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Convex Finance: Analysis and Forecast into the 'King-Maker' DeFi Protocol
An in-depth breakdown and prediction of CVX, one of the premier DeFi crypto assets.
In George R.R. Martin’s book A Clash of Kings, Varys poses a riddle to Tyrion Lannister. In case you have never read the books, this riddle was also popularized in the Game of Thrones show, particularly in season 2. For those of you who are unfamiliar with both the show and book, allow us to introduce you to the riddle:
“In a room sit three great men, a king, a priest, and a rich man with his gold. Between them stands a sellsword, a little man of common birth and no great mind. Each of the great ones bids him slay the other two. ‘Do it,’ says the king, ‘for I am your lawful ruler.’ ‘Do it,’ says the priest, ‘for I command you in the names of the gods.’ ‘Do it,’ says the rich man, ‘and all this gold shall be yours.’ So tell me – who lives and who dies?”
Don’t worry, you haven’t stumbled across a Game of Thrones Substack, this is still a post about Convex Finance.
What is the answer to this riddle? Is it the laws of society that rule us? Is it some higher being? Or does it all just come down to money? Varys poses an interesting answer to his riddle:
“Here, then. Power resides where men believe it resides. No more and no less.”
This probably makes no sense to you right now. You’re probably wondering to yourself, “What the hell does this have to do with crypto?” By the end of this article, you will understand how a seemingly meaningless quote from a book read by nerds like us can help us understand one of crypto’s most interesting assets.
Welcome to the Curve Wars.
In the Beginning, there was Curve
Before diving straight into Convex, it is first necessary to understand another DeFi application, Curve Finance. The point of this section is to give you a general understanding of Curve, and how it relates to Convex. Curve Finance, at its simplest, is a decentralized exchange. Unlike decentralized exchanges such as Uniswap or Sushiswap where cryptos of different prices and values are traded (Ex. You trade your ETH for LINK, two different assets), Curve is a decentralized exchange for assets that you should trade at the same value, mainly stablecoins. For the purposes of this article, you can simply think of it as a decentralized exchange for stablecoins.
Why is a decentralized exchange necessary for stablecoins? The answer is liquidity. We all know that stablecoins should trade at $1. Whether it’s USDT, USDC, DAI, UST, or whatever your stablecoin of choice is, the $ value of it *should* be $1. However, that is not always the case. For whatever reason, sometimes stablecoins deviate from their $1 peg. Curve Finance enables arbitragers to take advantage of these deviations through their exchange, and in the process, help correct the peg. The more liquidity and more volume traded, the more stable the stablecoins should be. At its core, Curve Finance is a decentralized exchange for stablecoins which plays an important role in helping them maintain their peg.
The next step to understanding Curve Finance is its token. Enter the Curve DAO Token (CRV). CRV is critical to the functioning of Curve Finance. It is a governance token that lies at the heart of the protocol. In order to fully capture the benefits of CRV, it must be locked as veCRV. This part can be a bit confusing, so pay close attention. By locking your CRV into the DAO, you will receive veCRV in return. This is important because veCRV:
Receives trading fees from the protocol
Participates in governance and votes in gauges
The first benefit of veCRV is fairly straight-forward. By locking your CRV, the protocol will reward you trading fees. Currently, a 0.04% fee is applied to every trade on Curve. Liquidity providers get 0.02% and veCRV holders get 0.02%. Understanding so far? Hopefully, because here comes the complex part.
In addition to this, and arguably most importantly, veCRV holders vote on gauge weights. Curve Finance, for the next ~300 years, will emit new CRV tokens on a predictable schedule. Currently, it is creating ~633,000 new CRV tokens daily. Every year, this emission decreases by roughly 16%. On August 14th, for example, CRV emissions will reduce to ~532,000 CRV daily. The question that now remains is: Who gets this newly emitted CRV?
The answer is the liquidity providers. BUT, veCRV determines who gets how much they get. Think of it like this: 633,000 CRV is set to be allocated to Curve liquidity providers. But how do we optimally distribute this emission? Should we just distribute it based on $ amount provided to Curve? veCRV introduces a simple, yet genius solution to how we should allocate emissions. The solution? Vote on it. veCRV voters pick the weights that each pool (Ex. 3pool- DAI, USDT, USDC) will be allocated. Currently, 3.334% of new CRV is distributed to liquidity providers in the 3pool. Every two weeks, veCRV holders will re-vote on how emissions for the next 2 weeks should be distributed to the pools. This creates an important flywheel effect:
Provide liquidity to a pool of your choice (Another Ex: MIM)
Buy/acquire CRV and lock it into veCRV
Vote to increase the CRV emissions to the pool you are participating in
Receive CRV emissions and lock it into veCRV, thereby increasing your voting power and increasing your future emissions
This dynamic has spawned what many are calling the Curve Wars. Protocols and DeFi users scrambling to acquire as much as CRV as possible. Why? To turn it into veCRV and increase their control over future supply distribution of CRV tokens. This has become extremely lucrative for some, as Curve Finance is the far and away #1 exchange over stablecoin trading. Basically, it’s a gold rush, but the gold in this scenario is CRV.
