Tokemak: A Deep Dive

Setting the Scene

Influence over the allocation of liquidity to digital assets has become one of the most sought-after resources for a growing number of open finance protocols. From standard governance token liquidity mining popularized through DeFi Summer (mid-2020) to protocols buying voting power in Curve to direct liquidity to their protocols, we have seen countless experiments and innovations focused around building and attracting liquidity.

With the introduction of the AMM, protocols became able to bootstrap their own liquidity without relying on CEX listings. Recently we have seen innovations in capital efficiency via Uni v3, Curve v2, and Sushiswap Trident (soon). Cross-chain liquidity aggregators are now building their foundations for a multichain economy, and we are seeing a reactionary move away from liquidity mining towards protocol-owned liquidity and protocol-directed liquidity, allowing protocols to preserve their treasury while attracting liquidity, and without introducing sell pressure on their tokens while they build. Projects experimenting with protocol-owned or directed liquidity are a significant part of what has loosely been labeled “DeFi 2.0,” protocols that attempt to solve some of the challenges of past models through tokenomics.

Tokemak is one of the first protocols to experiment with protocol-directed liquidity, where token holders decide on where liquidity is directed. Curve may come to mind as having the largest influence over where liquidity is directed. However, Curve’s control over liquidity is limited to the incentives it pays out to LPs in the form of its own governance token, and relies on a hyper-inflationary token model to do so (at least at the moment). Olympus DAO (along with Olympus Pro projects and similar forks) is another example of a DeFi 2.0 model, and after accumulating a significant amount of protocol-controlled assets (“PCA”, often “PCV” in Olympus terminology), is considering moving in a more sustainable direction through the direction of PCA.

Tokemak introduces an alternative way to attract liquidity, claiming to offer DAOs and new DeFi projects a way to “seamlessly generate and deploy sustainable liquidity,” while offering yield farmers single-asset deposits.

After launching with a fully diluted valuation upwards of $5B and attracting upwards of $1B TVL, Tokemak has attracted both praise and skepticism.

In this analysis, we will take a deep dive into Tokemak’s model and try to figure out whether this idea of “tokenized liquidity” is sustainable.

Prefer a PDF? You can also download this report here!

Introducing Tokemak

Named after the term for a nuclear fusion reactor, Tokemak’s primary mission is to ‘generate and deploy sustainable liquidity.’ At its core, Tokemak is a market making protocol designed to provide liquidity across decentralized exchanges (including AMMs, order books, and RFQ-based exchange protocols).

There are two main participants that Tokemak brings together through its platform to accomplish this provision of liquidity.

1. Liquidity Providers (LPs) - Tokemak offers single-asset staking to LPs with mechanisms that prevent impermanent loss.
   
2. Liquidity Directors (LDs) - LDs deploy liquidity to different dexes. They assume a portion of the impermanent loss risk, but not all, and get rewarded in return. This role includes two major categories: speculators that guide the liquidity in return for profit, and liquidity demanders, such as projects that wish to direct liquidity towards their token.
   

A few core components of the platform include the following, which we will investigate in more detail later:

Genesis Pools

These are pools that liquidity is paired against when deployed to decentralized exchanges. There are currently only two pools, ETH and USDC.

Token Reactors

A Token Reactor is simply a single-asset pool into which LPs deposit assets, and from which LDs deploy liquidity (paired with Genesis Pool assets).

TOKE

TOKE is Tokemak’s platform token, and is used to direct liquidity. LDs stake their TOKE in return for an equal number of votes which they can use to direct liquidity from the Reactor of their choice to a dex of their choice (as long as it is approved by Tokemak).

Since every TOKE entitles a holder to direct a certain amount of liquidity, Tokemak describes TOKE as “tokenized liquidity.”

Value Propositions

Value Props to LPs

The market for single-asset staking with no impermanent loss (“IL”) is limited. While options exist for stablecoins (such as Curve, where for many pools impermanent loss is negligible), there are not many options for volatile assets.

Bancor v2.1 and Bancor 3 (coming soon) are perhaps the most comparable protocols, and offer a similar value proposition of single-asset staking through impermanent loss insurance. We will chat further about this later in Competition & Comparisons.

Tokemak provides an alternative, where LPs simply deposit their idle assets and earn rewards in the form of TOKE.

