The Economics of Thorchain
A look at the intrinsic value of RUNE
In this post I attempt to examine Thorchain and its native token RUNE purely from an investment standpoint. My main focus here is to establish a fair value for the price of RUNE, or at the very least a framework that the reader can use as a mental model in making their own assessment. In doing so, I will begin with a brief overview of Thorchain and the problem it is trying to solve as well as a few key details about its technical infrastructure that are relevant to the economics of RUNE, and ultimately it’s value. This will suffice for providing the reader with a broad understanding of the concepts at play and conducting the evaluation that follows, however it will by no means be a full technical breakdown of the protocol. I have provided links for those interested in learning more about the technical side of Thorchain, which I highly recommend checking out if you have the time. I also do not dwell on explaining any common blockchain terms unless they are completely unique to Thorchain. The assumption here is that the reader carries a basic understanding of how blockchains and traditional AMMs work and is comfortable with notions such as staking, liquidity providing, impermanent loss, etc. This is also a financial valuation and I will be using basic investment theory at its foundation, however if you did not study finance in school you don’t need to worry, I do my best to break down the logic behind finding the intrinsic value of RUNE step-by-step and all of it will be explained in an easy-to-follow manner as we go. As long as you have a notion of time value of money and some basic arithmetic, you will be fine. On a final note, I make many assumptions about key inputs in the model throughout the post; in each one I outline my reasoning and have generally erred on the conservative side as I believe any good investor should, however I will leave the entire model in workable format at the end for readers to plug in their own assumptions and change the output. This way, anyone can feel free to change the inputs and view the revised results if they don’t agree with the assumptions made here or even simply just want to stress test the value of RUNE under different scenarios.
So without further ado, let’s jump right in.
The Cross-Chain Problem
Before taking a dive into the specifics of Thorchain and the mechanisms at play, we need to first understand the market it is trying to address. Thorchain positions itself as an AMM (automated market maker) for cross-chain swapping. Traditional AMMs such as Uniswap or Sushiswap offer users a way to swap between crypto-assets in a decentralized and permissionless manner, providing an alternative to the centralized means of exchange. This has grown to be a thriving industry over the past couple years, capturing hundreds of billions of dollars in annual volume despite being capped by a major limitation: as they currently stand, these services only allow for swapping assets across native blockchain networks. In other words, an ERC-20 asset based on the Ethereum network can only be directly swapped for another ERC-20 asset and not for an asset native to another blockchain such as Solana, Avalanche, Fantom or even Bitcoin.
The bifurcation of assets onto separate networks that don’t communicate with each other is one of the major issues plaguing the industry today. This is known as the interoperability problem and is a limitation born from design, not accident; a direct consequence of what makes a blockchain decentralized in the first place. The core premise is that these systems are trustless in nature, which means to minimize the reliance on external parties and therefore only accept a change in state if verified internally. However it is by this very design that we are faced with the problem of interoperability. Put simply, blockchains cannot rely on external sources for truth, so every network uses its own consensus mechanism to verify the transactions that occur within its boundaries. In this sense, blockchains are blind to anything that occurs outside of their walls and cannot verify the legitimacy of transactions on another blockchain, secured by a different consensus mechanism, making them unable to account for the exchange of assets across other networks.
Finding the right solution to this is becoming a matter of increasing importance as we continue our move towards a multi-chain future. A future where substantial amounts of value are being stored and transacted within isolated networks, but absent the ability to flow freely between them. Despite this, the ability to do so has largely been missing from the current DeFi landscape.
It is worth noting that there are a number of projects working to address the interoperability problem although none have presented a complete solution thus far. The two major attempts are the Cosmos IBC model and Polkadot relay-chains, each of which has a novel mechanism for bringing interoperability to future blockchains that build or connect to them, but neither provides a solution to bring true interoperability to existing blockchains. They are still walled off from any of the ecosystems present today and it is premature to think that all current and future blockchains will one day be connected to any one of these services for true interoperability.
To compensate for the lack of this critical component, we have opted to use work-around solutions such as wrapping services which create a derivative of the real asset for use on another blockchain while only maintaining exposure to the price of the underlying, but none of its practical functionality. Sure, you can wrap ETH to the Solana network through the Wormhole protocol but now you have exited the Ethereum blockchain and are no longer:
A) Secured by that network
B) Able to transfer the asset through that network
C) Recognizable by the native applications of that network
While this solution might be sufficient for some portion of total demand that simply wants to track the price of an asset without actually using its native blockchain, especially today as mere price speculation represents the bulk of all demand, it is insufficient otherwise. Even for the purpose of speculating on price it is usually inferior to simply holding the spot asset itself and removing the frictions of an intermediary, not to mention the loss of yield from staking (or other interest-bearing options) usually available on the native chain.
Because of this, wrapping services are most commonly used as a middle-ground in getting from blockchain A to blockchain B. If, for example, a user wanted to trade BTC for ETH, they would use a wrapping service to lock their BTC into a contract and receive a derivative asset on the Ethereum network which represents BTC and is pegged to its price through a redemption mechanism. The user would then need to swap that derivative using a liquidity pool in return for their desired asset, in this case ETH. Thinking through the technical procedure shines a spotlight on the multiple points of friction involved in executing what should be a simple task. All-in-all this results in added costs (monetary but also time and effort) as well as security risks. Such is the nature of introducing more stops along the route which act as detours at best and potential points of failure at worst, as witnessed in the $326 million Wormhole exploit last week and detailed just a month prior by Vitalik Buterin in this reddit post.
Even looking past the strenuous user experience and many security issues, this round-about way of swapping between assets is simply inefficient from an infrastructure perspective. The services and liquidity pools needed for this process are not readily available across all blockchains since each asset needs to be manually implemented and a deep enough market must form around that new derivative for it to be reliably exchanged. What’s more is that there are multiple different wrapping services which don’t directly communicate with each other and only serves to further fragment the liquidity in this market.
Finally, given the lack of a sufficiently developed application layer on blockchains like Bitcoin (which by itself accounts for over 40% of the total market by size) and other commonly traded cryptocurrencies, solutions may only exist for transferring out of these chains but not into them. One can wrap BTC onto the Ethereum network and trade it for actual ETH in the way we described, but I bid you good luck in finding a way to wrap LTC onto the Bitcoin network and then swap it into a liquidity pool for BTC. In the absence of the appropriate application layers, a swap of this nature would require adding even more abstractions to complete.
While wrapping may have its place for very particular needs, in the face of these inefficiencies it seems inevitable that a method which would allow for the direct swapping of spot assets will ultimately attract the majority of practical demand and better serve the needs of this industry. The potential market that this solution would address is sizable, as we will see in our valuation below, and the first to meet this demand will be in a position to capture significant market share and cement themselves as the dominant player in this industry.
This is where Thorchain comes in.
The Thorchain Solution
Thorchain’s aim is to create the first truly decentralized cross-chain swapping architecture for use across all public blockchains. In doing so, it actually strives to be more than just an AMM; Thorchain aims to establish itself as the underlying infrastructure that the entire industry will use to conduct cross-chain transfers. The distinction there is of vital importance and one that we will revisit shortly, but first we need to form a basic understanding of how Thorchain works from a technical perspective to fully appreciate its long-term objectives.
Thorchain was built on top of the Cosmos SDK and Tendermint framework and uses a novel consensus mechanism called Proof of Bonding to secure its network.
