The DeFi Superset: Understanding the Value of the OSMO Token
Introduction
Osmosis is a cross-chain AMM built using the Cosmos SDK. Launched in June 2021, Osmosis currently connects IBC-enabled chains. The protocol has plans to implement an ETH bridge later this year.
The native token, OSMO, is the staking token for the network and the liquidity mining reward for the AMM. Liquidity providers earn OSMO, which they can deposit back into liquidity pools or delegate to a validator for staking. The reward for staking is also OSMO.
Osmosis’ most unique feature will be the introduction of “superfluid staking” in the next few months, allowing OSMO holders to use their tokens for staking and providing liquidity at the same time. There will be likely be many more superfluid use cases to come.
This article explains the value proposition of OSMO. My thesis is that the superfluid nature of the token will create unprecedented yield for OSMO holders. Yield opportunities for OSMO will eventually become (n + 1) the yield of all other DeFi tokens.
Over time, we are likely to see other AMMs move to their chains of their own. This design is probably the best way to structure an AMM, as it ensures that protocol governance serves the interests of liquidity providers.
As the first to implement this design, Osmosis will have a significant head start on the competition. OSMO is likely to become increasingly scarce and more valuable as the AMM sees greater adoption.
DeFi Superset
Imagine that Uniswap was its own Proof-of-Stake chain. Uniswap can now connect hundreds of networks. There are thousands of pools, most of which use UNI as the base pair (not ETH). The Uniswap AMM is soon supporting an entire ecosystem of on-chain DeFi: lending protocols, options markets, and stablecoins backed by assets from multiple chains… DeFi moves off Ethereum entirely and onto the Uniswap chain.
In this world, UNI is not just a governance token. It is also the network staking token. LPs can use their UNI tokens in liquidity pools and the staking pool at the same time, earning both transaction fees and staking rewards.
What is the market cap of UNI in this scenario? $100 billion? $500 billion? UNI would not only be the most valuable DeFi blue chip. It would be the only blue chip, replacing ETH as the base currency of DeFi.
This version of Uniswap is not hypothetical. Osmosis is currently building this vision: an AMM as the entire chain, connecting every other chain, with the native staking token as the base pair for the liquidity pools.
I like to think of Osmosis as a strange little planet, like Arrakis in Frank Herbert’s Dune. Arrakis looks simple and barren. But underneath the sand a process is taking place by which the most valuable commodity in the universe is formed: an exceedingly rare spice called melange.
OSMO is the spice melange of decentralized finance. If you judge Osmosis by its current TVL, you will end up no different than the explorers who sailed past Arrakis in search of greener worlds. OSMO will become the most valuable, highest-demand asset in cross-chain DeFi, and there will not be nearly enough of it to go around. Ever scarcer, increasingly valuable, and the denominator to DeFi.
OSMO is the only asset on the market today that would make sense as the base currency of cross-chain DeFi. OSMO is (n+1).
The DeFi superset.
All About The Token
There are two key ingredients to a successful token-backed protocol.
- The protocol’s features serve the token. A feature can be good in theory, but bad in practice if it takes value away from the token. Protocols must be very thoughtful about the features they implement.
- The token serves the community. Protocols need to distribute equity to their users and make sure the value of this equity continues to increase.
The token must be the roadmap. Let’s explore this further…
Features + Community
As one of the most uniquely designed AMMs in crypto, Osmosis competes with other protocols on features alone. The AMM is an iteration of Balancer, allowing for custom weights and more than two pools (as well as Balancer’s Liquidity Bootstrapping Pool capability for token sales). Osmosis will go even further than Balancer by enabling experimentation with new types of curves.
On top of Balancer’s design, Osmosis utilizes Curve’s gauges design to distribute liquidity rewards with the added bonus of allowing external protocols to load their own rewards into Osmosis’ gauges.