To take things further, Tokemak has made the security of LP funds its highest priority, even if it means harming the protocol itself to ensure LPs are able to redeem the same amount of assets they deposited. Multiple LP safeguards are in place to fully make up for any significant impermanent losses by LPs.

Value Props to LDs

Liquidity Guides

TOKE holders earn APR (in TOKE) by allocating their votes towards different reactors. By keeping the system in balance and deploying liquidity to high-performance pools, these LDs can earn higher returns.

Liquidity Demanders

These LDs are DAOs, early-stage DeFi projects, or any project that wishes to drive liquidity to their digital assets. By staking TOKE, they can direct liquidity to their tokens without the negative effects of the typical liquidity mining launch. Tokemak is taking an open approach to building DAO-to-DAO partnerships, allowing protocols to negotiate token swaps in return for tokenized liquidity.

Who’s Building Tokemak?

Tokemak originated out of a DeFi market making project called Fractal, founded in 2018. The team is non-anon and includes past Fractal members along with new recruits, all heavily weighted towards deep DeFi liquidity and tokenomic experience.

A Quick Look at a Few Team Members

Carson Cook (@LiquidityWizard) - Carson has spent the last four years focused on liquidity and market making in the blockchain and DeFi space. With prior management consulting experience, Carson has been described as a strong builder and leader.

Mark - As CTO, Mark brings over 25 years of experience with software systems, with a focus on stock exchanges and automated trading.

Core Team - Other core team members have equally strong backgrounds in leading technology, Fortune 500 leadership, and liquidity management. A few of them can be found here on Twitter.

0xMaki - Sushiswap’s 0xMaki put a stamp of approval on Tokemak when he announced he would join as Chief Strategy Advisor in a Nov 24th Tweet.

Funding

Tokemak raised $4 million in April 2021 in a round led by Framework Ventures. Other participants include Coinbase Ventures, ConsenSys, Electric Capital, Delphi Ventures, and North Island Ventures.

How it Works (in More Detail)

In order to get a clear picture of how Tokemak works, and some of the incentives in place, we will walk through the liquidity provision process from the very beginning.

Sourcing Liquidity

DeGenesis Event

Tokemak raised north of $30 million during its “DeGenesis Event,” an initial sale of TOKE in return for ETH and USDC to fund its Genesis Pools.

Collateralization of Reactors Events (C.o.R.E.)

New reactors are voted on by TOKE holders through a seven-day voting event. Each TOKE represents one vote, and can be cast (off-chain) towards any reactor candidates. Candidates were initially chosen by the core team in the first C.o.R.E., and steps will be made in the future to decentralize this process.

The top 5 candidates by number of TOKE votes will become eligible for reactors (“eligible for ignition”). At this point, Tokemak reaches out to these projects to negotiate (if the project is interested) a token swap between TOKE and the project’s native token.

In other words, Tokemak is conducting DAO-to-DAO swaps in order to bootstrap enough liquidity to backstop potential impermanent loss by LPs.

If any of the top 5 projects are not interested, the 6th project by number of votes becomes eligible for ignition, and so on.

LP Reactor Deposits

As mentioned previously, LPs deposit assets into reactors. These single-sided deposits are protected from impermanent loss (more on this soon) and earn rewards in the form of TOKE. For each asset that LPs deposit (i.e. ABC) they will receive a tAsset at a 1:1 ratio (tABC). They can redeem these later at the same ratio, as guaranteed by the protocol.

Tokemak’s protocol attempts to keep the system in balance by increasing rewards to LPs for depositing to reactors with low supply relative to demand, and vice versa. As a high level example, we can imagine two reactors with equal deposit values, and different amounts of TOKE staked into them. In order to balance the system, higher rewards would be offered to LPs to deposit to the pool with more TOKE in order to meet the higher demand for liquidity.

So now we have protocol-owned ETH and USDC reserves from the DeGenesis Event in addition to protocol-owned reactor reserves (via DAO-to-DAO token swaps). With a capitalized protocol to backstop impermanent loss, LPs deposit liquidity to be allocated to dexes by LDs.

Deploying Liquidity

LDs stake TOKE in order to receive a purse of votes (1 TOKE = 1 vote) from which they can allocate to different reactors. Voting can be conducted via gasless voting on Polygon (and communicated to L1 via Polygon State Sync Service) or via an on-chain L1 transaction.