Users can be categorized into four distinct roles:
Node Operators (NO)
Liquidity Providers (LP)
Arbitrageurs
Traders
The idea here is fairly simple on the surface level, although the technical execution is always another story. A swap can be thought of as a two-step process, asset A is transferred out of a trader’s wallet and asset B is transferred into that wallet based on the exchange rate between A and B. But because blockchains are blind to each other, trading assets across them would require a way to account for the transaction outside of the native blockchains and then simultaneously execute the transfer out from chain A and transfer in from chain B. This is where Node Operators come in. Their role is to run a node from each participating blockchain and post the inflow and outflow of the transactions onto their respective chains. If a user wants to trade BTC for ETH, they would first submit a transaction to send BTC to the appropriate liquidity pool over the Bitcoin network. This transaction would then be accounted for by the Node Operators and posted onto the Thorchain network, at which time they would also process a transaction on the Ethereum network to send the equivalent amount of ETH back to the user wallet and make the accounting whole again.
These nodes must reach a majority consensus in order to move the funds and anyone can participate as a Node Operator provided that they have the capabilities to run the required software and are able to put up the collateral. The collateral here is in the form of the protocols native token, RUNE, and is bonded to the network as a safety measure against malicious behaviour by Node Operators who collectively stake an amount of RUNE equal to the total value locked (TVL) in the protocol. In the case of misbehaviour, the collateral can then be taken as reparation. Although the amount of RUNE required is quite high, making participation very exclusive at this time, there are proposals in place to bring down the barriers to entry through pooled vaults, lite nodes and bond-weighted rewards.
Conceptually, this works in a similar fashion to centralized exchanges which store pools of assets from multiple chains in their wallets and facilitate the exchange of these assets by accounting for them internally, with the obvious difference that in the case of Thorchain the entire process is conducted in a decentralized and permissionless manner, through Node Operator consensus, instead. In this sense, Thorchain is best thought of as a Layer 1 blockchain complete with its own consensus mechanism for the sole purpose of facilitating the exchange of assets across blockchains. This methodology allows any two assets from any two chains to be swapped for one another directly and without the need for derivative assets, circumventing the problems which could arise from them, as discussed above.
Now why would anyone want to allocate time and resources to becoming a Node Operator in the first place? Well like all other decentralized systems there needs to be certain incentives in place to attract participation onto the network. In the case of Thorchain this incentive comes from the distribution of platform revenue that is generated from trading commissions.
While this role is unique to Thorchain, given its necessity to facilitate cross-chain swaps, the other roles in the system (Liquidity Providers, Arbitrageurs and Traders) function similar to a traditional AMM. In short, the protocol needs to store capital for those who are looking to trade and this is done via liquidity pools which pair two assets to establish an exchange rate. Because the system is decentralized in nature, the liquidity must come from providers who deposit their assets into these pools in exchange for a portion of the revenues that the protocol generates, however one distinction from most other AMMs is that in Thorchain each asset is paired directly with RUNE in equal parts. Unlike Uniswap for instance, where you can have an ETH/USDT pool, in Thorchain this would be represented by an ETH/RUNE and USDT/RUNE pool and a swap between those two assets would need to route through both pools to complete. Exchange rates across these pools are maintained by Arbitrageurs who would be incentivized to buy the asset that is undervalued and sell the asset that is overvalued to make a profit when prices deviate from external sources. All of this comes together to create an environment where any trader can tap into the liquidity pools and swap out one asset for another in a fully permissionless and decentralized manner.
Et voilà, cross-chain swaps.
Two key innovations that Thorchain employs on top of this framework are the use of Threshold Signature Schemes (TSS) and Continuous Liquidity Pools (CLP), both of which play a role in its competitive standing and future success.
TSS is used to achieve consensus from multiple Node Operators when conducting a transaction and has increased privacy, lower costs and chain-agnostic behaviour making it easier to implement support for new chains as compared to the commonly used MultiSig approach.
CLP is a mathematical structure for setting up a liquidity pool which is designed to charge higher commissions to larger, and supposedly less cost-sensitive, traders and lower commissions for the median trader who is likely to be more cost-sensitive. The results of this model were analyzed by Delphi Digital in their research paper and show that Thorchain was able to extract a higher average liquidity fee while charging a significantly lower median liquidity fee vs Uniswap. The key here is that it pulls in higher revenues from less cost sensitive traders to subsidize lower fees for the rest and attract more traders overall.
We will explore the competitive implications that this has can have on Thorchain’s adoption later in our valuation and won’t go any further into the technical details for now as that is not the purpose of this post. If you would like to learn more about how it all works under the hood I will direct your attention to both the Delphi Digital report as well as this amazing writeup from ShapeShift’s Erik Voorhees which explains some of the nuances in greater detail than I ever could.
RUNE
This brings us nicely to the final component of the Thorchain ecosystem and where the focus of the rest of this article will be, it’s native token RUNE.
RUNE plays many roles in the Thorchain ecosystem which can be divided into the following:
Governance
Utility and fee payment
Liquidity pairing
Bonding collateral
While both governance and ecosystem utility are greatly important and can drive massive value on their own, we will be deriving the intrinsic valuation of RUNE from its role as a liquidity pair and bonding collateral because it is these functions in particular that have a deterministic relationship with the price of RUNE.
So how do these functions translate to monetary value? It might have been easily glossed over in the technical overview but the key here is that a certain value of RUNE needs to be stored within the network at all times. This value is 50% of the total liquidity locked in the pools, as each pool is paired in equal amounts of RUNE, and another 100% of that value bonded to the network from Node Operators who put up as much collateral as there is liquidity in order to secure the network. This results in a steady ratio in which 1/3rd of the RUNE on the network is locked in liquidity pools and 2/3rd RUNE are bonded for security. The balance is controlled by what is known as the Incentive Pendulum which is simply a function that weights the rewards between Liquidity Providers and Node Operators so that the desired ratio is maintained. If more than 1/3rd of all RUNE is inside liquidity pools and less than 2/3rd are bonded, the incentive pendulum would shift the reward distribution being paid out to those two parties in favor of Node Operators, incentivizing RUNE to flow from LP’s to NO’s until equilibrium is restored. Vice-versa if the balance tilts in the opposite direction.
Apart from the implications this has for network security, it also translates into a deterministic price for the token. We now know that the platform must always contain an amount of RUNE equal to 150% of the total value locked (TVL) in its liquidity pools; or put another way, 300% of the TVL of all other non-RUNE assets, however you would like to frame it. If there is $100 million of assets deposited into the pools then we know that $50 million of that is RUNE, $50 million is in non-RUNE assets, and another $100 million in RUNE is bonded by Node Operators, equal to $150 million total RUNE locked in the system. In this way the market cap of RUNE, and therefore the price of each token, is always proportional to its TVL by a minimum factor of 1.5x.
I say minimum here for two reasons. One is that an asset can (and usually will) trade above its current intrinsic value, either as a speculative premium to future growth or because of the added value brought on by its other components such as governance rights, etc. And the second reason is that there is actually another factor to consider here: the proportion of token supply that is held in the platform. Since the relationship follows that the value of all RUNE locked in the platform is equal to 150% of TVL, if there is any portion of supply outside the platform such as those on exchanges or held in investor wallets, then the total value of ALL supply (i.e. market cap) must be greater than the 150% multiple.
For the sake of a quick illustration, if 50% of circulating RUNE is collateralized on the platform which has $1 billion in TVL then we know that the total value of that portion of RUNE would need to be $1.5 billion and therefore the total market cap of all circulating RUNE would be $3 billion when accounting for the other 50% trading outside the protocol. In this sense the proper formula to derive the minimum market cap of RUNE at any point in time is the following:
Market cap = 1.5*(TVL) / collateralization rate
*where collateralization rate is the % of all RUNE that is held in the network
It then follows that the price per token would come down to simply dividing the market cap by circulating supply. Through this relationship the price of RUNE is anchored to the size of the assets in the protocol, giving it a deterministic price which will be the basis for calculating its intrinsic valuation. Apply to that any speculative premium you deem fair and you will arrive at an estimate of its true worth.
