In this article we provide fundamental analysis of new ZRX token model and its consequence on the valuation.
- ZRX currently changed its token model to better align incentives of holders and capture value
- Market makers act as staking pools and passive stakers as delegators
- ZRX value capture is a function of
DEX volumegas price, number of trades (transactions), individual market makers’ ability to profit and (in case of passive delegation) willingness to share profits with delegators
- New model may not really “align incentives” of all token holders as intended
- Based on DCF, ZRX appears to be massively overpriced even with generous assumptions
- As a bonus, we describe a way to short ZRX token in the DeFi ecosystem
ZRX token utility overhaul
0x is a decentralized exchange protocol (aka DEX), that aims to power token trading within Ethereum ecosystem. It is regarded as one of the most potent DEX projects with one of the best teams in the ecosystem.
Project raised 24M USD via ICO in August 2017. Their native token is ZRX, currently (Jan 2020) sitting at 38th place by market cap, with valuation of circulating supply at 133M USD. 1 ZRX trades for 0.22 USD, far from all time high of 2.50 USD.
Despite the fact that 0x project itself is definitely more legit than most ICOs, the utility of ZRX token itself was very dubious. Take a look at original 0x whitepaper from 2017:
While the project managed to strike partnerships, ship code and even attract some liquidity, ZRX token was at the mercy of market pumping and dumping, same as the rest of crypto world. In 2018 one team building on 0x even forked off from 0x codebase, removing ZRX token altogether, further proving that the token is useless and merely creates friction.
Today, 3 years after ICO boom, nobody really thinks that “fees and governance” is a sustainable token utility able to align the incentives and accrue value of the network. During the crypto winter, most of ICO projects just let their tokens bite the dust and disappeared in the pits of irrelevance. However, a few brave (and well capitalized) ones owned their mistake and embarked on a quest to redesign their token model, to appease their investors and fans and give their token real value capture properties.
0x team was among the brave ones. They announced a big token overhaul in April 2019, introducing the so called “Stake-based Liquidity Incentives” (described in detail in ZEIP-31).
Read the linked sources for details, we will just outline the big picture:
- Every crypto economic protocol worth its salt should identify its key activity and incentivize its key participants. E.g. key activity of Bitcoin is mining and key participants are miners.
- Key participants of a decentralized exchange are liquidity providers or market makers. This goes the same for centralized exchanges by the way. They also offer incentives to market makers, but these are not baked in the exchange itself, unlike in crypto protocols.
- Market makers are profiting by standing on both sides of the order book with passive (maker) orders, earning spread or fees, sometimes being subsidized by the exchange.
- In 0x DEX everyone who wants to earn profit as a market maker needs to 1. trade on the exchange with passive maker orders and 2. stake ZRX tokens and become a staking pool for other token holders to delegate their tokens to him.
- Fees are paid in ETH (note that this differs from majority of staking tokens which pay rewards in kind, it’s easier to perform valuation analysis this way, since we avoid self-referential dynamic of the asset).
- Market makers then earn fees from the network based on the number of ZRX tokens that they stake (or that are delegated to them) and also based on their own profitability (yes, that’s right, not every market maker will earn the same, we will get back to this later).
- Token holders who do not want to be market makers themselves can delegate their tokens to a market maker of their choice (acting like a staking pool). However, market makers decide how much of their profits they want to share with delegators (plus there is a common treasury pool that market makers can allocate profits to).
- All staked ZRX tokens also have governance voting rights. Market makers get to control 50% of voting power of their delegators.
So far everything seems to be OK. We let ZRX token holders earn some of the value created by our DEX and we incentivize market makers to provide liquidity. ZRX token basically acts as a fee sharing and governance asset, which ties it all together.
However, we must argue that this incentive design is very suboptimal. Reading the guide, we are reminded that:
As a passive staker you can earn trading fees only by delegating to a staking pool (= market maker) but you are not guaranteed to earn anything if the market maker performs poorly, so you must be able to pick a profitable one. You can only switch market makers every 10 days and it is not easy to determine beforehand which market maker is going to be profitable.
There are more issues with staking and market making on 0x right now. Difficulty for delegators to audit whether their chosen market makers are profitable upfront is just one of them. But for now, let’s just say that it is not clear if the new token model really aligned incentives of passive delegators and market makers. If anything, it seems to give too much power to market makers, while delegators are at their mercy.
Edit: We received a fair amount of feedback from ZRX community on our research. While the reactions were mostly positive, there were couple of factual mistakes pointed out. We are happy to update our research when presented with new facts. Look for green text to find corrections in our research.
One feedback we received indeed claims that market makers are the key agents in 0x ecosystem and new token model puts them in favor by design. However, delegators can use 100% of their ZRX voting power, if they unstake their tokens prior to voting. They need to plan ahead for epochs.
But there is one thing that the new token model achieves much better than the old fee and governance model.
Discounted Cash Flow Model
Tokens that grant us claim to on-chain cash flow are, despite their flawed designs, a true game changer. They let us use valuation models, such as discounted cash flow (DCF), that we already know for a long time from traditional investing.