The amount of liquidity that LDs control is proportional to their TOKE in that reactor. If you own 10 of the 100 TOKE allocated to the VISR reactor, you can direct 10% of the assets deposited by LPs.

This ensures that the system stays relatively balanced. If your 10 TOKE could be staked into another reactor to direct 20% of its liquidity (let’s assume it has the same asset TVL as the VISR reactor), an arbitrage opportunity exists and incentivizes LDs to consider allocating to this vault instead. As mentioned previously, TOKE rewards also promote a balance between TVL and TOKE staked in each reactor. If there are less votes allocated to this reactor compared to the VISR reactor, a higher TOKE APR becomes available to incentivize more LDs to allocate votes to this reactor.

To what exchanges can LDs direct liquidity?

The supported exchange protocols are currently maintained by a core team multisig and include Curve, Uniswap v2, Sushiswap, Balancer, and 0x (soon). Uni v3 is being worked on (and Visor is hoping to get involved) and the team is monitoring progress with Trident.

Cycles

Tokemak will operate according to 7-day cycles (though these are currently set to 24 hours during the current initialization “Cycle Zero”).

During a cycle, LPs can deposit assets and request withdrawals. LDs can stake, allocate TOKE to reactors, and signal where they would like to direct liquidity. However, it isn’t until the start of the next cycle that withdrawals are claimable, liquidity is directed and rewards begin accruing for new deposits.

Why Cycles?

The batching of transactions facilitates efficient use of gas. Users save money because they are simply depositing to a smart contract instead of deploying liquidity themselves. This also makes IL management easier, as the assets can be rebalanced on a regular schedule.

Mitigating Impermanent Loss and Making LPs Whole

What is Impermanent Loss Again?

Before jumping into examples with Tokemak, here’s a quick recap of some of the characteristics of impermanent loss:

Impermanent loss (“IL”), or more accurately coined ‘divergence loss’ is the difference between the value of two assets outside of a liquidity pool compared to the value of the assets if they had been paired together in the liquidity pool. It is the result of the mathematical equation (i.e. Uni v2’s constant product formula x*y=k) that AMMs use to price assets relative to each other, thus enabling markets without intermediaries.

IL works both ways, meaning if assets appreciate or depreciate in value (with respect to each other) there will be IL. As seen in the chart above, the more extreme the divergence in value between the two assets, the greater the impermanent loss.

An important takeaway here is that impermanent loss risk over time is much greater with highly volatile assets. This consideration comes into play when thinking about the choice of new reactors for Tokemak and how they may increase or decrease overall risk to the protocol.

Tokemak & Impermanent Loss

Let’s walk through an example of impermanent loss within Tokemak and see how the platform handles it!

In case you prefer to play with these numbers instead of reading, here’s a spreadsheet with the impermanent loss equations linked up.

Liquidity Provision

Building on an example from the Tokemak docs, let’s assume we have an asset ABC that is paired with ETH to be directed by LPs to Sushiswap.

LPs provide a total of 125 ETH and 25,000 ABC at the beginning of a cycle (technically before the beginning of a cycle) and it is all paired as ETH-ABC liquidity and deployed to Sushiswap at the above price points.

As the end of the 7-day cycle nears, we check in on the liquidity and find that the ETH price has depreciated by 5% and ABC has increased in price by 5%. The value of our liquidity position is now less than we started with, and less than if we had simply held the same quantity of assets (by ~0.13%).

While we have an overall loss here, we have more ABC than when started, and less ETH.

Tokemak’s LP deposits are single sided, so to make LPs whole (and let them withdraw the full 125 ETH that they deposited if they desire), Tokemak will need to source an additional 6 ETH.

Unless the two assets happen to correlate perfectly over the course of a cycle, there will always be a surplus of one asset and a deficit in the other. In this case, IL was $1,251.

Covering Impermanent Loss

At a high level, Tokemak hopes to generate more revenue from trading fees and incentives than it spends covering impermanent loss (just as is the case with every LP), building up PCA over time.

Building on our previous example, it may be reasonable to expect around $2,000 in fees generated over the course of the cycle (based on fees generated per dollar in the top 10 Sushi pools).

While we will talk about whether this model is sustainable over the long-term later, Tokemak needs to be able to absorb periods (or cycles) of significant IL, both on the individual reactor level and as broader market cycles change.