Osmosis is also cross-chain DeFi. The ETH bridge will allow the creation of liquidity pools using assets from completely different networks. (Perhaps once the OSMO token reaches a high enough value, Osmosis will implement atomic swaps and render Thorchain obsolete?)
These features are only the beginning. By the end of 2021, Osmosis will be the first DEX on any chain to eliminate MEV attacks. No front-running, sandwich attacks, or gas wars. Traders will enjoy complete transaction privacy.
At the end of the day, though, features don’t really matter unless they support the value of the token. DeFi is about incentives. The token must align the community. Issuing equity to users through tokens gives them an incentive to stay with the protocol, even when competitors are offering better APY in the short-term and newer features.
The other key rule of DeFi: features need to serve the token. People get so carried away with trying to improve various things about DeFi that they forget this basic rule. The most common example is gas fees. So many ETH competitors in the last few years have banked on low-fees as the killer feature. “Users will choose us because our chain is cheap, cheap, cheap!”
But most DeFi products require liquidity providers to have significant exposure to the native token. Recreating DeFi on low-fee chains usually means building on top of a near-worthless native token. There is no money-like quality to the native token. Without a credible base currency, there are no DeFi blue chips.
Throughout its life cycle, the protocol needs to continue shipping features that serve the token. This strategy is how you retain valuable communities and valuable teams.
Look at the DeFi communities with the strongest community leadership: Synthetix, Chainlink, Thorchain, Sushiswap, Yearn… Not surprisingly, these protocols aligned their communities with a token that accrued significant value in the early stages of adoption.
OSMO’s Value Proposition
Superfluidity
The key feature that Osmosis will implement is called superfluid staking. Imagine if liquidity providers could deposit their LP tokens into pools and also delegate them to validators for staking. Two places at the same time.
This feature cannot be implemented on other chains. Ethereum cannot issue ETH to Uniswap or Sushiswap LPs. This problem applies to most Cosmos DeFi as well, like the GravityDEX on the Cosmos Hub. Unless the Hub decides to allocate new ATOMs towards the DEX, there is no way to reward LPs and stakers the same token.
Osmosis uses superfluid staking to align the community. LPs become the stakers. The protocol lets users increase their rewards, rather than choose between liquidity mining and staking rewards.
In GravityDEX, the token divides the community. Every ATOM that goes toward the DEX is one less ATOM for stakers or other protocols on the Hub. Perhaps Gravity uses a new token as its farm token, making a bad situation even worse. Now the Hub has two systems of governance, with little vision for how the two communities are supposed to align with each other.
Osmosis will not encounter this problem. The AMM is the chain. There is one system of governance. The protocol serves liquidity providers. The Hub, on the other hand, will either have to abandon the DEX or pivot completely to using the Hub solely as an AMM. In which case, why build a DEX at all? Why not just use Osmosis?
Aligned governance also protects Osmosis from targeted vampire attacks. Poaching one DeFi product is not as simple as aggressively farming the token and then voting for the protocol to move chains, as was attempted in Ethereum DeFi. Osmosis will be ruled by OSMO holders, the liquidity providers, who are united in their interest to retain every product as they each contribute to it, superfluidly.
Osmosis’ superfluid staking is going to frustrate every AMM on the market. Eventually we will see DEXes, especially cross-chain ones, moving to a chain of their own so they can copy Osmosis’ formula.
But by the time people realize what needs to be done, Osmosis will have already done it. OSMO will have accrued significant value, meaning Osmosis has achieved network effect. (Network effect is just the amount of time that the other moats — team, token, community — have stood unchallenged.)
Osmosis has the head start, not just technically but socially as well. The community, many of which stuck around from Osmosis’ fair drop launch, has taken huge strides in the first month alone. Several community members have spearheaded governance workshops to turn the mysterious ION token, included in the Osmosis genesis file, into a DeFi product of its own.
This is all less than one month in. Key community members have stepped up to establish themselves as leaders and create the DAO.