This novel token structure is the first of its kind in the field of decentralized finance and, if proven to be successful, may pave the way for future projects to use a similar model and bring concrete value back to their investors. In an environment where it has been hard to decentralize the core aspects of financial applications while simultaneously returning cash flow back to the core token holders (because revenue has to be redirected to other parties instead - most commonly LP’s) Thorchain has found a way to bring real value back to their token by connecting it to the size of their platform so that the two can grow in parallel.
Looking ahead
So where does Thorchain stand today and where is it going next.
Thorchain officially launched its testnet on April 13, 2021 which they dubbed the “multichain chaosnet”. As with any testnet, the purpose of this was to stress test the network and its security in a safe and controlled manner before full release. In light of this goal, the total value that can be locked into Thorchain’s pools has been capped at a maximum ever since. This turned out to be an essential measure as just shortly after the initial launch their smart contracts were exploited three times over the course of the same month, resulting in total damages of just over $13 million. No investor funds were lost in this process and the network has been hardened as a result. Since the last attack on July 22, 2021 the team has passed multiple security audits, launched a bug bounty program and hired an independent security firm all in an effort to prioritize security before mainnet release. Today, 7 months later, the cap on liquidity has been raised to 24 million RUNE and the network hasn’t undergone any further exploits.
Six different blockchains have been integrated so far (Bitcoin, Ethereum, Binance Smart Chain, Bitcoin Cash, Litecoin and Dogecoin) with the seventh, Terra, to be implemented in just a couple weeks from now. Along with this upgrade the team has deemed it safe to fully remove the liquidity cap once and for all, opening the floodgates to unlimited amounts of capital to come into the network. This is a major pre-requisite to the upcoming mainnet launch.
But development won’t stop there.
While working to implement other chains into their system, following up with Cosmos shortly after the Terra integration and then proceeding to knock the rest off the list one-by-one, the team is already looking ahead to leverage their infrastructure and expand into other DeFi-related services. This venture is quite appropriately called ThorFi and refers to the other services that will be offered in addition to the decentralized exchange of assets.
Synthetics
The first initiative to launch earlier this week was synthetics which gives Liquidity Providers a means to collateralize their LP positions and create a derivate asset of any token, or even group of tokens. This will capitalize on the demonstrably large demand for derivate asset trading and open the doors to a wide range of extra features.
Chief among them will be the formation of a lending market where any user can borrow these newly-created assets and gain exposure to the price of the underlying for a fixed interest rate.
Synthetics can even be minted to track composite assets akin to an ETF, opening Thorchain to an entirely new market of participants looking to gain diversified exposure to a basket of cryptocurrencies across any chain.
Additionally, derivatives on Thorchain can be locked to yield a passive interest rate in a similar fashion to Terra’s Ancor protocol which has been averaging a 20% APY. It is not certain how much yield Thorchain’s mechanism will be able to generate just yet but needless to say it will almost surely be a game-changer.
Another unique feature of synthetics is that LP’s will be able to provide one-sided liquidity into Thorchain pools (instead of depositing a pair of assets) by using a derivative of RUNE, termed iRUNE, that can be evenly disbursed across all pools to contribute to the TVL and generate yield.
These are some of the features currently planned but are not an extensive list of everything that is possible with synthetics. Other possibilities include the creation of futures and options markets, leveraged instruments and more, each of which will only add to Thorchain’s growing revenue.
If you’re curious to read more on the potential of synthetics within the Thorchain ecosystem, I would urge you to check out Brokkr Finance’s latest post on the benefits of synthetics.
Algorithmic Stablecoin
Looking further down the road, there is an improvement proposal being considered to launch an algorithmic stablecoin that functions in a similar way to UST on the Terra network. The implications here are enormous. Not only will it work by burning RUNE to mint the native stablecoin, adding a deflationary effect to RUNE, but it will also enable assets in liquidity pools to be paired against it (instead of only allowing for RUNE-paired pooling) and will open the network to LP’s who prefer to provide liquidity against a stablecoin rather than RUNE. Given that over 70% of the total liquidity across existing AMMs are paired against stablecoins, the added value that this feature will attract to the network cannot be understated.
In terms of the burning mechanism that this will introduce, the net effect will be a reduction in total RUNE supply that scales with the demand of its stablecoin. The mechanism works so that for every stablecoin minted an equal amount of RUNE will need to be burned, making the supply of RUNE inversely proportional to the quantity of stablecoins issued. This market has been growing at an exponential rate in recent years and sits at just under $200 billion today, up from less than $5 billion only 2 years ago. If Thorchain can tap into even a fraction of this potential market, it could mean billions of additional dollars added onto its market cap.
If you would like to familiarize yourself more on how algorithmic stablecoins work and the novel mint/burn mechanism that Terra introduced, this Medium post covers all the basics in great detail.
Aggregation
Apart from DeFi services, the team is also working to ensure Thorchain’s long-term success in this area with the development of a critical feature known as DEX aggregation. The purpose of this feature is to connect Thorchain’s liquidity pools to any AMM on any blockchain so that trades can easily be routed across assets in the entire ecosystem. Likewise, they are creating the tools necessary for these AMMs to connect back to Thorchain’s pools from their own interfaces. This will serve to bootstrap the existing asset ecosystem on all chains directly from the get-go. It will also mean that Thorchain does not have to worry about contending with other exchanges and building up its own userbase from scratch but will instead just plug itself in to the existing ecosystem, all done completely under the hood. In this way Thorchain aims to bridge the current landscape and rather than compete with other AMMs, will serve as the underlying infrastructure for enabling cross-chain swaps across the whole industry.
From the perspective of existing AMMs, rather than expend the costs (time, money, effort) to develop their own cross-chain architecture it would be much simpler, and even more lucrative, to simply use Thorchain’s pools and bring cross-chain capabilities to their platform immediately. This is the final piece of the puzzle in completing Thorchain’s vision and once achieved will mean that all decentralized exchanges can enable cross-chain swaps by simply connecting to Thorchain’s liquidity pools, allowing their users to trade [any asset, any chain] for [any asset, any chain] and directly accruing that value to Thorchain whether or not traders even know it is being used. If successful, Thorchain will become a critical component for any decentralized exchange to incorporate if they wish to offer cross-chain services, or risk falling behind.
The ramifications of this will be massive. Being the first to market and build out a network in this industry comes with a major advantage that cannot easily be imitated. This can be summed up as the liquidity advantage. The necessary design of AMMs introduce an added cost to traders in the form of slippage, which happens to be a function of the depth of the liquidity in its pools. Lower liquidity translates to higher slippage and vice-versa. Moreover, higher liquidity also translates to higher security as it brings in further capital used to collateralize the system.
As such, an AMM with higher liquidity becomes more attractive to traders, bringing in more volume and resulting in higher overall revenue, which then has the effect of bringing in even more liquidity as the cycle repeats via positive feedback loop.
The fact that Thorchain will be first to market means that it will have a head start in accruing liquidity. This, along with its single asset pairing model (which helps to concentrate liquidity into fewer pools) and their strategy of rooting into the existing AMM infrastructure is a formula for high initial growth and may prove to be an invaluable defense against future competition in the cross-chain industry who would now have to contend with significant cost and security disadvantages.
Liquidity begets liquidity.
I will leave the reader with this illustration from Multicoin Capital which perfectly demonstrates the self-reinforcing effects at work on both liquidity and network security.
