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Tokenization has been with us for more than 20 years now. However, this noble idea was introduced in the blockchain space with the launching of the Ethereum network less than six years ago.
This token is a randomized data string with no exploitable meaning or value. However, the token retains the pertinent information about the underlying asset without compromising its security.
How tokens are distributed
After a startup mints tokens, the next step is distribution. How do end-users and the community get these tokens? There are two main approaches.
- Distribute tokens to users. Community members and users receive tokens for either ongoing or past actions. These actions include airdrops and various ongoing incentives such as liquidity mining rewards, staking rewards, and trading competitions.
- Sale of tokens to the public. Users invest money into a project and get tokens in return. Examples of investments include Pylon-style yield delegation, auctions, and fixed-price sales.
Flaws associated with both approaches
Distributing tokens to users through airdrops and ongoing liquidity incentives
Airdrops distribute tokens to users based on their past actions. They may be high-value users of other protocols or have previously used the present protocol — however, this approach rewards past behavior over future commitment. There is no assurance that these people will continue benefiting or contributing to the protocol after the airdrops. Many decide to sell these tokens and leave the protocol.
Ongoing liquidity incentives reward ongoing participation in the protocol and have become the preferred approach. This approach is also not perfect. Ongoing incentives are only used to reward actions that occur on-chain. Examples of such actions are providing liquidity, completing trades, or providing collateral. Such an approach favors whales with a lot of money at their disposal. On the other hand, stakeholders such as third-party integrators and community members who add value to the protocol are not favored.
Distributing tokens through public sales
Some projects decide to conduct public sales and facilitate price discovery. The first drawback is that public sales expose projects to regulatory risks. A typical sale demands an ‘investment of money,’ so these projects are seen as unregistered securities that may attract regulatory issues.
Even though public sales may solve the price-discovery problem, the low-initial-liquidity problem may remain unsolved. Projects can add initial liquidity themselves, but that requires a lot of capital. This approach also attracts regulatory risks since the project sets a price for its token and establishes the market. As a result, most tokens show high price volatility during launch and several weeks after.
How Lockdrop and LBA seeks to solve these challenges
Delphi Digital has been analyzing and helping design token launching mechanisms for a long time. From the analysis, the team noted that there wasn’t a structure that could solve the above challenges and also align to its goals. The team then came up with Lockdrop and Liquidity Bootstrap Auction (LBA) to tackle these challenges. The first products to test Delphi’s Lockdrop and LBA were Astroport and Mars.
Lockdrop (Phase 1) is the distribution phase. In this case, it is a time window where anyone can pre-commit to become a user of a particular protocol. When the time-window lapses, these users get a pro-rata share of the tokens based on the length of commitment and size of tokens held. These tokens will then be locked until Phase 2 ends.
Liquidity Bootstrap Auction (Phase 2) is the price-discovery phase. Lockdrop participants may commit all or part of their ASTRO into one stablecoin pair. For instance, ASTRO-UST liquidity pool. Other users may come and buy ASTRO from Phase 1 participants. When Phase 2 lapses, this is what happens:
- Stablecoins + native tokens are deposited into a liquidity pool. The final price of the native token is determined by the ratio of native coins to stablecoins.
- Various auction participants get LP shares pro-rata to their deposits. These LP shares are locked and vested linearly for over three months. If there is sufficient participation in Phase 2, there will be immediate and deep liquidation at the market price.
- All tokens issued at Phase 1 and not yet committed to Phase 2’s Liquidity Auction unlock and can be traded freely.
Phase 1: Lockdrop
As already mentioned, Phase 1 is the distribution phase. To better understand, Lockdrop and LBA, we use the context of Astrodrop token launch. This phase aims to put tokens in the hands of Astroport users. The ‘value’ that these users bring to the protocol should be equivalent to the tokens that they earn.
Value is measured in different ways. Lockdrop can be viewed as an airdrop. However, instead of rewarding users based on the previous actions, they are rewarded based on their forward-facing commitment to using this protocol.
If we take Astroport as our example, the long-term protocol clients are liquidity providers who provide liquidity in key trading pairs. Users commit Terraswap LP shares for pre-selected trading pairs to provide liquidity to Astroport. This liquidity will be locked for up to one year. Users who lock their liquidity will get 7.5% of the total ASTRO supply. A user’s share of the Lockdrop will be calculated based on:
- Number of ASTRO allocated to the trading pair announced before Phase 1.
- The weight is calculated based on how long you lock your LP tokens.
Phase 2: Liquidity Bootstrap Auction (LBA)
The price discovery phase aims to establish a price for the token. There should also be deep liquidity for the token at that price. This is what happens on the LBA:
- Users sell the tokens and not the protocol.
- Auction participants receive locked LP shares. In other auctions, users get unlocked tokens.
- The withdrawals are limited progressively over the last two days to limit manipulation by whales.
Still taking Astroport as our example, ASTRO’s price is determined by how much UST and ASTRO users add to their pool. If, for example, 100 ASTRO tokens and 100 UST are deposited, ASTRO’s implied price will be $1. However, the price can jump to $2 if an additional 100 UST is deposited.
The price mechanism is important as users commit to initializing and locking tokens in a liquidity pool for three months. The common risks of providing liquidity in an AMM but not being able to withdraw spontaneously based on the market conditions remain prevalent.
Users can deposit as much UST and ASTRO as they want during the first five days of Phase 2. However, only UST is withdrawable during the last two days to avoid manipulation. On day 6, withdrawals are limited to only 50% of your deposits. On day 7, withdrawals are not available.
This mechanism prevents the whales from depositing more than they intend to leave in the pool to inflate the price beyond reason and discourage other participants. These whales usually withdraw all the excess and lock in a much lower price like Mango Markets.
How Lockdrop + LBA design solves the current token distribution challenges (using ASTRO as a case study)
- Distribution. ASTRO tokens are distributed to those who pre-committed to use the protocol. Small wallets can boost their ASTRO shares by committing to locking their tokens for longer using voluntary locks. Non-users are also allowed to get tokens in a way that bots or whales cannot exploit. The users also have a say or control over the price they pay.
- Price discovery. Bottom-up price discovery through the LP share auction mechanism is achieved during Phase 2. Users or buyers who commit UST or ASTRO to the liquidity pool determine a fair price for ASTRO by the amount contributed in total to the pool.
- Sufficient float. There will be 110,000,000 ASTRO in circulation at the end of Phase 2, representing 11% of the total supply.
- Liquidity. Instead of auctioning ASTRO tokens, locked ASTRO-UST LP shares are auctioned. The pool is capitalized at the end of Phase 2, translating to deep and instant liquidity.
- Decentralization. It is not the DAO or the project teams selling tokens to the public but the users. Protocol users are granted these tokens and allowed to sell them through an auction.
Determining the price of a token and providing instant liquidity when issuing new tokens has been a big challenge. Lockdrop and LBA are just examples of new approaches to solving these problems. It is worth noting that ‘Lockdrop’ and ‘Liquidity Bootstrap Auction’ are two different approaches, even though they have been presented together in this write-up. We expect to see how other protocols that use this method will adapt them to fit their token issuance processes.