of the liquidity pools for OHM (mainly the OHM/DAI stablecoin liquidity pool on Sushiswap).

The net result is that OlympusDAO as a protocol becomes its own market maker, able to commit to providing liquidity regardless of market situations and ultimately mitigating volatility in its token price. The liquidity providers who sold their LP tokens are compensated with OHM purchased at a discount, and enter into the same incentive structure as any other OHM staker. In this case, the payoffs are (1,1) – the sellers of the LP tokens get a discount on their purchase of OHM vs the market price, while the protocol acquires liquidity and assets for its treasury, further bulking up the underlying NAV of each OHM.

These LP tokens further generate income for the protocol as they pick up the bulk of market maker commissions from trading. OlympusDAO owns 99.66% of all liquidity in the OHM/DAI pair, and in the last 7 days, OHM/DAI has been the most traded pair on Sushiswap, generating sizeable revenues for OlympusDAO and further adding to the value of total reserves:

Solving a broader problem

The entire notion of “protocol owned liquidity” came as a revolution for many projects which struggled with maintaining stability in their token prices. Many founders are developers, rather than traders, and the anxiety from having to deal with volatility in pricing (and subsequently, the morale of their communities) was a huge problem.

Yet they faced the same double-edged sword that Olympus had to deal with: how do you simultaneously get tokens out into the hands of as many users as possible, ensure sufficient liquidity for trading AND make sure that the market makers are committed to liquidity provision when most needed rather than bail at the most critical time?

In a way, staking programmes have been in place for a long time, although staking only mitigated some of the selling pressure in the inevitable crypto downturn. In fact, it is arguable that staking exacerbates the price moves by removing liquidity from the market.

So while everyone gets excited about the massive APYs that can be earned from OHM staking, we’re actually of the view that their greatest masterstroke was combining that with bonding. Having demonstrated the success of that model (staking + bonding), they recently launched Olympus Pro, a platform which allows other protocols to replicate the staking + bonding set-up, providing it as a service in exchange for a fee. Call it “protocol as a service”.

This allows other projects to avail themselves of the benefits of the Olympus model: controlling their own liquidity, earning fees from making their own markets and ensuring that there is always liquidity for their tokens especially on DEXes.

At the moment, five other DeFi protocols have partnered up with Olympus Pro: Abracadabra, Alchemix, Float, Pendle and StakeDAO. We would be extremely surprised if the list stops here.

For Olympus itself, to say that their development is “fast” is an understatement. Between the time we started writing this note till the point we finished it, Olympus has launched a new version of its contracts with the focus, not surprisingly, on bonding. OHM proceeds received by bonders are now immediately and automatically staked, meaning that any bond purchased for a discount automatically outperforms staking. More bonding, more liquidity, more control.

Additionally, they’ve added the ability to tokenise fixed-term bonds into NFTs (yes, they’re useful not just for JPEGs), while also allowing fixed-expiration bonds to be tokenised into ERC-20s (fungible tokens), which incidentally makes for a much more liquid market for the bonds themselves, and somewhat analogous to the traditional bond market: on-the-run bonds that have similar expiries are largely fungible with small adjustments, while fixed term bonds of specific expiries are generally non-fungible with other expiries.

Same-same but different. Decentralised bond trading instead of OTC? Why not.

Not skeuomorphic (our new favourite word)

Could this new approach of managing incentives structurally change the market dynamics in crypto? Potentially. Mitigating the risk of wild volatility by ensuring well-distributed liquidity across all prices drastically reduces the scope for the gaps that often characterise crypto price movements to happen.

But the more fundamental point that we want to drive home is that such a solution, obvious as it may seem now with hindsight, is actually impossible to implement within the traditional finance world. Companies can do stock buybacks and offer incentives for holding (e.g. dividends and ex-dates) but unless every listed company starts to build up their own internal trading desks to manage the volatility in their stock, they are very much at the mercy of the market when it comes to price action.

Moreover, where does one draw the line between “stabilisation” and “market manipulation”? Stabilisation is often permitted post IPOs to keep the price stable for a limited amount of time, but arguably beyond that window, it’s a free for all. Within the crypto world, the use of automatic market makers like Sushiswap rather than order-book based market-making allows protocols to ensure liquidity (and hence dampen volatility) without actively making discretionary quotes for prices. What started as a solution to a lack of liquidity in the early days of crypto DEXes is turning out to be an elegant, passive and even lucrative means of managing token liquidity.

Furthermore, the creation of fixed-income-like (not entirely similar) instruments with fixed-dated expiries that can be traded in high liquidity via a decentralised dealer that will make prices at all levels is something that is nearly impossible in the traditional world. Think about the scenes in The Big Short where bond discounts get ever more aggressive through the day as dealers start panicking and withdrawing liquidity, and one could only wonder if things could have turned out less chaotic (though equally unprofitable) had there been a party compelled to provide liquidity until the very end.

In our view, this is just the beginning of innovative approaches that can only happen in the world of crypto. These approaches are not only non-skeuomorphic (i.e. not just a crypto version of something that exists in the legacy system), they are crypto-native solutions built on crypto-primitive systems. #OnlyInCrypto

And we cannot wait to see what else the brilliant minds in crypto come up with in the months and years to come.