Tokemak has committed itself to guaranteeing to cover any IL by backstopping losses with according to the following mitigation waterfall:

1. Draw assets from the asset reserve (reactor reserve)
2. System-wide assets in surplus and system revenue (in our above example, ABC would be in surplus, plus any fees generated by the liquidity position)
3. TOKE (first drawn from rewards, and if insufficient, drawn from staked TOKE allocated to the reactor, and in the case of Genesis Pool asset deficits, TOKE from multiple reactors will be drawn)
4. Protocol controlled assets and system-wide reactor reserves (only in extreme situations if protocol guardrails fail to prevent extreme IL)

Paraphrased from Tokemak Docs

Guardrails

Back to our example, we had an impermanent loss of around $1,200 in our ETH/ABC reactor. In this case, we can be sure that the loss is a small portion of our asset reserve, thanks to what Tokemak calls its ‘deployment guardrails.’

Deployment guardrails simply seek to limit the amount of assets a reactor deploys by ensuring that there are enough reserves and TOKE to cover extreme IL events. Currently, Tokemak’s guardrails prevent insolvency (of single reactor reserves and the TOKE staked to that reactor) for up to 100% deviations (doubling or halving) in exchange rates.

Reserve Multiplier Deployment Guardrail

Currently, Tokemak has a 3x reserve multiplier as one of its guardrails, meaning that in our above example, at least 41 ETH and would have been required in reactor reserve assets to deploy the initial 125 ETH.

Since we were short only 6 ETH to ETH LPs in our example, this is able to be covered by the reactor reserves per the mitigation waterfall without tapping into system-wide surpluses and staked TOKE.

Staked TOKE + Min Reactor Reserve = Directable Liquidity

Tokemak also seeks to balance the LP deposits with enough reserves and TOKE staked to the reactor to cover an even greater loss. While we require ⅓ of a reactor’s deployed liquidity to be backstopped by reserve assets, the other ⅔ of its value is backstopped by TOKE.

Barring a loss of a magnitude that severely affects the TOKE price, we have enough assets to offset the extreme impermanent loss without tapping into Tokemak’s PCA (treasury). This also incentivizes LDs to allocate capital wisely since their TOKE acts as collateral.

Balancing the System

We talked on a high level about how incentives change in order to promote a supply/demand balance for liquidity, but let’s dive a bit deeper into how these work. TOKE rewards incentivize an equal amount of LP assets and LD deposits (TOKE staked) which helps collateralize the liquidity while incentivizing LDs to participate in under-represented pools.

Diving into more detail, there are two notable mechanisms in place to further promote efficiency of the system:

1. Total available rewards per reactor are based on the lesser of the two sides of the reactor. For example, if less ABC is staked than TOKE, the rewards available will be based on the TOKE balance, not the ABC balance, and vice versa. If there is more TOKE allocated than ABC, both participants are incentivized to meet the excess liquidity demand by increasing ABC LP deposits.
2. The above totalRewardsAvailable is only paid in full to reactor participants if the TOKE and reactor assets are balanced relative to the total assets in the Tokemak system’s reactors. This ensures that participants are rewarded the maximum only when participating in a well-balanced system, ensuring that there is sufficient demand for deploying asset ABC, and assets will be fully leveraged.

The End Game: A Liquidity Singularity Event

The current Tokemak model of sourcing liquidity from LPs to then direct to exchanges is just phase one in Tokemak’s plans.

The end goal for Tokemak is to achieve critical mass in PCA (Protocol Controlled Assets) to the point where LPs are no longer needed and the protocol directs its own liquidity across all L1s and L2s.

At this point, TOKE emissions would cease and TOKE would have transitioned from a speculative asset to an asset backed by TOKE’s PCA, and holders may be able to burn TOKE to redeem their share of PCA, or hire a fund manager to allocate and invest their PCA across different investment strategies.

How Do We Get There?

Tokemak will grow its PCA by paying all rewards in TOKE to LPs and LDs. That way, any profits made accrue to the protocol. We’ll discuss this aspect shortly in tokenomics, but Tokemak is also focused on capturing market share in other dimensions in order to move towards the controller of all liquidity.

What Comes After More DEX Integrations?

