Dynamic Fountain Model
1. Intro
In an essay published by Multicoin Capital in 2021, it is argued that “the best way to justify value capture for DeFi tokens is to have some sort of risk in the system that needs to be managed.” As of this writing, most of DeFi token mechanism designs fail to achieve that goal. At the same time, revenue/profits of DeFi protocols are sitting in the treasury idly because it is technically and legally difficult to distribute them to token holders.
Here the Phezzan team presents “Dynamic Fountain Model”, in which by connecting Phezzan token (referred as “$PHE” below) holders’ financial incentives to Phezzan’s insurance fund, the interests of $PHE holders are aligned with those of makers/takers on Phezzan Protocol.
This Dynamic Fountain Model is just a high level idea, all specific numbers and some specific mechanisms are just an illustration.
2. The potential problem with only fee extraction tokens
The $PHE has to capture value for token holders or else it will be a “useless governance token”. But at the same time, if the $PHE only extracts fees from Phezzan Protocol, it will make Phezzan vulnerable to price wars and forks.
For $PHE to capture value, it has to serve the benefits of traders/market makers/MM Strategy developers/Liquidity Providers on Phezzan Protocol.
The general idea is that $PHE holders collectively act as an insurance provider for makers/takers on Phezzan Protocol. Because now it’s their money on the line, $PHE holders will try their best to design, improve, and implement the best liquidation mechanism on Phezzan Protocol. The better the liquidation mechanism on Phezzan Protocol is, given others equal, $PHE will have more intrinsic value.
Holders of $PHE can be separated into 2 categories: those who stake their $PHE into Phezzan’s insurance fund and those who don’t. Since $PHE stakers have the risk of losing their token, they should have a higher return.
But it’s difficult to accurately calculate the risk in dollar terms. When Phezzan’s liquidation mechanism runs well and the crypto market is booming, there is not much risk. But if there is a black swan event or Phezzan’s liquidation mechanism breaks, $PHE stakers face huge risks.
Honestly the Phezzan team has not figured out the best way to assess and compensate for such risks.. The mechanism in “5.2 Benefits for $PHE holders” is only an initial idea and most likely will change in the future.
3. Three kinds of pools and book value
There are three kinds of pools in Phezzan’s Dynamic Fountain Model.
3.1 Insurance Pools
Insurance Pools consist of only stablecoins. Since Insurance Pools serve as the main risk buffer, any token other than stablecoins may have death spiral issues in a black swan event.
3.2 Insurance Side Pools
Insurance Side Pools consist of only $PHE. After $PHE launches, there will be an Insurance Side Pool for each Insurance Pool. The value of an Insurance Side Pool will be capped at 50% of the corresponding Insurance Pool based on the Book Value of $PHE to avoid death spiral in bear markets.
Insurance Pools + Insurance Side Pools = Phezzan’s insurance fund.
3.3 Buyback Pools
Buyback Pools consist of only stablecoins. Buyback Pools are to be used to buy $PHE from either the market or the Insurance Side Pools.
3.4 Book Value
The Insurance Pools and Buyback Pools get their capital from the 50% of trading fees that go to $PHE holders.
Assume that the total value of all Insurance Pools and Buyback Pools is $ 1 billion dollars. And there are 50 million $PHE minted, which includes $PHE in circulation, still locked, and in treasury.
The Book Value of each $PHE in this scenario is $20. Assuming all positions on Phezzan magically disappear one day, Phezzan has no future, and all intangible assets gone, each $PHE can be redeemed to $20.
Ideally the market price of a $PHE should trade above book value.
4. How does the Dynamic Fountain Model work?
Imagine a wine fountain at a wedding:
The cup on top gets filled first, then the cups right beneath that, then cups under previous cups. Whenever someone takes a cup of wine, that person will take the cup on top, then other cups. First in, first out.
In the Dynamic Fountain Model, there will be many pools with a similar structure.
When Phezzan Protocol starts to generate revenue, 50% of all trading fees, which belongs to $PHE holders, will start to go through in the following order.
4.1 A few Insurance Pools first
2 Insurance Pools will be filled first. The size of each Insurance Pool is equal to 2% of the average daily trading volume on Phezzan over the past month.