Valuation
Now that we are armed with the knowledge to assess Thorchain’s role in the DeFi ecosystem and how that will correspond to the price of RUNE, we can begin to lay out a framework for arriving at a fair value for the token. As mentioned in the introductory paragraph, the real aim here will be to think through all the factors at play and develop an idea of how it might evolve over time. We are forced to make many assumptions, as is the nature of trying to forecast anything, but I would advise the reader to think through each step along the process for themselves and draw their own conclusions. For this, I will leave a spreadsheet at the end which can be used to change the assumptions so that anyone can arrive at their own valuation.
Re-stating the relationship that we had arrived at earlier:
Market cap = 1.5*(TVL) / collateralization rate
Since market cap represents the total value of all circulating tokens we can simply divide by supply to get the value per token:
RUNE value = 1.5*(TVL) / (collateralization rate * circulating supply)
That will tell us the the value of RUNE at some point in the future (t), but of course we are most interested in figuring out what that should be worth to us today, so we will take that value and discount it back to the present at an appropriate rate. This is where the time value of money gets factored in:
Current value = Future value / (1 + discount rate)^t
Finally, we need to choose a timeframe (t) for which we will be assessing these variables over. Since things tend to move very fast in this space, making estimates a lot more uncertain the further out we go, I think it is reasonable to use a 2-year time horizon. This is roughly how long many of the current DeFi leaders have been around, with the industry really only kicking off in the summer of 2020. Since we will be using the current state of the DeFi industry and its players as a reference for some of our estimates, it would make sense to also apply a “catch-up rate” of similar length to Thorchain here.
Taking a preliminary look at the variables we need to estimate (TVL, collateralization rate, supply and discount rate) it becomes apparent that the parameter with the highest degree of uncertainty will be TVL.
Collateralization rate can be estimated within a narrow band using the data we have on lock-up rates across similar blockchains.
Supply can be most accurately predicted as Thorchain has a known inflation schedule.
Discount rate is simply the required rate of return that we, as investors, demand for exposing ourselves to this particular asset. As will be explained later, this can be different for everyone and is largely unique to each investor. That being said, here we will use what we believe to be the market-average discount rate for a cryptoasset with the same risk profile.
TVL however, is a little less cut-and-dry. The entire DeFi space is still in its infancy and, especially after a very volatile year, it is hard to predict how the value locked in the industry will grow going forward, let alone how cross-chain value will grow. On top of this, framing Thorchain’s expected market share in terms of TVL would be an apples-to-oranges comparison with the rest of the industry since it is only composed of same-chain trading volume at this time. To better estimate this metric we will be breaking it down further into its constituents, each of which can be examined more accurately before bringing them back together to form TVL.
To do so we have to realize that TVL is simply the value locked into a protocol by liquidity providers and is directly correlated with the monetary incentives that these LP’s receive for depositing their assets. As we covered earlier, this largely comes from platform revenue and is derived from trading volume plus any extra incentives.
By framing Thorchain’s future market share in terms of the magnitude of volume that we think will accrue to the platform, we can compare it to the countless examples of AMMs we have around today and get a good idea of how that will evolve with time and ultimately translate to TVL for Thorchain.
If that isn’t entirely clear at this stage, don’t worry, it will become more apparent as we work through it.
Let’s start with volume.
Volume
We first want to know the total volume that is expected to accrue to Thorchain over our timeframe. To do so, we must start by identifying the total addressable market (TAM) and then estimate Thorchain’s share of that pie.
The steps that I take to achieve this are as follows:
Extrapolate growth trends to find the total volume of decentralized trading in year 2
Take the proportion of volume that is expected to be cross-chain
Remove any volume that is taken by non-spot trading solutions (such as wrapping services)
Apply Thorchain’s market share to the TAM based on probability-weighted outcomes
The results are summarized here:
Total market volume of decentralized trading in year 2 = $1.52 Trillion
Proportion of volume that is cross-chain = 43.5%
Cross-chain decentralized trading volume = 1.52T * 0.435 = $661.2 BillionProportion of volume that will accrue to spot-trading solutions = 80%
TAM for Thorchain = 661.2B * 0.8 = $528.96 BillionThorchain’s probability-weighted market share = 54.5%
Annualized volume of Thorchain = 528.96B * 0.545 = $288.28 Billion
Let’s start from the top, decentralized trading volume.
Decentralized Trading Volume
This is the monthly volume across all major decentralized exchanges (DEX) since 2019, courtesy of theblockcrypto.com
Note that “DEX” will be used interchangeably with “AMM” going forward, since many of our illustrations use this terminology. Both terms represent the same protocols being discussed.
The first thing we notice is that trading volume is cyclical and correlates to the price action of the overall market. Anyone who has been in this market for the past year will know that we had a major bull run leading up to May of 2021, followed by a devastating crash and subsequent recovery over the next few months until we entered the current bear trend sometime last November.
Over the past 12 months total DEX volume came in at $1.384 Trillion USD, or an average of roughly $115 Billion USD per month. Today we still sit at a higher monthly volume than we did one year ago in March of 2021 with a ~9% YoY growth from then to now.
Considering that 7 of those 12 months were spent in a bearish market trend it is actually pretty impressive that this number isn’t negative, and even more so when we compare it to YoY change in the spot volume of centralized exchanges over this same period (graph below).
Here we actually see a whopping -36.8% change in monthly volume from March of last year. Even visually, you can notice a stronger positive trend between the first and second half of 2021 for DEX vs CEX volume. This gives us some insight into the fact that there are DEX-specific growth factors at play, providing a strong tailwind on top of the broader market environment. This relative growth can be captured by looking at how the ratio between CEX and DEX volume has changed over that time period using the graph below.
Sure enough, we can see a positive uptrend in DEX volume relative to CEX. This has come about for a variety of reasons but can mostly be attributed to three factors in particular:
The industry of decentralized exchanges is still in its infancy and as with any new industry is still in the early stages of its adoption cycle. Just 2 years ago almost no one knew that there was an alternative to exchanging assets without going through a centralized counterparty. Today, although we have come a long way, we are still largely in the experimental stage and plagued with severe frictions like poor UI, high network costs and the risk of falling victim to the next DeFi exploit. These things will work themselves out with time as the industry matures, and with it the ratio of people who opt to use a decentralized means of exchange, but it doesn’t happen overnight and instead manifests as a steady rate of growth over longer periods.
There is added functionality associated with being directly on-chain that simply cannot be imitated by off-chain solutions. Because of the permissionless nature of the blockchain, any application can seamlessly plug themselves into a decentralized exchange and route through its service as if it were part of its own. Yield aggregators, DeFi tools, data services, NFT marketplaces and P2E games are just some of the applications that we have already seen use this capability to route through a DEX and give users the ability to swap between assets from their own interfaces. This has proven to be a powerful component for most Web 3.0 applications because of the current multi-coin landscape that we find ourselves in. As such, each new application acts as a sort of LEGO block that can connect and benefit from the existing apps with ease, bringing exclusive value to on-chain services that will continue to compound with the rate of innovation.
The third major tailwind comes from a global crackdown on centralized crypto exchanges as seen in China and other countries, giving some users no choice but to look to decentralized means for trading. Even in countries that are not outright banning the exchange of cryptoassets, we are still seeing a sharp increase in regulatory scrutiny which adds an extra layer of friction and drives a portion of their userbase towards decentralized counterparts.
These factors have proved to be persistent over the past couple years and has culminated in a positive trend in the DEX/CEX volume ratio. Regardless of how the overall market performs in the year ahead, I expect this trend to remain intact and the ratio to continue increasing, albeit at a slower rate than the previous 2 years given that we are past the initial boom that brought DEX volume from 0 to where it is today.
