The THORChain incentive pendulum is an interesting concept to keep the network balanced
As someone relatively new to crypto, there are a number of things belonging to this universe that I entirely or partially ignore and when it comes to DeFi, this number increases exponentially.
One of the recent things included by the LeoFinance team in the CubFinance economics was the incentive pendulum. I had never heard of that concept before, but I remember Khal saying that THORChain's incentive pendulum inspired him, so I decided to look at that to try and understand that mechanism.
What is the THORChain incentive pendulum?
Essentially, the incentive pendulum is a mechanism that allows the system to increase or decrease the amount of rewards going to node operators and liquidity providers.
It's called a pendulum because it can go back and forth depending on a predefined set of conditions.
Why does the pendulum exist?
When I first learned what the pendulum does, I found it an interesting mechanism, but, naturally, I started to wonder why that shift in the way rewards are distributed is desired or needed?
Fortunately, THORChain docs has a comprehensive guide on that subject, and it will be the primary source for most of the content of this post.
A short explanation is that the pendulum exists to keep the network balanced, stopping it from becoming unsafe or inefficient.
Network states
THORCHain defines the state of the network according to the relationship between the amount of Rune which node operators have bonded and the amount which has been added to liquidity pools by liquidity providers, and based on that, it classifies the state of the network at a given point in time in one out of the five following categories:
- Unsafe
- Under-Bonded
- Optimal
- Over-Bonded
- Inefficient
Right off the bat, I'll let you know that the "Under-Bonded" and "Over-Bonded" states are seen as not desirable but also not critical, so we won't be bothering about them in this post.
Let's take a look at the other three possible states.
Optimal
As the name suggests, this is the desired state where there is a perfect balance between bonded and pooled capital. In this state, the network is both safe and efficient, and the pendulum does nothing.
One thing that's worthy of note is that this state is achieved when 67% of Rune in the system is bonded and 33% is pooled, which I found weird at first because it doesn't sound balanced at all, but the explanation for that is very logical: node operators have higher costs than liquidity providers, so this is a way to even out the income for the two agents.
Unsafe
This happens when there is too much capital in liquidity pools. It's considered an unsafe state because, in this case, it is profitable for node operators to work together to steal assets from the network.
In this case, the pendulum will act, increasing the amount of rewards going to node operators and lowering the rewards going to liquidity providers. The expected outcome is that more node operators get involved due to higher rewards, and liquidity providers pull assets out and go somewhere else, driving the system towards the desirable Optimal state.
Inneficient
As you can probably imagine, this is the opposite of the Unsafe stage, and it happens when there is too much capital bonded by nodes compared to what is in liquidity pools. The problem with that is the capital being put to secure pooled assets is much greater than what the pooled assets are actually worth.
Here, the pendulum acts again, but now it will increase the rewards for liquidity providers while lowering the rewards for node operators. That should attract more liquidity providers due to the increased rewards and drive some node operators away, restoring the balance of the system once again.
What about the CUBFinance pendulum?
I think it does something similar, but I'm not sure if it goes by the same mechanics or if it has the same purpose of balancing out the network. That's something I'd like to find out, and when I do, I may write a post about that.
Another thing I might do is delve deeper into the mathematical aspect of the algorithm. THORChain provides all the formulas and a comprehensive explanation of what they call an Incentive Curve, and since I'm a big nerd and love dealing with equations and numbers, I'm tempted to do a more detailed analysis of that.
But don't worry! I'll spare you for now.
Final thoughts
THORChain is one of my favourite crypto projects and I recommend everyone check out the cool things they do. A good place to start is the THORChain guide right here on LeoFinance.
Reading about the THORChain incentive pendulum was very enlightening because I had never considered the potential risks of an unbalanced network. The pendulum is a clever solution to mitigate those risks, and I'm glad other projects are implementing similar measures.