Ideally as Phezzan grows, Insurance Pools get bigger and bigger over time. However there will be chances when Phezzan’s trading volume drops. In that case, the size of Insurance Pools will decrease as well. The extra volume will go to the following Insurance Pools and Buyback Pools.
The size of Insurance Pool 1 and 2 will keep changing all the time, thus the “Dynamic” Fountain Model. Insurance Pools, Insurance Side Pools, and Buyback Pools will get rebalanced every 10 minutes if the volume change is bigger than 0.1% of the original size.
Normally a perpetual DEX sends ~10% of the trading fee to the insurance fund. In Phezzan that number is close to 50% in the beginning. Using this model, the insurance fund will get large quickly on Phezzan.
If Insurance Pool 1 is below 10% of target volume, a multi-signature wallet will have the power to open Insurance Pool 2 and let it start to pay out.
There might be extreme cases where it is better to reserve Insurance Pool 2 than to use it directly. The Phezzan team will make sure the signers of the above mentioned multi signature wallet responds in a timely manner. In the future this power will belong to the Phezzan community.
4.2 Buyback Pools
The size of Buyback Pool 1 is equal to the combined size of Insurance Pool 1 and 2.
When Insurance Pool 1 and 2 are at their target volume, Buyback Pool 1 will buy $PHE from the open market and burn them under certain conditions which the Phezzan team has not figured out yet.
4.3 When insurance fund is in use
This article only talks about how Phezzan’s insurance fund will be used. For more information on the entire liquidation mechanism of Phezzan Protocol, please contact the Phezzan team at contact@phezzan.xyz.
When the insurance fund is needed, Insurance Pool and Insurance Side Pool will start to work at the same time at the same rate.
Say there are $10 million in Insurance Pool 1 and 2 million $PHE in Insurance Side Pool 1, when $5 million of Insurance Pool 1 is paid out, 1 million $PHE in Insurance Side Pool 1 is used.
But since Insurance Side Pools consist of $PHE, it needs to be swapped into stablecoins.
4.3.1 If book value is higher than market price
If the book value of $PHE is higher than the market price, Buyback Pool will buy the $PHE from Insurance Side Pools paying the book value until the book value of $PHE is equal to the market price. Bought $PHE will be burned.
The proceeds of those sales will be used to pay in the insurance fund. The capital spent from Buyback Pool will go to insurance funds, not stakers of $PHE in insurance side pools.
If the Buyback Pool buys from the market, the capital will not go to insurance funds. If the Buyback Pool pays market price instead of Book Value, $PHE stakers are better off selling in the open market.
4.3.2 If book value is lower than market price
If the book value of $PHE is lower than the market price, the $PHE within the Insurance Side Pool will be sold in the open market until the book value of $PHE is equal to the market price.
The proceeds of those sales will be used to pay in the insurance fund.
4.3.3 Example Alpha
Let’s assume there are 2 Insurance Pools of $1m each and a Buyback Pool of $2m. Assume the book value of $PHE is $2 and market price of $PHE is $3. Further we assume that Insurance Side Pool 1 and 2 are 50% of the corresponding Insurance Pool based on the Book Value of $PHE, thus $500k each with 250k $PHE in each Insurance Side Pools.
If there is $900k to be paid from the insurance funds, $600k of it will come from Insurance Pool 1 and $300k will come from Insurance Side Pool 1. Since market price is higher than book value, 100k $PHE from Insurance Side Pool 1 will be sold in the open market to raise the 300k needed.
4.3.4 Example Beta
Let’s assume there are 2 Insurance Pools of $3m each and a Buyback Pool of $6m. Assume the book value of $PHE is $3 and market price of $PHE is $2. Further we assume that Insurance Side Pool 1 and 2 are 50% of the corresponding Insurance Pool based on the Book Value of $PHE, thus $1.5m each with 500k $PHE in each Insurance Side Pools.
If there is $900k to be paid from the insurance funds, $600k of it will come from Insurance Pool 1 and $300k will come from Insurance Side Pool 1. Since book value is higher than market price, 100k $PHE from Insurance Side Pool 1 will be bought by Buyback Pool 1 to raise the 300k needed.
4.4 Then repeat
When Insurance Pool 1, 2, and Buyback Pool 1 are filled, the same process will repeat again for Insurance Pool 3, 4, and Buyback Pool 2. Then Insurance Pool 5, 6, and Buyback Pool 3, et al.
