Is Olympus a Ponzi scheme or an innovation? Starting from the master-level incentive design mechanism

Author: Three Body Capital
Compiled by: Perry Wang

A few months ago, when we were researching the previously discussed Alchemix, we first learned about OlympusDAO and its native token OHM. At that time, the now ubiquitous (3,3) (a meme representing profit) project and its peers were increasingly common on crypto Twitter. We thought it was worth investing some capital for a speculative experiment, so we bought some OHM and staked it.

Olympus is an absolutely captivating story that beautifully integrates game theory, incentive design, and new cryptographic primitives. It should be made clear that, as always, this article should not be interpreted as any investment advice and does not constitute a recommendation for any asset. The usual rules of the crypto space apply: do your own research, make your own decisions, and consult a friendly banker for paid advice if necessary.

For centuries, markets have been viewed as the aggregate decision-making of market participants, which is correct. However, when it comes to creating incentives for specific forms of behavior, especially coordinating positive actions, the market has largely declared failure.

The price volatility in the crypto space is primarily due to the liquidity of tokens being controlled by large traders and market makers (also known as "whales"). However, they are considered a necessary evil—otherwise, how would new project tokens have liquidity, especially when developers want to focus on building rather than market making?

The incentive model of OlympusDAO, along with its strategy of fully controlling its own liquidity, is a masterclass in incentive design. Crucially, this is a crypto-native model, a plug-and-play tool that should exist. This single fact may be more important than anything else in this article.

To reach the summit, we must start our journey from the foot of the mountain.

Olympus: Fundamentals

All crypto projects have a rich library of documentation and readily available reading resources, and Olympus is no exception. The purpose of this article is to highlight specific parts of the projects we are interested in, but if you want to truly satisfy your curiosity (which you should!), you can find it here.

On this basis, OlympusDAO set out to build a crypto-native reserve asset.

Just think about it, and you can clearly understand the daunting mission they face. In the early days of the crypto industry, the "base" asset was Bitcoin—everything was paired with Bitcoin, and the only place to invest with a "neutral" strategy was to go long on Bitcoin. The problem was that, unlike the situation we are accustomed to now, Bitcoin was much more volatile at that time.

Then, as the Ethereum ecosystem began to flourish, stablecoins emerged—whether centralized (like USDT or USDC) or decentralized (like DAI), they provided an exit valve for the crypto world. Positions could exit and be exchanged for "stable" assets pegged to the dollar.

The emergence of stablecoins propelled the Cambrian explosion of cryptocurrencies, but the lurking issue has always been the risk associated with the U.S. government, as the potential value (support, peg, or otherwise) relies on the dollar or its equivalents. In fact, as stablecoin providers have increasingly faced small-scale conflicts with regulators, this risk has now come to the forefront.

The team behind OlympusDAO (still anonymous to this day, a strong testament to the absolute brilliance of decentralized networks) has a unique vision: to create a crypto-native reserve asset supported by purely decentralized assets rather than fiat assets. In other words, the future they envision is not "physical assets"—the base currency will not be the dollar, and monetary policy decisions by the Federal Reserve (or any other central bank issuing fiat currency) will not directly affect its price.

In other words, they want to assemble an institution equivalent to a crypto central bank from scratch, accumulating various high-quality crypto-native assets in its asset reserves that can be used to support the value of the reserve assets issued by the protocol—their native token, OHM.

This sounds like a great idea, although the question is also evident: if OHM is a reserve asset, it needs to be stable, so why wouldn't this crypto token be frequently sold off like other tokens?

Secret Sauce: Game Theory

Game theory can allow us to discuss for hours and still barely scratch the surface of the most fascinating parts of behavioral economics, and anyone can delve into this field. The key point we need to understand here is that Olympus's application of game theory principles is, to say the least, very clever.

As one might expect, the language of game theory is very concrete, so when necessary, we will attempt to provide simple explanations of how specific terms differ from their everyday usage. First, let's look at the concepts of "strategy" and "equilibrium."

In everyday language, "strategy" always implies some complexity, such as military invasions or corporate acquisitions. In contrast, the "strategy" used in game theory is a simple, clear course of action; for example, in a game of rock-paper-scissors, a strategy could be: "play rock five times, then randomly choose rock or scissors," "play rock, then scissors, then paper, always in that order," or "after my opponent plays paper, I will always play paper next." Of course, most people do not play this game in this way, but economists (and game theorists) tend to simplify.

Similarly, "equilibrium" in everyday language often indicates some state of balance. In game theory, "equilibrium" is actually much more specific: in this state, all participants in the game have no motivation to change their strategies.

Understanding these two terms makes it very simple to construct the game-theoretic outcome needed for building a reserve asset: everyone must buy, believing that others will buy; no one should sell, because if they sell, they will lose out on significant gains.

From the beginning, Olympus's goal has been to construct an incentive mechanism that gives anyone participating in this "game" a strong motivation to buy, stake, and most importantly, to always hold OHM tokens regardless of market conditions.