Filtering out that initial surge and extrapolating a straight-line relationship in the ratio from November 2020 (6.43%) until today (13.95%) we get an annualized increase of 5.64% in DEX/CEX volume.
This would result in a final ratio of 25.23% over 2 years. We will label this our optimistic scenario as it assumes no change to the current status quo.
In reality, we have to acknowledge a major risk on the horizon from regulatory bodies clamping down on DeFi services that don’t fit their investor-protection policies. The risk here is that as they stand many of these applications operate outside of the jurisdiction of securities laws and bypass what are considered to be essential measures by policy-makers such as AML and KYC. Every day that goes by where we hear news of the latest scam, rug pull or money laundering attempt is another day closer to bringing the regulatory hammer down on this industry.
What this would likely mean is DeFi applications that wish to offer services within these jurisdictions would need to fully comply with AML, KYC and all other exchange laws to operate without issue.
Although the implications of this would almost certainly reduce volume, it would by no means kill it. I would stipulate that a majority of the current users wouldn’t care if they had to associate their identity and answer a few questions on a one-time basis to use these services. The majority of users today trade on DEXs for other reasons, some of which we mentioned such as the composability to other on-chain applications, but also because DEXs:
Allow self-custody of assets
Are fully transparent
Offer virtually every token for trading
Moreover, regulation won’t affect every user at once as DEXs are global services and regulation can only be enforced geographically. Even after being recognized, it may ultimately prove to be hard to enforce as the nature of being decentralized makes it difficult to target the services directly and if penalties are imposed on the investor level there are sure to be ample work-arounds for anyone who doesn’t want to adhere to the regulatory procedures. In fact a lot of services that people actively partake in today are also in grey areas, or even outright illegal, but are so easy to get around that sometimes we even forget they are outlawed in the first place, i.e. streaming or pirating of movies and other media.
In consideration of this I will still choose to apply a 50% reduction to global DEX volume in the case of regulation, bringing the ratio down to 12.615% in this scenario. Since it is likely that action will be taken by most regulatory bodies sooner rather than later, given the spotlight put on the industry in recent times, we will also apply a 90% probability of regulation occurring within the next 2 years. When taking both scenarios into account, our probability-weighted DEX/CEX ratio becomes:
DEX/CEX ratio = (25.23*0.10) + (12.615*0.90) = 13.877%
Interesting enough, this amounts to almost the same ratio that we begin with today and tells us that our assumptions about regulatory risks will completely negate the strong underlying growth of this emerging industry. This perspective can help the reader in making their own judgment should they have a strong opinion about which force will overtake the other.
Taking a step back for a moment and looking at where volume seems to be headed in the big picture, we find ourselves sandwiched in the middle of high inflation, slowing economic growth and the tightening of central bank policy, none of which is conducive for a prolonged bull run like we saw in the years prior. Throw in some extra geopolitical tensions from Russia/Ukraine and the direct effect it is having on commodity prices and I think it is safe to say that a market so far out on the risk-curve will likely have a rocky year.
Of course it is also prudent to think that the rate of global adoption in this technology may also be accelerated by recent events (sanctions and other limits to legacy financial systems) but we’ll make the safe assumption that the current bear market extends over the first year, then because it is hard to call where this will all lead to in 2 years from now, we can just assume a normalized growth trend for the second year.
Looking at the effects that the 2018 crypto bear market had on CEX volume, we see an average of $71.98 billion per month in the 12 months that followed February 2018’s record high of $168.76 billion to the $33.88 billion low exactly a year later. This represents a -57.35% average drawdown from peak volume.
To be quite honest I don’t expect the same magnitude of effect this time around given that in 2018 almost no serious investor or financial institution was trading in the crypto markets. Today that sentiment seems to have done a complete 180, from individuals and firms all the way up to sovereign nation states. That being said, I will leave my intuitions out of this and simply use the data at hand, once again erring on the conservative side.
Our local peak in monthly CEX volume clocked in at $1.4 trillion last November. Applying a 57.35% reduction would give us a monthly average of $597 billion or $7.164 trillion of annualized CEX volume in year 1.
Looking at data for the year of 2021, we saw $14.74 trillion in total CEX volume. Approximately half of the year was spent in a bearish trend and half in a bullish trend, although altogether it was definitely a year of heightened trading activity due to the sudden emergence of crypto onto the global stage. That being said it is reasonable to think that the overall participation in crypto markets looking 2 years out will be a lot higher than it is today as the majority of potential investors are still warming up to this new asset class and have yet to seriously partake in it.
So all-in-all, for our year 2 estimate I will assume a volume that is halfway between our year 1 bearish prediction and the heightened volume that we saw last year, giving us an annualized volume of $10.95 trillion in the second year. Note that this is still over 25% lower than last years volume, but I believe that between the big picture trend of rapid adoption and the near-term trend of unfavorable market conditions, this represents a fair compromise in the face of so much uncertainty.
Now we can combine our two estimates to arrive at an expectation for total DEX volume in year 2. This will simply be the annualized CEX volume multiplied by the DEX/CEX ratio we arrived at earlier:
DEX volume = $10.95T * 0.13877 = $1.52T
*rounded to the nearest thousandth of a decimal
Cross-Chain Trading Volume
This is a great start but what we are truly interested in is finding the expected volume that will accrue to cross-chain swaps in particular. Luckily, we have a lot of historic data on hand to derive this. Centralized exchanges have records of data that one could analyze to determine what proportion of all trading volume is transferred between two assets of the same chain or across different chains. If we expect that the ratio of cross-chain swaps which occur on centralized exchanges would be identical on decentralized exchanges then we can just apply it directly to our findings, and since I cannot convince myself of a reason why this would not be the case I will proceed with this methodology.
I collected 7 days worth of trading volume, grouped by pairs, on Binance (which accounts for roughly 2/3 of spot trading volume across centralized exchanges) and found that ~43.5% of all trading volume happens across two assets from different chains, i.e cross chain.
With this our estimate of total cross-chain trading volume can be stated as:
Cross-chain trading volume = $1.52T *0.435 = $661.2 billion
Spot Trading Volume
The result we arrived at should represent our estimate of the total addressable market volume (TAM) for decentralized cross-chain swaps over the next 2 years. This volume will naturally be split between wrapping solutions and the spot-trading solution introduced by Thorchain and any competitors that follow, so we must put together our competitive analysis of wrapped vs spot solutions and consider the market share of each. As mentioned, there are a number of inefficiencies that an investor is exposed to when using a wrapped asset, which are:
Unsecured by the native blockchain
Unusable on the native blockchain or its ecosystem (for governance, utility, yield, etc.)
Extra frictions when trading
Intermediary security risks
Fragmented liquidity
Slow implementation across new chains
If a suitable cross-chain solution existed for spot transfers then we could safely assume that demand would shift from the less efficient method to the more efficient. Of course wrapped assets will always have their place for other use cases, like gaining exposure to the price of the underlying without moving to another blockchain. But in this way the use case becomes akin to a derivative product and we are only accounting for spot trading volumes here. Notice that we started with spot trading volume from CEXs and determined all ratios after based on only this trading activity rather than total CEX volume/activity which would also include derivates. So we can omit that use case when thinking about how wrapped services will compete in the spot trading market as it is outside of the TAM that we have calculated thus far.
So we know that wrapped asset trading is sub-optimal vs a spot trading solution and that an efficient market should trend completely away from it over time. However we cannot expect such a major transition to happen overnight, but rather over the course of months and years. The major inflection point for this switch will happen when legacy DEXs integrate direct cross-chain swapping into their services by integrating with Thorchain (or future competitors). The tools to enable these integrations will be released soon and we can expect a few months to a full year after that until a sufficient amount of DEXs are fully integrated as per the usual adoption curve of this industry. With that being said, we will assume that 80% of trading volume will happen through spot trading solutions in 2 years time.