In a recent Twitter Space, Carson touched on Tokemak’s roadmap, and made it clear that Tokemak will not only be focused on streaming liquidity to decentralized exchanges.

After “quickly expanding to other venues,” Carson would like to see Tokemak expand into money market protocols and vaults (like Yearn), expand to L2s and to other L1s, and “evolve into an any-any protocol.” Carson touched on NFTs as well and is exploring ERC-721 support.

Is a Liquidity Singularity Event a Meme?

Most likely, but if the model proves successful (i.e. if it is able to accumulate PCA post-IL and survive major volatility events), Tokemak will continue to accumulate assets over time. While it may not be the only source of liquidity in the market, it has the potential to be a giant as its PCA compounds in value.

Tokenomics

As we have seen, TOKE rewards play an important role in both sourcing LP deposits and allowing Tokemak to operate efficiently and accumulate PCA.

At the moment, Tokemak relies on TOKE for the following:

• To reward LDs for directing liquidity and allocating TOKE (and thus liquidity) efficiently
• To backstop reactors and maintain solvency through volatility
• To bootstrap reactor reserve assets via CoRE DAO-to-DAO token swaps
• To reward LPs for efficiently allocating LP assets where there is demand for liquidity
• To promote liquidity for TOKE Sushi LPs (there are also CoRE voting boost perks)

As PCA increases when fees paid to deployed liquidity is greater than impermanent loss, Tokemak’s initial liquidity mining rewards are essential to achieving critical mass. By paying TOKE rewards to both LPs and LDs, Tokemak is able to retain 100% of the net profits.

Sustainability of TOKE Emissions

We will focus on two major allocations in TOKE’s token distribution, Reward Emissions and DAOs & Market Makers, as these are the two that directly facilitate the accumulation of PCA.

TOKE emissions were not designed to be sustainable past a two-year time horizon, and instead are intended to bootstrap PCA to the point where Tokemak controls a significant portion of the market’s total liquidity.

Reward Emissions

30% (30 million) TOKE will be emitted as rewards to LPs and LDs over at least 24 months. As we mentioned in the “Balancing the System” section, rewards are only paid in full when the system is in balance, so it is likely that rewards extend slightly beyond the minimum period.

All LP and LD rewards (as a variable APR) are paid in TOKE, allowing profits to accrue as PCA. Note that since PCA may be viewed as intrinsic value backing TOKE, LPs and LDs in a way earn trading fees stored in the form of TOKE.

DAOs & Market Makers

Tokemak, through its CoRE process, seeks to facilitate token swaps with DAOs in order to capitalize new reactors with asset reserves.

8.5% (8,500,000) of the TOKE supply has been reserved for this purpose, but how many reactors is that?

The bottom 5 reactors currently have around $5-10m in LP deposits, while the top 3 range from $30-70m. For the sake of this example, let’s assume the average new reactor requires around $3m in reserve assets to allow for around $10m in LP deposits upon ignition. A $3m DAO-to-DAO token swap at the current TOKE price would be around 83,000 TOKE. At these levels, Tokemak could launch 50-100 new (relatively small) reactors. This is quite a bit of fuel and should carry Tokemak through quite a few CoRE events. For reference, Tracer conducted a swap with Tokemak for $1.5m, as the smallest reactor chosen in CoRE 1 and Sushi swapped $3m.

Optimized Liquidity Distribution

Efficient Use of Capital

Tokemak makes good use of its assets. With only 1/3 of a reactor’s assets required to collateralize the reactor, Tokemak is able to direct ~3x as much liquidity as it holds in its reactor reserves. This leverage is unlike other lending protocols. For example, instead of overcollateralized pools like found on Aave which often see relatively low utilization rates, 100% of LP deposits in Tokemak are able to be deployed to dexes.

Arguments Against Efficiency

While the above is true, TOKE is still technically staked to reactors to backstop against IL, so the argument could also be made that while individual reactor assets may see a high utilization rate, they are in fact collateralized when you take into account the target TOKE deposits.

Some questions have been raised as well regarding how Tokemak plans to utilize Uni v3 since concentrated liquidity positions compound the effects of IL, thus increasing the risk of PCA assets being required to mitigate losses.