Recent introduction of 0x staking makes it possible to calculate future expected cash flows and derive a “fair price” of ZRX token based on the DCF model. What we call fair price is simply a price the ZRX token should have to generate the same return as a “risk-free rate” of Dai Savings Rate (currently 6% p.a.).
There are multiple variables entering the DCF model; values for uncertain or currently unknown variables were selected to err on the generous side (e.g. we’re taking into account only the circulating supply of 600M ZRX tokens, not the total supply of 1B). Also please note that that 0x fees are paid in ETH but for the sake of simplicity we will use USD as a reference currency.
Assumptions for the DCF model are:
|ZRX supply (circulating)||600,000,000|
|Tokens staked||50 %|
|Discount rate (current DSR)||6 %|
|Market maker spread||0.2 %|
|Rewards shared||10 %|
Explanation of assumptions:
ZRX supply (circulating): per public data (e.g. Coingecko).
Tokens staked: the most unknown variable. Since ZRX has little utility besides the recently introduced staking, we simply assume around half of the circulating supply might seek to capture at least some miniscule yield through staking. However, as of 15th Jan 2020, only 0.5% of all tokens are staked.
Discount rate: We have chosen current Dai savings rate, which we think should be the go-to rate for risk-minimized yield in Ethereum DeFi ecosystem.
Market maker spread: current bid/ask spread market makers collect on 0x DEX. This should decrease as the DEX attracts more trading activity; we err on the generous side by keeping it at the current level.
Rewards shared: currently the largest pools offer 0-5 %; we err on the generous side by assuming larger rewards will prevail in the future to attract more liquidity.
Using the assumptions outlined above, we model ZRX DCF under 3 scenarios:
1) Conservative – Current 0x DEX Vol: current average 0x DEX volume is around 770k USD daily (per 0xtracker.com). For the DCF model conservative scenario, we are rounding the volume up to 1M USD daily.
Update: right before releasing the article we noticed the volume rose up to almost 4.5M USD. However, this just seem to be one of couple spikes, average is still much lower. For that reason it’s sufficient to go with 1M USD daily volume in our model.
2) Bullish – Bistamp Vol: Bitstamp volume is roughly 50M USD daily, per Coingecko.
3) Mega bullish – Coinbase Pro Vol: Coinbase Pro volume is roughly 150M USD daily, per Coingecko.
We find that under a conservative scenario (current DEX volume) and under the defined assumptions, ZRX token is currently overvalued by a factor of 52. If ZRX token were to be priced by the market purely on the DCF basis, its price would be about $0.004, as with this price the staking yield would be on par with the discount rate of 6 % p.a. (current DSR).
For ZRX to sustain current price levels and provide a yield similar to the discount rate, the DEX volume would have to reach Bitstamp levels (Bullish scenario in the model).
The mega bullish scenario would see the DEX volumes rise to the Coinbase Pro levels. ZRX price under this scenario would be around $0.6 – price levels not seen since Nov 2018.
Even though the bullish & mega bullish scenarios are heavily optimistic in terms of DEX volumes, the resulting fair price would still be deeply below the all time high price of $2.50 (Jan 2018).
While we do not necessarily think that DCF valuation is precise (mainly due to many assumptions), it is certainly a useful model, especially in the case when the valuation hinted by DCF is an order of magnitude lower than the real market price.
You can review the model in Google sheets here. On the second sheet, you can play around with custom assumptions. Go wild and let us know what ZRX valuation you came up with!
The most important correction: We incorrectly claimed that 0x fees are based on volume traded. More precisely, we got following estimate from 0x forum (source):
“The calculation for Profit function is roughly: risk adjusted profit = current volume * potential spread captured. Current volume is ~100k$ and capturing 0.20% is feasible”
According to feedback from ZRX community on reddit (source) this simplification is not precise, since 0x fees are a function of number of filled orders, 0x gas price and “fee coefficient” (around 150 000). So the equation is roughly:
[filled_orders] * [gas_price] * [150,000]
We still think that even our volume based model is pretty useful, but we needed to check how this tx based model affects the value capture of 0x.
0x gas cost = 6 gwei (source)
trade count in 24h = 2000 (source)
fee coeficient = 150 000
ETH/USD = 160
fee for trade = 6 * 150000 = 900 000 gwei = 0.0009 ETH = 0.144 USD
fees generated by 0x in 24h = 2000 * 0.144 = 288 USD
Let’s compare it to our volume based model, with current volume of 400 000 USD (source).
fees by 24h volume = 400 000 * 0.002 = 800 USD
Conclusion: In this scenario, tx based fee design captures even less value than volume based design. The system is essentially designed to be more profitable with lot of small trades than less bigger ones. This may favor some niche use cases such as game item trading, but will fail to capture value from high value trades. Also bear in mind that this model relies on external inputs such as gas price, which adds even more complexity to market making.
Please read this before shorting the hell out of it! We claim that ZRX token is massively overpriced. This is always a strong claim to be made, dealing with liquid public markets which tend to be somewhat efficient.
If we concur that market is not off by such a high margin, what could cause ZRX token to have such a high valuation? Here are some possible reasons (mostly speculations though):
- High future expectations – 0x is technically a great project, with exciting roadmap ahead (with innovations such as 0xmesh). All these expectations might be “priced in”.