Alignment produces a…
Chain Reaction
2021 will be a busy year for Osmosis. Now that the protocol is launched, the high APY for LP rewards should bring in significant liquidity. By late 2021, the ETH bridge will be live, just as superfluid staking and threshold decryption are set to be implemented. (This timeline is based on comments by the team in the Osmosis telegram groups.)
Initially, OSMO’s value will be based on superfluidity. You can use your token for multiple purposes. With the launch of a stablecoin protocol, then there would be three simultaneous actions that users can take. Eventually, there will be four, then five, and six….
As the protocol grows more sophisticated and layered, the yield opportunities on Osmosis increase far beyond (n + 1). Osmosis becomes the DeFi superset.
The best part: increased yield also means increased OSMO, not just from staking rewards but potentially through OSMO allocations made by governance to these new protocols built directly on top of the AMM. Since Osmosis is an AMM at its core, OSMO holders (liquidity providers) will want to incentivize new products and DeFi applications built on top of Osmosis because they can use them to compound their yield. DeFi is not zero-sum on Osmosis. It is additive.
Through superfluid staking, the community becomes even more aligned than before. Each new product on Osmosis deepens the alignment. At this point, the chain reaction of value accrual takes hold.
- OSMO becomes the default base pair for the AMM. Since OSMO can be used for staking, liquidity providers prefer pools that contain OSMO to ETH. The community continues to recalibrate liquidity mining rewards to ensure that OSMO remains the most utilized token on the network.
- OSMO becomes increasingly scarce. The majority of OSMO remains bonded, leaving very little OSMO to go around despite high early inflation.
- Scarcity + high demand means the value of OSMO continues to rise. Liquidity pools start to contain increasingly less OSMO, increasing demand even further.
Osmosis allows liquidity providers to choose which tokens to use in a liquidity pool. LPs can decide not to use OSMO at all, if they prefer. This might seem to undermine the value of OSMO, but it actually increases its potential value.
Giving LPs the option to use other tokens means that the ecosystem can expand much more rapidly. Osmosis will attract liquidity providers from a high number of chains, significantly increasing the total value locked (TVL) on Osmosis.
Moreover, if OSMO eventually reaches a price where LPs are discouraged from using it due to fears of a crash, allowing token pairs without OSMO means on-chain liquidity continues growing.
Since OSMO is the staking token, the market cap of OSMO increases to ensure the security of the network. This value proposition is similar to RUNE, except Osmosis has the ability to incorporate other token pairs besides OSMO. This means Osmosis should attract significantly more liquidity than Thorchain. Hence, the market cap of OSMO will likely tower over that of RUNE.
Furthermore, Osmosis could potentially absorb Thorchain’s capabilities, making OSMO’s market cap into the value of the AMM + Thorchain.
Potential Valuation
The easiest way to think about OSMO’s potential value is to estimate the future TVL of DeFi and Osmosis’ probability of capturing it, while also factoring in the staking to TVL ratio.
Analysts differ on the total addressable market of the DeFi industry. Some speculate that DeFi is likely to absorb several trillions worth of the traditional finance industry, possibly within the next few years.
In this scenario, Osmosis could capture only 5% of the DeFi market and still achieve a significant size. This assumes a fully operational Osmosis, with active and engaged governance, stable applications of superfluid staking, and widely-utilized cross-chain bridges.
Osmosis could easily capture more than 5% of DeFi TVL in the next few years. The fair launch has created an aligned and passionate community. The team has presented an ambitious yet innovative roadmap, with the technical expertise to execute it. Superfluidity seems to be a matter of “if, not when” for DeFi, meaning Osmosis will have a significant lead on its competitors.
Conclusion
A successful token-backed protocol requires a clear path to value accrual for the token. The token is the moat. It dictates which features are important and creates aligned governance. Osmosis’ roadmap serves the token, making OSMO an attractive investment opportunity.
Year 1 OSMO liquidity mining may be looked back on as the biggest generational opportunity since the Ethereum ICO.