If they can truly achieve this, OHM will be able to establish a reputation as a stable and reliable reserve currency in the cryptocurrency world. After all, the reliability of a reserve asset depends on the trust its holders have in it, and trust can only be built over time.

This is the brilliance of Olympus's mechanism design: the staking rewards set are greater than the potential dollar losses caused by market volatility over a period of time, effectively eliminating any reason for stakers to sell their staked OHM. This was achieved early on with an absurdly high staking reward of 150,000% APY, which as of the writing of this article is currently around 8,167%. In other words, at the current price of OHM, buying and staking OHM essentially guarantees stakers a profit in dollar terms over the course of a year, unless the value of the OHM token drops by more than 98.8%.

We provide some numbers for this: at the current price of around $881 for OHM, the "break-even" price for staking OHM for one year is $20.20. In other words, at the current price, if you hold until the distribution phase of OHM ends (currently ongoing), if the price is above $20.20 after 312 days, you will achieve a profit in dollar terms.

Next, we need to examine what crypto assets are in the Olympus treasury—in other words, what reserve assets support the value of each OHM. This data is readily available on their dashboard.

But first, let's look at some numbers—OHM's treasury assets currently have a market value of $407 million.

Among these, excluding assets like ETH and SUSHI that are subject to dollar market value fluctuations, and only retaining stablecoins like DAI and FRAX (for those unfamiliar, FRAX is currently the largest stablecoin in the AVAX ecosystem), the "risk-free assets" in the Olympus treasury are valued at nearly $107 million.

The capped supply of OHM is 3,342,369 (of which 2,136,676 have been issued), and the "book value" of each OHM at maximum dilution market price is $121.20, with $32.07 of that value supported by stablecoin assets.

Compared to the $20.20 "break-even" price for staking OHM for one year, the incentive allure of OHM is quite evident; unless all cryptocurrencies face a catastrophic event, holding and staking OHM is a very reasonable choice: the returns for OHM stakers are almost guaranteed to rise.

But what about the premium over net asset value (NAV), which is almost a crazy 9x premium! On one hand, calculating the break-even point is based on the current market price of OHM, which includes the premium, and considers the potential risk of price decline thereafter. Moreover, OlympusDAO's goal is not just to create a static reserve asset pool. In fact, this asset pool is revenue-generating, producing fees from the assets it collects.

Ultimately, if someone believes that cryptocurrencies will go to zero because they will eventually evaporate, only then will OHM have no value in his/her eyes.

OHM aims to be a purely crypto-native reserve asset. Therefore, to be part of Olympus, one must believe that crypto technology will continue to exist; this is a necessary prerequisite.

So far, we have briefly discussed the project's clever incentive design and how OlympusDAO fundamentally incentivizes OHM holders not only to buy OHM but also to stake and continue holding OHM, regardless of market fluctuations.

Returning to the theoretical language of game theory, knowing that other stakers have almost no motivation to make any strategic changes (where stakers choose to stake and hold OHM) achieves a kind of equilibrium strategy. The result is a win-win, or the typical return symbol (3,3).

But the beauty of Olympus doesn't stop there. Next, we will discuss the truly interesting part.

Another Major Benefit: Owning Your Liquidity

OlympusDAO is positioning itself as the central bank of the cryptocurrency world. Attracting a stable group of "diamond hands" holders who have no motivation to sell OHM is one aspect of this mechanism. But "diamond hands" create another problem: lack of liquidity.

If no one wants to sell, the asset has no liquidity, and thus has little use. Therefore, liquidity needs to be created for OHM to facilitate trading. However, in the crypto space, creating liquidity often means handing OHM over to market makers, and the incentive mechanisms usually mean they only provide liquidity when profitable, choosing to withdraw liquidity when the project needs it most, leading to vicious price fluctuations of the token. Most importantly, there are no final buyers. All of this severely undermines OHM's ability to establish its status as a reserve asset.

The solution OHM created for this is to own its liquidity. It achieves this through a "bonding" mechanism, which involves purchasing liquidity tokens representing shares in large automated market maker (primarily Sushiswap) liquidity pools, in exchange for selling OHM tokens at a discounted price from the total nominal issuance, which can be unlocked in a shorter period. Through this method, OlympusDAO ultimately owns the majority of the liquidity pools for OHM (primarily the OHM/DAI stablecoin liquidity pool on Sushiswap).

The end result is that the OlympusDAO protocol itself becomes its own market maker, able to promise liquidity regardless of market conditions, and ultimately reducing the volatility of its token price. Liquidity providers (LPs) who sell their LP tokens will receive compensation for purchasing OHM at a discount, entering the same incentive structure as any other OHM staker. In this case, the benefits are mutual—LP token sellers can obtain OHM at a discount relative to market price, while the protocol acquires liquidity and assets for its treasury, further increasing the net asset value per OHM.

