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Analysis of DEX Inflation Via Yield Farming Vs. Token Price
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TLDR below. This is not financial advice.
Inflation is not only an important variable in monetary policy in the economy, but also important in crypto. Inflation is the easiest way to fund development. This forces holders to indirectly pay for development through the loss of value or ownership of the token over time to the protocol.
Inflation is usually referred to via a token release schedule; the researcher actively recalculates it.
What Is Inflation?
Inflation in traditional economics refers to the increase in prices of goods. Inflation in token economics refers to the increase in token supply.
Inflation is the persistent increase in the general price level of goods and services over time and the value loss of a currency. When the general price level rises, a unit of currency buys fewer goods and services than in the past. Thus, inflation reflects a decrease in purchasing power per unit of a currency. In the economy, inflation is affected by many factors such as demand-pull, cost-push, structural changes and import and export, etc.
In the crypto space, inflation is the issuing of new crypto/tokens into circulation which puts selling pressure on them. In theory, their value should decrease with an increase in supply, if demand is constant. Inflation in the crypto space is mainly affected by the increase in the supply of circulating tokens.
Token Issuance Model
The only impact on inflation is the issuance of tokens into circulation. Token inflation is used to bootstrap growth or to start a community. In this section we are going to find the answer to this question: which issuance models have been used so far in crypto space?
Bitcoin seems to be a prime example of algo supply as the amount of $BTC mined per block is predetermined — that has never existed in human history before, a transparent monetary policy. It is easy to know what the $BTC supply will be on any particular date in the future. Or at least, what will be the supply at any new block.
This model appears most on the Ethereum/BSC platform. ICO/IDO/IEO projects provide a total supply (available) and they will be released from time to time as determined by the project.
Technically, projects release 100% of the total final supply of tokens but release only a fraction of it into the market. The remaining allocations are bound according to a pre-existing schedule (which may or may not be public).
This leads to a risk of fraud as the team has control over this supply. They can unlock 100% of the tokens they are holding and sell them on spot.
An important example in this model is Ethereum. In its early days, the Ethereum community decided to let the network grow on its own with contributions in economics design by its own community. However, we rarely see projects using this model at present, because it does not clearly define a specific future monetary policy.
We have now classified the supply models that affect inflation. In practice, we see more algo supply and scheduled supply and their combinations.
In this section, we will detail how each particular project controls inflation and what model they are using.
Initially, Uniswap distributed $UNI in two ways: the $UNI bonus liquidity program and the $UNI release. In essence, Uniswap used the scheduled supply model.
Based on the distribution plan, we have aggregated inflation for each year as follows:
Year 1: 206%
Year 2: 51%
Year 3: 21.62%
Year 4: 8.89%
The annual inflation rate (2%) will be applied after 4 years.
For now, the distribution is still going on and it represents project funding.
Sushiswap is different from Uniswap in that they continue to maintain the program of providing liquidity and unlocking $SUSHI according to the schedule. At the same time, Sushi also provides data on unlocking tokens on a monthly basis, which makes it easier for us to evaluate. Below are the monthly inflation rates we collected.
In the early months of the Sushiswap implementation, a large amount of $SUSHI was minted to encourage new users, and thus the inflation rate in the early stage was very high. Specifically year 1 is more than 60% of the total supply.
The inflation rate will decrease quickly in year 2 at 9.36% and year 3 at 3.58%.
While inflation should theoretically reduce the value of a particular asset, in a strong bull market, enough demand can still outweigh the selling pressure from inflation.
You can clearly see this in the inflation chart (monthly) of Sushiswap. Despite the huge inflation in the early stages to incentivise users, the value of $SUSHI is increasing rapidly. This is something interesting in the crypto space.