Applying this to our results so far gives us an estimate of Thorchain’s total addressable market:
TAM of Thorchain = $661.2B * 0.8 = $528.96B
Thorchain Volume
Finally, the amount of this volume that accrues to Thorchain will be dependent on its place among the eventual competition that will follow. As of right now, there are very few alternatives even trying to compete in this domain with Chainflip seemingly the only direct competition to Thorchain. Despite being furthest along, they are still only in the developmental phases and have yet to release a testnet or minimum viable product as Thorchain moves towards mainnet launch. Looking at possible competitors that employ different methodologies, there are a number of cross-chain messaging solutions in the works such as Stargate, Axelar, Synapse and Celer Network. The technology powering these applications is vastly different and comes with its own set of tradeoffs which will need to be discussed in a separate write-up, but the important thing to note for our analysis today is that none of them have fully launched into a production environment yet and are still no more than ideas on a whitepaper thus far.
Because of this Thorchain will have the first mover advantage in integrating itself into the current ecosystem and accruing the holy grail that is liquidity, leading to the economies of size advantage that come with it. This will give it a good probability of achieving long term dominance similar to that of Uniswap among traditional AMMs.
In the worst case scenario it fails to capitalize on its first mover advantage and becomes obsolete over time as superior innovations come forth. Although this is a possibility in any industry and even more so in one as fast moving as this, it would be very unlikely to happen over the course of our timeframe as most innovations take at least 1-2 years to develop in the first place.
The third alternative would be a middle ground between total dominance and total failure in which Thorchain splits market share among other key players that emerge. This would be similar to what transpired in the decentralized lending industry with Aave, Compound and MakerDAO. Although more plausible than the second scenario, it is far less likely to occur in the AMM industry because of the sustained liquidity advantages that are present here. The largest of these benefits is the cost reduction that comes alongside an increase in pool depth and is a unique characteristic of AMMs that is not shared with the lending industry since slippage is not an input to their costs. On top of this, the fact that there are no viable competitors near launch also makes it highly unlikely that strong opposition will present itself and compete with Thorchain in the span of only 2 years.
Taking all of this into account we would first need to define what each scenario would imply for Thorchain’s market share, which I think would look something like this:
Dominance – 77.5%
Split – 25%
Failure – 5%
77.5% is Uniswap’s share of market volume over the past 7 days using data taken from https://dune.xyz/hagaetc/dex-metrics. If volume is split among fierce competition we will grant a 25% market share and in the event that it is rendered obsolete by further innovations we will give it a very low value of just 5%.
We also have to establish a probability for each scenario, like so:
Dominance – 60%
Split – 30%
Failure – 10%
Putting it all together, we finally arrive at our estimate for the volume that Thorchain will amass over the next 2 years. Starting with $528.96B in total industry volume and multiplying through our probability-weighted market shares we get a value of:
Thorchain volume = $528.96B * (0.775*0.6 + 0.25*0.3 + 0.05*0.1) = $288.28B
Volume is the single most important measure of an AMM’s success. If the purpose of an AMM is to service the trading of assets then volume is a direct indication of the scale that the service has achieved. It also directly translates into revenue for its participants who capture a share of that revenue by locking their assets into the system to support its function. This is the relationship between volume and total value locked and the basis for how we will transform the volume that we have found into TVL in the next section.
From Volume to TVL
A good place to start would be to examine the average relationship between volume and TVL in the industry as a whole. This relationship can be framed as a ratio of TVL/volume and tells us how much TVL accrues to a DEX for every unit of volume.
Taking data from TheBlockCrypto we find that DEX volume averaged $125.82 billion per month over the past 6 months, annualized to $1.51 trillion a year. We are using 6 months data here because the first half of 2021 marked the parabolic boom of DeFi and was an extraordinary volatile environment for both metrics, which may not lead to an accurate representation of the relationship between them.
TVL for those same exchanges averaged $64.42 billion in this period, or 4.27% of annualized volume. This gives us some good reference for the industry average, however taking a look at the individual protocols that comprise this reveals a very large dispersion around the mean.
Using data from the month of February, Uniswap’s TVL was only 1.1% of its volume while its long-time rival Sushiswap had a ratio of 6.02%, significantly higher. Results for some popular exchanges like Balancer and Curve even go as high as 12.94% and 22.67% respectively. This variation comes from two main distinctions: First, commissions may differ between each service and second, there may be additional incentive structures in place that attract LP’s beyond the revenue earned just from commissions.
A prime example of this is seen in the case between Uniswap and Sushiswap. The standard commission (for non stablecoin-to-stablecoin pools) is 0.3%. Uniswap pays this entire amount to LPs while Sushiswap deducts 0.05% of this for paying token holders instead and therefore offers slightly less to LP’s. On the other hand, Uniswap doesn’t offer any extra incentives while Sushiswap pays out additional rewards through a program called Onsen. These rewards more than make up for the slight loss in commission and has resulted in a TVL ratio almost 5.5x higher than Uniswap.
In the case of Curve, the major incentive is in its design which almost completely does away with impermanent loss (IL) by only pairing stablecoin-to-stablecoin or synthetic assets in its pools. This directly reduces the cost and risk for providing liquidity to Curve and has resulted in LPs pouring in significantly more capital per unit of volume as compared to other exchanges. The effect that IL can have on an investors wealth can be massive in a space as volatile as this. A recent study by Topaz Blue found that this phenomenon actually caused a net loss for 49.5% of liquidity providers on Uniswap over their study period.
For some reference, here is a graph depicting the total loss incurred from IL as price changes in the underlying asset.
Apart from just the nominal losses incurred from this phenomenon there is also an added layer of risk when IL is involved which comes in the form of volatility as losses are not known ahead of time. As such, a reduction of IL provides tremendous incentive that actually goes beyond its face-value, meaning that $1 in IL reduction provides value of over $1 to the investor. Reason being that the elimination of IL will also eliminate the element of risk that comes with it; a $1 average payout that is accompanied by high volatility is worth less than a guaranteed $1 payout. This illustrates the power of eliminating IL and explains the high 22.67% TVL ratio that we see for Curve.
Thorchain has implemented a wide range of incentive structures to boost its TVL alongside the growth in volume. These incentives are:
Trading commissions
Unlike traditional exchanges, which charge fixed commissions, Thorchain’s fee structure varies according to the Continuous Liquidity Pool (CLP) mechanism that it employs. This allows them to extract fees from different tiers of traders more efficiently.
Focused pool concentration
Thorchain’s single-asset pairing model creates deeper liquidity pools, translating to lower slippage and higher trading volumes.
Impermanent Loss protection
This is arguably one of Thorchain’s most important incentives. All LPs who deposit their tokens for a minimum of 100 days have full IL protection, subsidized directly from Thorchain’s treasury reserve. Protection starts to build after having deposited assets for 30 days and slowly increases until reaching full coverage on the 100th day. As we saw, IL is one of the biggest risk factors for an LP and its elimination will significantly bolster the amount of TVL that flows onto the platform.
Block rewards
Another major incentive. Thorchain pays out additional rewards over the base revenue that is generated. These rewards are funded through a portion of the monthly inflation in RUNE and is based on a declining issuance schedule, similar to Sushiswap’s Onsen program. The schedule is designed to target a 30% APR at inception and decline to 2% by year 10 at which point the majority of revenue will come from trading commissions. This will be a substantially bigger block reward than Onsen over the next 2 years, making total LP rewards even more enticing.
ThorFi revenue
As we explored, Thorchain’s expansion into other DeFi services will bring in higher market volume and additional yield which only adds to platform revenue.