Viewing Tokemak Through Different Lenses

Carson has made some interesting points when referring to liquidity, including a few of the following statements (all paraphrased):

• In the internet of value, value flow is the new data flow, and liquidity is thus bandwidth
• By removing friction, we minimize spreads, and perhaps some day we can get rid of them altogether
• Just as Uniswap is to Coinbase, we are to Jump Trading
• TOKE is tokenized liquidity, and liquidity is a utility

It may be helpful to draw a few parallels to other structures to help us view Tokemak through a few different lenses.

As a Distributed Hedge Fund

I really like how Nat Eliason put it when referring to Tokemak in one of his newsletters.

“It’s like a hive-minded hedge fund where capital allocators earn some extra rewards, but also take on most of the risk. And depositors are protected at the protocol level from having their funds lost. It creates a really virtuous cycle of incentives, where everyone wants everyone else to do as well as possible, since that’s also the individual-maximizing outcome.” - Newsletter

As a DAO Marketplace for One of the Most Important Utilities

With DAOs competing for reactors, DAOs competing to aggregate TOKE and direct liquidity to their tokens, and DAOs (possibly soon) competing to direct liquidity through their protocols, we might view Tokemak as a DAO-to-DAO marketplace for liquidity of all types.

Examining the First C.o.R.E. Token Reactors

One of my first thoughts when looking into Tokemak was “I’ve never heard of APWine,  sounds volatile and thus prone to a high risk of IL. And taking on an unproven algostable like Frax is risky over the long-run. The model for choosing reactors must be broken.” (APWine and Frax are two of the ten Tokemak reactors chosen for ignition so far).

My skepticism and low risk tolerance aside, it is worth exploring the first reactor winners in an attempt to understand the advantages and risks of this voting model.

CoRE 1 (results)

Frax, Alchemix, Tracer DAO, Olympus DAO, Sushi

CoRE 2 (results)

Shapeshift, Visor, Synthetix, Illuvium, APWine

Reflections on the First 10 Reactors

In general, Tokemak has so far achieved a generalized mix of protocols by type and market cap, with a few time-tested projects and a few newer ones.

APWine & Visor Seek Protocol Volume

Both APWine and Visor represent protocols hoping to direct liquidity to their platforms. APWine hopes to drive volume to its DEX, while Visor hopes to channel Tokemak’s capital to Uni v3 positions via its pooled LP management protocol. While these protocols benefit from having their own reactors on Tokemak, the token swap also offers them the chance to utilize their TOKE to stream volume through their protocols.

Sushi falls into this same category, and also teased the possibility of rolling together tSUSHI and Sushi staking in the future. xtSUSHI stakers would then be able to direct liquidity in addition to voting via the Sushi DAO.

Bootstrapping Protocol Token Liquidity

Illuvium provides a great example of Tokemak solving the liquidity challenge for young DAOs. Illuvium benefits most from directing liquidity to its own token, and primarily accepted a reactor for this reason.

Shapeshift + A Big Offer from Erik Vorhees

Erik posted a letter to the Tokemak community announcing that he had contributed $60,000 in bribes to Votemak (which turned into $800,000 by the end of the voting period through matches and additional contributions), had bought $1m in TOKE to LP with, and would create a $50,000 bounty for devs to integrate Tokemak with Shapeshift.

This demonstrates the possibility of leveraging both bribes and mutual collaboration to form a DAO-to-DAO partnership with Tokemak. Tokemak gets additional resources to streamline development, TOKE holders earn income on their TOKE for voting, and Shapeshift gains the ability to direct liquidity in the future through its own protocol.

Can Reactors be Unwound?

Okay, so some great partnerships have been established through reactor ignitions, but what happens when something goes wrong? Can Tokemak claw back the reserve assets from a reactor to minimize risk to its PCA if an asset is deemed too volatile or risky by the community? And how siloed is extreme impermanent loss risk?

In short, Tokemak owns the reserve assets in a reactor, and may manage them as it desires, but the governance structure has yet to be implemented.

The question as to how siloed an individual reactor is, is an interesting one because a big portion of the assets backstopping losses are in the form of TOKE, whose price is also partially correlated to the performance of reactors.

For a smaller reactor failure (i.e. losing more than the asset reserves + protocol surplus can cover), TOKE stakers would pay LPs to make up for the losses. This may cause some shock as TOKE moves hands and perhaps as a smaller amount of PCA is deployed, but is unlikely to significantly affect the overall diversified Tokemak system.