This stuff can be quite confusing if it’s your first time being exposed to it. If you’re still not quite getting it, we highly recommend checking out yuga.eth’s Substack (Link to his profile. He has a great write-up on Curve and the Curve Wars. You can read it here!
Enter Convex: The Evolution of the War
There’s one problem with all of this. In order to fully realize the benefits of your veCRV, you need to lock it for 4 years. In crypto, that might as well be an eternity. For 4 long years, your veCRV is locked and you can’t sell or trade it. What if, however, there was a way to bypass that pesky time lock? This is where Convex Finance enters.
Convex is a simple, yet revolutionary protocol that takes full advantage of veCRV’s benefits. Convex says, “Hey, give us your CRV. We’ll lock it in the max time for you and give you the benefits AND give you a liquid form of it that you can trade.” Here is how it works:
Convert your CRV into cvxCRV. This is irreversible. You cannot convert your cvxCRV back into CRV. You can trade it for CRV, but once cvxCRV is created, it cannot be turned back into CRV. Therefore, it’s supply is never decreasing. Secondly, cvxCRV is just tokenized veCRV. Every token on cvxCRV represents one token of veCRV.
If you stake your cvxCRV on the Convex platform, you will: “Earn CVX rewards, Curve trading fees, airdrops, and a share of 10% of the platform’s total CRV earnings”
You can unstake at any time, there is no time lock requirement. Therefore, you can also sell your cvxCRV at any time.
Since Convex’s inception, it has become a blackhole for CRV. As of writing, Convex controls just under 175 million veCRV. Considering that there is roughly 370 million veCRV in total, Convex holds enormous control over governance and gauge weighting as they have ~47% of the voting power. The only problem that remains is who gets to control how Convex’s enormous stack of 175 million veCRV votes. This is where CVX comes in to play.
CVX is the native token of Convex Finance. It can be either staked or vote locked. For the purposes of this article, we will be focusing on vote locked CVX, otherwise known as vlCVX. vlCVX is how we will be determining our valuation of CVX. So… what is vlCVX? Remember that huge stack of veCRV we mentioned earlier that Convex controls? vlCVX determines how that veCRV votes. A voting protocol to determine the votes for another voting protocol. Each vote locked CVX controls 5.24 veCRV as of writing. For every vlCVX you own, you gain 5.24 veCRV in voting power. Additionally, since CRV deposited into Convex’s protocol as cvxCRV is irreversible, that veCRV controlled by each individual vlCVX will continue to increase indefinitely. Lastly, vlCVX is locked for 16 weeks. So during those 16 weeks, your CVX is illiquid.
vlCVX is very interesting because it almost functions similarly to a stock. Wait…what? No, we don’t mean in the sense that it represents a share of a company. We mean that we can use it to price vlCVX similarly to a stock. Allow us to explain. As you can probably tell by now, veCRV is very valuable. Being able to control future emissions is extremely valuable to liquidity providers and protocols behind the stablecoins. Walk through a thought experiment with us:
Let’s say you just created a new cryptocurrency, let’s call it Average Joe’s Dollar (AJD). How do we get people to use our new coin? You have to incentivize them!
There are two ways in which we can incentivize:
1) We can simply incentivize people to use AJD by promising them future emissions of AJD if they use it. However, there is a major problem with this. By doing this, we inflate the supply of AJD and dilute holders, driving the value of an individual AJD down.
2) We can use Curve to incentivize our users! If they provide liquidity to an AJD pool on Curve, they can be rewarded in future CRV emissions, not AJD emissions! This way, the supply of AJD doesn’t get diluted, but yet people are incentivized to use AJD. To do this, we must acquire as much veCRV as possible to vote for the pools that utilize our AJD coin.
However, we run into another problem. Acquiring veCRV is expensive. What if there was another way to acquire votes? What if we paid veCRV holders to vote for our pool?
This brings us to our next concept: Bribes. Protocols and liquidity providers will pay you to vote for their pools on Curve. Votium is an incentives platform for vlCVX holders. On this platform, buyers such as aforementioned stablecoin protocols and liquidity providers will bribe/pay vlCVX holders to vote for their pool’s. Through this, holders of vlCVX can amass a steady cash flow that is paid to them every 2 weeks. With bribes introduced, it is now time to introduce the model we developed to forecast the value behind CVX.