If the examples of Sushiswap and Curve are any indication, Thorchain’s incentive programs are sure to meaningfully boost its TVL ratio. However, we must also acknowledge any potential dis-advantages of Thorchain’s model in relation to the rest of the industry.
Higher trading fees
When swapping between non-RUNE assets the trade must be routed through two pools instead of one and accrue gas/slippage fees across both. This is a natural consequence of having every pool paired with RUNE.
Single-asset pairing
LPs must hold RUNE to provide liquidity with another asset instead of being able to provide liquidity with any two assets that they choose. This will inevitably deter some LPs who do not want personal investment exposure to the price of RUNE.
Split revenue
LPs are not the only party with a claim on platform revenue. Because of its unique design Thorchain’s revenue is also used to pay out Node Operators, decreasing the incentive paid out to LPs and directly affecting TVL.
A caveat for the first issue is that gas fees across most blockchains are relatively low and don’t even comprise a noticeable amount of total fees. As for blockchains with higher gas costs (namely Ethereum), we should expect these added fees to inevitably go down with time as they work to implement the necessary scaling solutions.
As far as the second issue is concerned, the solution is already being sought out ahead of time and will come with the introduction of Thorchain’s algorithmic stablecoin. Once live, Thorchain will be able to support stablecoin-paired pools while still maintaining the deterministic price of the RUNE token since every stablecoin requires an equivalent amount of RUNE to be burned in its creation. Taking a look at pools on Uniswap I found that roughly 72% of TVL is locked into stablecoin pairs. The introduction of this mechanism will cover the vast majority of LP pairing preferences while bringing new functionality to the ThorFi ecosystem by tapping into the multi-billion dollar industry of stablecoins and adding a deflationary component to RUNE at the same time. Truly powerful.
In regards to the final point on split revenue, if the TVL deposited by LPs is proportional to the amount of revenue they receive (plus added bonuses) then we should only take the share of LP revenue into account when determining the TVL that will accrue to Thorchain. The share of revenue directed at LPs is decided by the incentive pendulum and can be adjusted according to on-chain governance proposals. The limits for this are set to distribute between 1/3 and 1/2 of all revenue to LPs with the remainder going to NOs.
In an attempt to bootstrap LPs early on, the balance is currently set at the upper limit of 1/2, meaning that 50% of all revenue is directed to LPs. I believe it would be reasonable to think that this balance remains for the majority, if not all, of the next 2 years when growth matters most. However we can never be certain of this so we will once again err conservatively in the face of the unknown and rather than assume the status quo we can simply take the midway point to represent an equal probability of the two options. Half-way between 1/3 and 1/2 gives us a value of 41.5% which we will take as the share of Thorchain’s revenue that will be distributed to LPs, on a probabilistic basis.
Ok, now that we have listed out all the relevant incentives and dis-incentives, we can find our TVL/volume ratio. At this point, one thing that becomes clear is that accounting for the effects that each incentive structure would have on attracting liquidity could prove to be difficult in the absence of a proper comparable. Lucky for us, Thorchain does have a very strong comparable which we can use to weigh our incentives against, Bancor.
Like Thorchain, Bancor also pairs each pool with its own native token (in this case BNT) and shares the same advantages/disadvantages that come with that model, except for the fact that Bancor allows LPs to provide liquidity in any token they choose as opposed to pairing with BNT, leaving Thorchain at a slight disadvantage for attracting TVL based on LP preference for different assets as mentioned before.
Bancor also has the exact same 100-day IL protection policy, helping to boost its TVL ratio far above the industry average, but does not have the extra incentives that come from Thorchain’s CLP structure, block rewards and ThorFi revenue.
It is my belief that these extra incentives will more than make up for the TVL lost from limited asset-pairing options on Thorchain, however there is a great deal of uncertainty as to when ThorFi revenue will reach impactful levels and when stablecoin pairing will be implemented. To account for this we will assume that the extra incentives Thorchain brings will just make up for the TVL lost from its pairing model, establishing a rough 1:1 TVL ratio with Bancor and giving us a solid reference thus far.
Finally we will apply the 41.5% share of LP revenue to Thorchain’s TVL and arrive at our result.
Bancor’s average TVL ratio was found to be 9.06% of volume, using the last 6 months data from TheBlockCrypto. Taking 41.5% of that yields a TVL ratio of 3.76% for Thorchain.
Applying this to our estimate of volume we converge on Thorchain’s expected TVL in 2 years:
Thorchain TVL = 288.28B * 0.0376 = 10.84B
Collateralization Rate
As of today, Thorchain’s total collateralization rate sits at 18.86%. Many standard PoS protocols see staking rates from 40-60% of token supply at maturity.
Staking in a typical PoS protocol is analogous to bonding via Node Operators. In Thorchain this only accounts for 2/3 of the collateralization rate with the other 1/3 coming from the RUNE locked into liquidity pools. Because of this we should apply a 1.5x mark-up to the typical staking rate to arrive at our estimate for Thorchain at maturity.
Taking the mid-point of the standard PoS range (50%) and applying our mark-up, we arrive at a rate that is almost four times larger than today:
Collateralization rate = 50% * 1.5 = 75%
Remember that the higher we make this variable, the more conservative our final value will be
Inflation Schedule
RUNE resides on 3 blockchains: Thorchain, Binance Smart Chain and Ethereum.
According to data from the official token release schedule, the circulating supply of RUNE across all 3 chains is 335 million today.
There are another 34 million tokens to be distributed to the core team and seed investors, staggered over the next few months.
In addition, a little under 25 million more tokens will be issued over the next 2 years for incentives such as block rewards, culminating in a total RUNE supply during year 2 of:
RUNE supply = 335m + 34m + 25m = 394 million
Discount Rate
The final piece of the puzzle is to determine an appropriate rate for discounting our future value of RUNE.
This is simply the rate that an investor demands for exposing themselves to the risks of the asset and is traditionally measured by volatility. To be more specific, financial models often use the beta of an asset which represents the volatility in relation to some broad market index. The reason that relative volatility, or beta, is used instead of total volatility is because it is usually assumed that the marginal investor has a sufficiently diversified portfolio and any form of risk that is specific to only one asset is diversified away, leaving only the systematic risks which affect all assets.
A quick word of caution is that in practice this may not be the case for any individual investor who is not completely diversified. I will proceed to use a beta approach here because I want this to be as representative as possible to the average investor, but would also recommend that the reader think about the discount rate that would apply to them.
Operating under these assumptions, we could start by finding the discount rate which would be applied to the crypto market as a whole. If we take BTC as our representative of this market (since it constitutes 44% of the market by size), we can use the following inputs to get a beta in relation to the S&P500 stock market index:
Standard Deviation (BTC) = 0.75
Standard Deviation (SPY) = 0.1316
Correlation coefficient (BTC/SPY) = 0.36
Calculated from 2021 data
Beta (BTC) = (0.75 * 0.1316 * 0.36) / (0.1316^2) = 2.052
Of course we don’t expect an asset the size of RUNE to have the same volatility profile as BTC or the broad crypto market. To adjust for this we will factor in RUNE’s annualized volatility of 1.76, also taken from Messari. The way I will do so is by simply taking the multiple of RUNE/BTC volatility (which tells us how many times more volatile RUNE is compared to BTC) and apply that to our beta. This gives us the following result:
Beta (RUNE) = (1.76/0.75) * 2.052 = 4.815
Instead of directly measuring RUNE’s beta against the SPY we used the correlation of BTC/SPY and simply accounted for RUNE’s higher volatility by applying it as a direct multiple. The theory behind this approach is that it is just not reasonable to think that the relationship between RUNE and the broad market will be even remotely similar going forward. We have to remember that RUNE is an early-stage asset and was influenced more by its own progress and rapid growth than by market-wide events this year. As a result, the variation in its beta would be very large from one year to another and unreliable for estimation. Instead, we are assuming that BTC is the best proxy to capture systematic risks for the crypto market as a whole and we use that in conjunction with RUNE’s price volatility to best represent our final beta.