Where greater risk may enter is if a single larger reactor fails. For example, FRAX currently makes up around 10% of Tokemak’s reactor assets (excluding Genesis Pools). If FRAX were to fail (i.e. due to the market preferring collateralized stablecoins over partially collateralized stablecoins during a derisk market event), Tokemak may need to tap into its PCA to make investors whole, and since the amount is great, this may affect the TOKE price. The more TOKE drops while trying to make investors whole, the more PCA is needed to fill the gap, and it could, in theory, cause a bit of a vicious cycle. The risk of an event like this drops as PCA increases and the reactor landscape becomes more diversified.

Investment Logic

Time Horizon for Significant Profits

The biggest risk for Tokemak is that it doesn’t achieve “critical mass” by the time its token incentives expire. Let’s define “critical mass” in this sense as enough PCA to outperform the market-wide growth in TVL, which would allow it to establish itself as controlling a significant portion of the total market liquidity as the market grows.

With a time horizon of only two years to accumulate PCA without the need to factor in IL, and a total DeFi TVL just shy of $250 Billion, and a max growth rate of 30% on liquidity deployed (this is a generous number for the sake of our example), to control 1% of the market’s liquidity within two years as PCA, Tokemak would likely need an average of $5-10 Billion in reactors over the next year and a half. With around $1B currently, Tokemak must grow relatively quickly. This exemplifies that Tokemak’s growth to the point of a “Liquidity Singularity” is likely a very long way away, and may take many years of compounding its PCA after the emission bootstrapping phase ends.

Estimating Tokemak’s Potential Profits

In the above example, we assumed Tokemak was able to earn up to 30% on deployed liquidity, but a more realistic expectation may be 5-15%. By looking at the top Sushi pools by TVL, we can see that 30% is an outlier, and even the top 10 pools by APY average out at around 10%.

This is still decent for Tokemak, which would aggregate $100m per billion of LP deposits per year.

What will happen with Uni v3?

Uni v3 and a future of more efficient AMMs mean more fees generated but also more IL. As Tokemak does not care (much) about IL while it is able to cover losses via emission incentives and via TOKE and other backstops, the effects of compounded IL via concentrated liquidity positions may be an important consideration when Tokemak transitions to PCA-heavy liquidity provisioning.

We can see in a recent report that on average, Uni v3 liquidity providers suffered losses after factoring in IL.

Will LDs (TOKE holders) be able to direct liquidity efficiently enough to increase the PCA after IL? Will the remaining profits be significant enough to continue fueling Tokemak’s growth as one of the major liquidity provisioners?

Competition & Comparisons

Bancor

Bancor v2.1 has engineered a solution to this challenge, by subsidizing impermanent loss through the sale of its token when trading fees are less than the impermanent loss on qualifying pools. However, this ‘impermanent loss insurance’ has some significant limitations. Pools are capped and often require BNT to open up more space, and the IL insurance accrues over the course of 100 days.

However, Bancor 3 is coming soon and it looks like they are incorporating at least two features that will directly compete with Tokemak’s value proposition: immediate impermanent loss insurance and protocol-directed liquidity.

It’s notable that Bancor v2 has roughly the same TVL as Tokemak, and will likely be able to migrate a fair amount of its liquidity to v3. While we won’t dive into a detailed comparison here, a few key differences include Tokemak’s multiple impermanent loss backstops (vs Bancor reliance on its token value) and its ability to direct assets paired with USDC and ETH to third party exchanges in order to generate higher fee revenue.

Tokemak Claims the Meta Highground

As Carson mentioned, he views Tokemak as encompassing Bancor, and seeks to position Tokemak as a meta protocol that simply directs liquidity to Bancor as one of its many protocols receiving liquidity.

Moat

Tokemak has claimed the first-mover position as a pure liquidity direction protocol. With just over $1B TVL (not including TOKE), it already controls significant liquidity.

With the CoRE model, protocols are already in competition for the next reactor spots, and we can expect this to heat up.

If Tokemak is able to continue its growth trajectory, demand for TOKE will likely appreciate and thus fuel its ability to grow the number of reactors and LP deposits exponentially.

Its partnerships and strong backing add to Tokemak’s moat. Just recently Insurace added protocol insurance packages for Tokemak and we can expect the partnerships to move quickly with reactor projects incentivized to participate in facilitating growth.