The reason to have separate Insurance Pools and Buyback Pools is that again there might be extreme cases where it is better to reserve the remaining Insurance Pools or Buyback Pools than to use it directly. A similar process as in “4.1 A few Insurance Pools first” will take place.
5. The risks/rewards/benefits of the Dynamic Fountain Model
5.1 Risk for $PHE holders
$PHE holders who stake their token in Insurance Side Pools may not get their token back. If Alice stakes 100 $PHE in a $1m $PHE Insurance Side Pool and $100k of that pool is used. Alice would lose 10 $PHE permanently. However, Alice will IOUs as described in “5.2.2 Stablecoin rewards”.
5.2 Rewards for $PHE holders
5.2.1 $PHE rewards
$PHE holders who stake their coins in Insurance Side Pools will earn some APY in $PHE, whose rate is undecided at this moment.
$PHE stakers in earlier Insurance Side Pools will have higher APY because they get liquidated first, the differences in rates are also undecided at this moment.
$PHE rewards are the base rewards for $PHE stakers.
Once the initial $PHE emission is completed and Phezzan enters a flexible inflation/deflation phase, the APY in $PHE for any Insurance Side Pool will be at least higher than the inflation rate.
5.2.2 Stablecoin rewards
If staked $PHE is used as in “4. How does the Dynamic Fountain Model work?”, Phezzan Protocol will issue IOUs to affected $PHE stakers. Those IOUs will be twice the dollar value of market price or Book Value of $PHE, whichever is higher, at the time when staked $PHE is used.
When Phezzan’s insurance funds are filled again, those IOUs will get paid.
In example Alpha, $600k in stablecoins will be paid to $PHE stakers in Insurance Side Pool 1 when Insurance Pool 1, Insurance Pool 2, and Buyback Pool 1 are all filled again.
5.3 Benefits for taker/makers on Phezzan Protocol
In example Alpha, if there were no $PHE holders who staked their token into Insurance Side Pool 1, the insurance fund would need to pay $900k instead of $600k.
In example Beta, the amount needed to buyback $PHE from the open market is reduced. Instead of buying from the open market using Payback Pool, Buyback Pool buys from Insurance Side Pools. It is more expensive to buy $PHE from Insurance Side Pool paying book value than buying $PHE from the open market. But the stablecoins paid out in example Beta are directly used for the insurance fund, not to sellers of $PHE in the open market.
The book value of $PHE decreases every time the insurance fund is put into use, thus making $PHE holders become de facto insurance providers of Phezzan Protocol.
6. Others
There are many details about the Dynamic Fountain Model that the Phezzan team needs to figure out. Here are a few things related to the Dynamic Fountain Model that we have been thinking about.
6.1 Protocol Owned Liquidity Pools
In the future Phezzan Protocol may consider Protocol Owned Liquidity Pools as a part of the Dynamic Fountain Model.
It takes a long time to build protocol owned liquidity. While there are definitely many benefits in the long run, the Phezzan team still needs to figure out lots of details and would like to take a more conservative approach in the beginning.
6.2 Staking into Insurance Side Pools to avoid $PHE inflation
The long term goal of Phezzan’s flexible inflation/deflation mechanism is to achieve on average a single digit inflation for $PHE. At the same time the Phezzan team will try its best to make sure that the intrinsic value of each $PHE grows much faster than that rate at least in the first decade of Phezzan’s existence.
Therefore, staking $PHE into Insurance Side Pools is a good way to avoid inflation but should not affect the value appreciation of $PHE much. The main driver for $PHE token holders to stake into Insurance Side Pools should be the confidence they have towards Phezzan’s liquidation mechanics, meaning the insurance fund shall be rarely used, and a nice APY.
7. Summary
Thanks for reading this far. The Phezzan team understands that designing a new token model while combining it with the insurance fund is extremely important and difficult. All the mechanisms and numbers in this document only reflect the current thinking of the Phezzan team and may change in the future.
The Phezzan team looks forward to learning from our readers to improve the Dynamic Fountain Model. Please shoot Roland a message on Telegram if you would like to discuss more.
8. Translation to other languages
8.1 Turkish translation by @Damnational from Phezzan community
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