Forecasting CVX’s Price: Our Model
Bribes, in a sense, work very similar to dividends. By just holding vlCVX, you can expect to receive a cash flow every 2 weeks. This is similar to holding a stock that pays out dividends to its holders. Thus, we can determine the price of CVX similarly to how we would determine the price of a stock. We will be using the Dividend Discount Model to predict the price of CVX. For those of you who are unfamiliar with what that is, the relevant part is that the price of a stock should be equivalent to the summation of all future dividends. Additionally, since money today is worth more than money in the future, we must also apply a discount rate to future dividends. For the purposes of CVX, just replace dividends with bribes. The important part is this: The price of CVX should be equal to the present value of all future bribes.
Before diving into our price prediction, one important caveat: We should expect bribes to continue to increase in the short term. How do we know this? Because it is currently profitable for bribers to pay the bribees. Llama Airforce is a great website that collects Votium data. As of writing, bribers can expect to get approximately $2.77 in CRV + CVX emissions for every $1 paid out in bribes. Not immediately, but eventually, we should expect bribers to increase their bribes until an equilibrium between the dollar amount paid out in bribes is equivalent to dollar amount received in CRV + CVX emissions. As of the latest data, that equilibrium point would be ~$2.77. Once that point is reached, bribers should be indifferent towards paying for bribes, or just outright buying CVX. Let’s get into our price prediction now.
Bribes will continue until Curve stops emitting. A reasonable assumption since Convex’s supply of veCRV cannot decrease.
An average equilibrium point of $2.50 for bribes. This is the hardest assumption we must make. Since the equilibrium point is dependent on mainly the price of CRV and also the price of CVX, we choose to be very conservative here. At current CRV and CVX prices, the equilibrium point is ~$2.77. Our model actually accounts for a decrease in equilibrium point, in the aims of producing a conservative estimate.
Bribers will increase their bribes at a 5% rate per round until the $2.50 equilibrium is reached. Again, another conservative estimate. At that rate, an equilibrium will be reached by March of 2023.
The next round’s bribe will be $0.60. We use this as our initial estimate since that was the bribe paid out last round.
A discount rate of 25%. A fairly conservative rate that could be adjusted both upwards and downwards based on your own personal assumptions.
For the base prediction, we will be discounting our bribes at a 2-week interval. However, for sensitivity tables, they will be discounted annually for simplicity.
Based on these assumptions, we arrive at a price prediction of $248.07 for CVX. At current prices of $43.33, this gives CVX an upside of 5.73x. Allow us to repeat: Based on the conservative assumptions we made, the present value of all future CVX bribes is $248.07 while the current price is only $43.33. In our opinion, CVX is grossly undervalued.
Of course, there are risks to this model. The biggest one we want to address is also the most obvious: What if the price of CRV tanks? If CRV does sink in price, we can expect to see bribes reduce proportionately. However, to ease those fears, we made a sensitivity table for your viewing:
We highlighted the scenarios in red where the present value of future bribes is less than the current price of CVX. At CVX’s current price of $43.33, the market is pricing in some serious risk. Seriously, to arrive at that valuation, the average bribe paid out will need to be $0.50 while the discount rate would be 30%. Bribes have already eclipsed that mark and the equilibrium point has not even been reached yet. No matter which way you slice it, CVX seems extremely undervalued at these prices. Unless Curve Finance completely falls of a cliff (A very unlikely scenario), we should expect to see CVX steadily rise in value throughout the coming years.
BUT WHAT ABOUT STABLECOIN REGULATION!?! Although regulation is certainly coming, stablecoins aren’t going anywhere. Don’t believe us? That’s fine. Would you believe Jerome Powell though?
Stablecoins are here to stay, and by extension, Curve and Convex. Even if we go full on bear market, CRV and CVX should survive as they are the two DeFi protocols with the most Total Value Locked.
Without outright spewing pure hopium, our model probably underestimates the value of CVX. Convex Finance is growing beyond just being a staking platform for CRV. Recently, Convex announced the release of cvxFXS. FXS is the utility token of Frax Finance, a stablecoin protocol. Similarly to Curve, Frax implements the ve-token design as FXS can be staked as veFXS. The discussion about Convex’s relationship with Frax is one reserved for another day, but maybe you’re starting to see the bigger picture. Convex Finance is evolving into a platform that will become the premier staking platform for any protocol that implements the ve-token design. The future value of CVX is so much more than just the bribes related to CRV.
After taking you through a journey of the Curve Wars and Convex’s role in all of this, perhaps the riddle we echoed at the beginning of this article begins to make sense in the context of Convex. By holing vlCVX, you are the sellsword. Are you just a simple mercenary who performs his services to the highest bidder? Or do you wish to take bribes from protocols that you personally believe in? Ultimately, the choice is yours. But one thing is clear: Power resides where the market believes it resides, and the market has clearly chosen Convex Finance as the most powerful entity in the Curve Wars.
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Disclaimer: None of this should be deemed financial advice. It is purely for entertainment purposes only.