The complexity of Tokemak’s platform also increases its moat. No projects have yet forked Tokemak and acquired a leading market position and the requirement to continue moving quickly with governance, multichain design, and support for more types of markets will help box out competition.

Notable Risks

Model Risk

Perhaps the largest risk is the protocol model risk. The model remains unproven and liquidity is yet to be deployed. Significant unknowns exist with the development of more efficient AMMs and cross-chain liquidity provisioning systems.

Downside Risk

Another notable risk (mentioned previously) is the platform taking on downside risk under extreme IL conditions from LPs. While the team claims to have modeled for many scenarios, it may only take one black swan event with an over-allocated reactor to put a stomp on Tokemak’s path towards sustainable PCA growth.

Token Distribution Risk

The TOKE allocations to investors and the team make up almost 50% of the total supply. With the DAO reserve only holding onto 9% of the supply, it is worth noting that when reward distributions end, Tokemak may have a limited ability to rely on its token to continue fueling growth.

If it has not achieved critical mass within its two-year reward distribution phase, Tokemak leaves space for competition to mimic or compete with its model with their own bootstrapped emissions.

Smart Contract Risk

While  the complexity mentioned in the previous section can be a moat, it also introduces significant smart contract risk, and while Tokemak’s contracts have been audited, they have not been time tested or formally verified.

Valuation

Tokemak is a completely new model and there are too many unknowns to establish a proper valuation model, but one easy metric to look at is liquidity leverage ratio, the amount of liquidity you can control per TOKE staked in reactors.

Liquidity Leverage Multiple = Liquid Asset TVL / TOKE LD TVL

Liquidity Leverage Multiple = 1.1B Asset TVL / 260m TOKE = 4.2

                    where Asset TVL = combined value of tAssets (non-TOKE TVL)

In other words, at TOKE’s current utilization rate and price, you can direct $4.2 of liquidity per $1 of TOKE.

Between 2-5x leverage on liquidity is likely a reasonable range for TOKE to trade within until it proves it can build up substantial PCA in return for its token emissions, as one of its core value propositions to LDs is to make liquidity more accessible.

Important to note here is that there is a very low percentage of TOKE allocated to reactors, around 7 million TOKE (7% of total supply). The next year will be hyperinflationary for TOKE and this number will rise substantially, so Tokemak will need to continue aggregating assets at a similar rate to keep providing a similar discount on directed liquidity to LDs.

In terms of its TVL/Market Cap ratio, Tokemak falls roughly in line with Aave, Yearn, and Sushiswap. Note: while many people use this metric to compare DeFi valuations, it means something different for every protocol!

Votemak

Bribes also factor into the valuation of TOKE. With the rollout of CoRE 2, we saw the launch of Votemak which allows for projects to post bribes for TOKE votes in their favor.

At the time of writing this, there have been around $2.5m of bribes. With around 9m votes in the last round, this equates to a dividend of around $0.30 per TOKE. Annualized, this may be a couple dollars, and as competition for reactors heats up, we can expect this number to rise (though we will likely see more votes cast as well!).

Questions & Considerations

Exchanges Acquiring TOKE

As Tokemak directs a greater and greater amount of liquidity, exchanges like Sushi and Uniswap may fight to acquire TOKE.

As Carson highlighted in a Twitter Space, whereas right now we see individual projects acquiring TOKE to stream liquidity to their own tokens, it is not crazy to imagine exchanges directing liquidity to pairs on their own platforms to offer competitive spreads.

What’s the Bottom Line?

Tokemak has demonstrated an ability to attract single-asset stakers (LPs) and has structured its tokenomics in a way that allows it to accumulate PCA for the next few years. Many market participants including multiple DAOs have validated the idea (as we can see from the growing demand for reactors). However, the protocol is extremely early on its path to becoming the market’s default liquidity provisioner, and will require continued exponential growth to give it a good shot at being able to convert from an LP to a PCA-driven model. The current valuation is reasonable from a Liquidity Leverage perspective but Tokemak is entering a hyper-inflationary phase and has yet to prove that it will be able to grow its PCA after impermanent loss (which won’t matter for another two years but will be a deciding factor in its valuation).

Helpful Links

Tokemak Blog: https://medium.com/tokemak

TOKE token dashboard: https://dune.xyz/airbayer/Tok