These LP tokens further generate income for the protocol, as they earn most of the market maker fees from trades. OlympusDAO holds 99.66% of all liquidity in the OHM/DAI currency pair, and over the past 7 days, OHM/DAI has been the most traded currency pair on Sushiswap, generating substantial income for OlympusDAO and further increasing the value of its total reserve assets:

Solving a Broader Problem

The entire concept of "protocol-owned liquidity" has sparked a revolution for many projects struggling to maintain stable token prices. Many project founders are developers rather than traders, and they must deal with the anxiety brought on by price volatility (and subsequent community morale), which is a significant headache for them.

However, they also face the double-edged sword that Olympus must contend with: how do you simultaneously distribute tokens to as many users as possible, ensure sufficient trading liquidity, and ensure that market makers are committed to providing liquidity when it is most needed, rather than withdrawing at critical moments?

To some extent, staking projects have been implemented for a long time, although during inevitable crypto downturns, staking can only alleviate some selling pressure. In fact, the controversy surrounding staking is that it removes liquidity from the market during downturns, which can actually exacerbate price volatility of crypto assets.

Therefore, while everyone is excited about the astronomical APY that can be earned through staking OHM, we actually believe that the project's greatest masterful design lies in combining staking with bonding. After proving the success of this model (staking + bonding), they recently launched Olympus Pro, a platform that allows other protocols to replicate the staking + bonding setup as a service, with other protocols only needing to pay fees. This is referred to as "protocol as a service."

This means that other projects can also benefit from the Olympus model: controlling their own liquidity, earning fees through their own market making, and ensuring that their tokens always have liquidity, especially on DEXs.

Currently, there are five other DeFi protocols collaborating with Olympus Pro: Abracadabra, Alchemix, Float, Pendle, and StakeDAO. We believe this list will grow longer in the future.

For Olympus itself, to say they are developing "quickly" is an understatement. From the time we started writing this report to its completion, Olympus has launched a new version of the contract, with a development focus on bonding, which is not surprising. The OHM rewards received by bonders can now be automatically staked immediately, meaning that any bond purchased at a discount will automatically yield more than staking. The more bonding there is, the more liquidity there will be, and the greater the protocol's control over liquidity.

Additionally, they have added the ability to tokenize fixed-term bond tokens as NFTs (yes, NFTs are not just for JPEG images), while also allowing fixed-term bond tokens to be tokenized as ERC-20 (fungible tokens), creating a more liquid market for the bonds themselves, somewhat akin to traditional bond markets: running bonds with similar maturity dates are essentially equivalent to fungible assets that may adjust slightly, while fixed-term bonds with specific maturity dates are typically not replaceable by bonds with other maturity dates.

Similar yet different. Decentralized bond trading instead of over-the-counter (OTC) trading? Why not.

Non-Physical Assets (Our Current Favorite Term)

Can this new approach to managing incentives structurally change the market dynamics of cryptocurrencies? There is a possibility. By ensuring a good distribution of liquidity across all price ranges, the risk of extreme volatility in crypto assets can be significantly reduced, thereby narrowing the range of price fluctuations.

But a fundamental point we want to emphasize is that such solutions, while seemingly obvious in hindsight, are practically impossible to implement in the traditional financial world. Traditional publicly listed companies can conduct stock buybacks and provide incentives for holding stocks (such as dividends and ex-dividend dates), but unless every publicly listed company starts building its own internal trading platform to manage the volatility of its stock, stock prices are largely dictated by the market.

Moreover, where is the line between "stability" and "market manipulation"? In traditional finance, stabilizing prices after an IPO is usually allowed, maintaining price stability for a limited time, but after this time window ends, similar actions can provoke public outcry and regulatory scrutiny. In the world of cryptocurrencies, using automated market makers like Sushiswap instead of order book-based market making allows protocols to ensure liquidity (thereby suppressing price volatility) without actively quoting prices at their discretion. Using this as a solution to liquidity shortages in the early days of crypto DEXs has proven to be an elegant, passive, and even profitable means of managing token liquidity.

Furthermore, creating fixed-income instruments with fixed maturity dates (not entirely similar) can be traded with high liquidity through decentralized traders, keeping prices unusually stable, which is nearly impossible in the traditional world. Think of the scenes in the movie "The Big Short," where as traders begin to panic and withdraw liquidity, bond discounts become increasingly aggressive within a day, and people can only hope for a mechanism to ensure that the situation does not become too chaotic (even if equally unprofitable) and can continue to provide liquidity until the end.

In our view, the aforementioned mechanism design is just the beginning of innovative approaches that can only emerge in the crypto world. These approaches are not only non-physical assets (for example, not just crypto versions of assets that exist in traditional finance), but they are also cryptographic primitive solutions built on crypto-native systems.

We can't wait to see what great ideas the geniuses in the crypto space will come up with in the coming months and years.