The Incentive Pendulum
Keeping the network balanced
This article is written by @Bitcoin_Sage. He shares valuable insights and information regarding Thorchain on a daily basis with his followers on Twitter. If you enjoy this article or are interested in Thorchain, consider following him.
In the previous articles I wrote about providing liquidity to Thorchain and already briefly mentioned the incentive pendulum. In this article we’ll zoom in and discuss it in detail.
The Function of the Incentive Pendulum
The incentive pendulum is an essential part of the network. It keeps the network in a balanced state where the network is secure and efficient. It does this by changing the distribution of rewards to nodes and liquidity providers.
The Different States of the Network
The network can be categorized in 5 different main states:
- Inefficient
- Over-bonded
- Optimal
- Under-bonded
- Unsafe
The under- and over-bonded states are less severe intermediary states. Being under-bonded is not a threat in itself because it is not yet profitable for node operators to steal. Being over-bonded is not a problem in itself because the system is still operating quite well.
The Rebase Foundation created an amazing tool to simulate how rewards shift when the incentive pendulum changes. Below I discuss the three most important network states.
Inefficient
When there is too much capital bonded, the network becomes inefficient. This is undesirable, as there is much more capital used to secure the pooled funds than they’re actually worth. In this state the vast majority of rewards go to the liquidity pools.
The incentive pendulum reacts by distributing a higher % of rewards to the pools. Resulting in increased returns for liquidity providers. Encouraging them to pool more funds, to profit from increased returns. At the same time nodes are disincentived, as they receive lower rewards. Competition to be churned in decreases, causing a decrease in bonded RUNE with every churn. Operators might also unbond and look for more profitable opportunities. They might even add funds to the pools, because it might be more profitable at this point. Over time this will restore balance and bring the network back into an optimal state.
Optimal
In this state the network is secure and working efficiently. The amount of RUNE bonded is 67% and RUNE pooled is 33%. Rewards are distributed 2:1. The incentive pendulum favors neither side.
Nodes receive higher rewards because they have more risk and higher associated costs. From Multi-chain chaosnet on, rewards will distributed in a 1:1 ratio. This ratio can be adjusted at any time in the future by the nodes, if needed.
Unsafe
When there is to much capital in pools, the network can become unsafe. The value of pooled capital is higher than the bonded capital. This state is very undesirable, because it becomes profitable for nodes to collude and steal funds
The incentive pendulum corrects this by distributing a higher % of rewards to nodes. This incentivizes nodes to raise their bond and will result in more RUNE bonded. At the same time it disincentives liquidity providers, as they are now getting lower returns. Causing them to withdraw capital from the pools. Over time this restores balances to the network.
In a future article I’ll discuss THORchain’s security. For now I’ll refer you to a thread I wrote on Twitter, about THORchain’s security.
Consequences for LPs and Nodes
Because the incentive pendulum constantly shifts the distribution of rewards it’s wise to keep an eye on it. There could be situations in the future where the network becomes extremely underbonded. In this scenario it might be more profitable to withdraw funds and search for a better return somewhere else.
There could also be a situation in the future where it’s very profitable to add more funds to the pools. Taking advantage of an overbonded state.
From Multi-chain chaosnet on rewards between nodes and liquidity providers will be split 1:1. Increasing rewards for liquidity providers by 50%.
The Incentive Pendulum is Essential
Without the incentive pendulum the network would eventually end up in an unsafe state. Node operators would take advantage of this and steal funds from the network. Causing trust in THORchain to collapse and funds either being withdrawn or stolen.
The incentive pendulum makes sure everyone is rewarded appropriately, stays friends and more importantly it incentivizes all participants to keep all funds on THORchain secure.
If you have any questions or would like me to elaborate on a topic, don’t hesitate to ask in the comments or on Twitter.
In the next article we’ll take a look at how Thorchain secures its assets and what would happen if nodes would collude to siphon funds from the network.
If you’d like to read more articles/guides about Thorchain check this Medium page out.
Written by Bitcoin_Sage
Twitter: @Bitcoin_Sage
Medium: @Bitcoin-Sage
Published by THORchain
Official documentation: docs.thorchain.org