To illustrate this point, I calculated the correlation coefficient between RUNE and the SPY over the past year and it returned a value of -0.11, giving us a slightly inverse correlation and negative overall beta. That correlation also changes drastically depending on the start date of the calculation, making it completely unreliable.
Finally, we just need to apply this beta to the discount rate of the broad market (SPY) and we will have an idea of the required rate of return that should be demanded for an asset of this nature. To do this I have used the numbers provided by Aswath Damodaran, a brilliant professor out of NYU Stern who goes through the process of finding the discount rate for the S&P500 stock market index every year. His findings for 2022 were published in January so I updated the numbers with values from March 10, at the time of writing, and arrived at a market discount rate of 6.25%. This consists of a 1.99% risk-free rate (using the 10-year treasury yield) and a 4.26% equity risk premium. The beta for RUNE will be directly applied to the equity risk premium, before adding the risk-free rate to give us our final discount rate:
Discount rate = (4.815 * 4.26) + 1.99 = 22.50%
For those readers who are not familiar with how to construct a discount rate using the model showed here, you could simply take note of the final result and move on or think about a fair discount rate for yourself by considering that it should simply represent the minimum amount of return that you would be willing to accept for holding a cryptoasset as volatile as RUNE. For reference, consider that the market is requiring a 1.99% return for “risk-free” assets and 4.26% more than that for assets as volatile as a stock market index. Given those alternatives, what is the minimum return that you would demand to get paid for holding something as volatile as RUNE in your portfolio?
Putting It All Together
Now that we have all the necessary components, we can bring them together to find a fair value for RUNE today.
Parameters:
TVL = $10.84 billion
Collateralization rate = 0.75
Circulating supply = 394 million
Discount rate = 22.5%
Time = 2 years
Future value:
Future value = 1.5*(TVL) / (collateralization rate * circulating supply)
Future value = 1.5*(10.84B) / (0.75 * 394M) = $55.03
Current value:
Current value = Future value / (1 + discount rate)^t
Current value = $55.03 / (1 + 0.225)^2 = $36.67
In short, our assumptions about the potential market size of cross-chain trading solutions and Thorchains competitive positioning within this market led us to an expected value of $10.84 billion in total-value locked after 2 years. Given the deterministic relationship between TVL and market cap we know that this would translate to about $21.68 billion in market cap if 75% of all RUNE is collateralized on the protocol. Dividing by a total supply of 394 million tokens yields a fair value of $55.03 per RUNE in year 2 and $36.67 today when discount back to the present.
Actually, to be more precise, this is the fair value for the floor price of RUNE that is expected in 2 years time and not a total price.
The total price will be decided by its deterministic value found here plus the value added by all of the following characteristics which were not accounted for in our process:
Governance rights
Ecosystem utility
Deflationary effects
Each one of these factors have the potential to add billions of dollars in market cap on top of the deterministic value which we arrived at. In fact, the majority of DeFi tokens around today (worth hundreds of millions or even billions in market cap) are only functional as a governance token and carry no promise of actual value accrual or any further utility.
Ecosystem utility is arguably an even stronger price driver as witnessed in the outstanding valuations of many layer 1 protocols, network tokens and gaming assets. Binding the utility of a token to a strong and fast growing ecosystem creates a direct correlation between the network usage and the practical demand for the token. On the Thorchain network, RUNE is used as fee payment for executing transactions and in this way also acts as a layer 1 smart-contract protocol with RUNE at the base of all activity. Even in the early stages of testnet we are already starting to see the signs of a healthy ecosystem developing on Thorchain, both with the ThorFi services being integrated as well as the multiple independent projects building on top of it.
All of this will have the practical effect of putting more pressure on the demand-side of RUNE’s price elasticity. On the other side of that equation, free-floating supply will tend to constrict with time as the amount of RUNE collateralized to the system increases in a deterministic fashion and is only accelerated with the deflationary effects brought on by the launch of its algorithmic stablecoin.
We are likely to see a very strong incentive for burning RUNE to mint native stablecoins because of its potential use as a pairing asset in Thorchain’s liquidity pools. If this feature comes to fruition, all demand for stablecoin pairing will flow exclusively to Thorchain’s native stablecoin because of the lack of alternatives on the network. This interplay creates a powerful dynamic for reducing supply in parallel to the future growth in TVL.
To imagine the effects that this could have on RUNE, taking our value of $10.84 billion in TVL and assuming that 72% of that will be paired against Thorchain’s native stablecoin (as per the average Uniswap pool), we could estimate that $7.8 billion dollars worth of stablecoins would be minted via burning of RUNE without even accounting for demand across other ThorFi or ecosystem applications. At the current price of $8 this would require 975 million tokens to be burned, more than 3 times the existing supply of RUNE. If we used our estimate of $55.03 for the future price of RUNE instead, it would still imply a burn of roughly 142 million tokens (36% of the circulating supply at that time).
I believe that all of these elements will coalesce to put massive pressure on the price of RUNE and somewhere between its current TVL and the $10 billion mark expected in year 2, Thorchain will reach an inflection point where the tightening forces of supply and demand pushes price to far exceed its deterministic value.
Throw in any momentum factors that would arise from market participants who will inevitably try to front-run its growth trajectory and we have a recipe to potentially send the price of RUNE into the range of hundreds of dollars per token.
The practical nature of the markets will always push price past its intrinsic value.
With this optionality in mind, the value of $36.67 that we arrived at here is the minimum that I would be willing to pay for one RUNE today.
RUNE also acts as the perfect diversifier in a portfolio of cryptoassets. Most assets in this space come with an embedded bet on the success of the blockchain that they reside on. A Solana-native decentralized exchange is only as good as the growth in adoption of the Solana network, for example. Thorchain on the other hand is completely uncorrelated to the success of any one chain. Rather, it’s a bet on the growth of the entire cryptocurrency industry and the need for transacting across all chains, regardless of which ones win out in the end.
For all of these reasons, I believe that RUNE is the best way to bet on a multi-chain future and would make a strong addition to any investor’s portfolio at current prices.
And with that we have come to the end of our exploration into Thorchain and the investment thesis for RUNE. As promised, I have attached a spreadsheet that anyone can use to arrive at a fair value for RUNE under their own assumptions. I only hope that the reader found this post informative and that, at the very least, I was able to provide some new insights into this fascinating application of blockchain technology.
If you need to reach out, you can find me on twitter @_FabianHD and any feedback or personal opinions are more than welcome.
Oh and for the sake of full disclosure, if it wasn’t obvious already, I own some RUNE.
Cheers,
Dear Fabian,
really awesome analysis & write-up, helped me greatly to understand Thorchain better and get an idea about a potential valuation. I'm not the deepest technical guy, but was a bit surprised that only Chainflip is mentioned as a competitor, what about e.g. Synapse Protocol, Anyswap/Multichain, Flare, MAP Protocol?
E.g. MAP Protocol claim Thorchain to be centralized due to the ~33 signing validator nodes (MPC/TSS) and to be the only decentralized sollution in the space (https://forum.maplabs.io/t/why-are-thorchain-and-anyswap-renamed-as-mutichain-are-no-match-for-map/3052)...
Thanks also for sharing the valuation Spreadsheet, liked to play around with the values a bit (e.g. higher discount 40%, lower dominance 30% - still lead to a fair value today of around $28).