- Liquidity margin – Investors prefer liquid investments over illiquid ones, thus pricing them higher. Crypto market is full of what we could consider early stage tech startups with high growth potential, which are already liquid, unlike traditional tech startups. However, this may not apply across the board, since equity has usually clearer value capture. Plus lack of feedback from public markets may actually increase the chance of “irrational” valuations. If 0x was purely private company, it’s not clear how it’s equity would be valued.
- Strong vested interest – There are many powerful VCs involved in the project. These investors have an incentive to keep the price of the token high. For instance, they may be creating price floors on exchanges. Tokens of these investors may also be subject to vesting lockups, meaning that they can’t sell. But information on this is scarce (and we are too lazy to dig deeper).
- We just miss something – It’s entirely possible that the other market players have strong bullish information that we simply do not possess.
- Not enough shorting opportunities – Shorting provides important feedback to overpriced assets. ZRX token cannot be easily shorted. That’s why we provided a guide on shorting ZRX, however there are too many risks currently associated with shorting tokens like ZRX. One of them is the low borrow liquidity on Compound (the ZRX money market is less than 1 % of ZRX market cap).
- Blockchain multiple – Investments of quickly growing industries usually trade with a generous multiple. Maybe the market signals us that the multiple for blockchain projects or DEX protocols is 50x.
The tragedy of crypto securities
When it comes to token design, it is easy to dismiss it as a clumsy attempt to fix a useless token. But we need to understand that in the face of increased scrutiny by regulators (mainly SEC), changing the token model of high profile project such as 0x is no easy task. These projects tread on the edge of creating an unregulated security, which has a lot of negative consequences, starting with the risk of unlisting of their token from exchanges and ending with subpoenas and cease and desist letters.
Just consider how much better it would be to just change the token model to:
“Whichever address holds our tokens will automatically be periodically paid pro rata % of on-chain fees generated by our network”.
On top of that you may add an extra incentive for active network participation:
“If a token holder address provably performs a key activity on-chain, it will be assigned 1.x times more rewards compared to a passive token holder”.
However, while technically easy, this is a big regulatory no-no. Especially for projects that aim to have anything to do with USA. Thus, most of the projects are forced to either implement suboptimal value capture models or to file for SEC listing. And filing with SEC means saying hello to many regulatory hurdles and expensive processes and goodbye to world of easy liquidity and open global investor reach. We call this phenomenon the tragedy of crypto securities (lightly inspired by this article).
For these reasons we think that many projects wish they could just get rid of their token altogether but are now stuck with it, lest their trigger the wrath and lawsuits from their ICO investors. So we really have to applaud any project that even tries to make the honest effort to fix their token model.
Also, the team really cannot be blamed for apparent over-valuation of their token. They merely changed the utility of the token, and as a consequence it is more easily analyzed and valued. The rest is in the hands of Mr. Market.
Bonus: short ZRX in 10 DeFi steps
Disclaimer: none of the following is financial advice. The market can remain irrational longer than you can remain solvent. It is very risky to short any crypto asset, no matter how strong your opinion on it’s “fair value” is. We are currently not shorting ZRX and do not plan to open such position in the next 3 days.
If the reader believes the ZRX token truly is overpriced, there is a creative possibility to short in DeFi ecosystem. The following is a step-by-step guide on shorting ZRX utilizing Compound money market.
Step 1: Go to https://compound.finance/ => click on App (upper right corner) => connect with Metamask/Ledger/Coinbase wallet
Step 2: Click on collateral of choice (DAI or USDC recommended) => click Enable
Step 3: Click Supply => deposit desired amount (at least 150 % of value you’d like to short)
Step 4: Click on “Use as collateral” – see screenshot
Step 5: Once confirmed, you should see your Supply Balance and available Borrowing Power at the top of the page, like this:
Step 6: Now you can borrow assets against your deposited collateral. Go to Markets and find ZRX, click on it. Click on Enable ZRX, then Enable Borrow.
Step 7: Click on Borrow and fill in the desired amount (or click on Safe Max – do not go over this amount or you risk quick liquidation in case of fast price movement):
Step 8: Go to Kyberswap, Uniswap or any exchange that allows ZRX trading. Sell borrowed ZRX for DAI (screenshot below is from Kyberswap):
Step 9: Deposit the DAI into Compound. You will see your Supply Balance and Borrowing Power increase. You won’t get liquidated unless ZRX rises at least 2x in USD price.
Step 10: If ZRX falls in price, reverse the steps 9 to 7 (withdraw enough DAI to buy ZRX back, repay the ZRX, withdraw your collateral + profit). If ZRX rises in price, either deposit additional collateral or accept the loss and rebuy ZRX. If you can’t buy ZRX in time, you will get liquidated and suffer a 13% liquidation penalty.
While we were pretty ruthless to one of the few legit projects in the ecosystem, our aim was not to spread FUD. Rather, our aim is to point out the possible market irrationality and discuss developing trend of tokens, which can be valued using traditional financial models (there is already a website with financial metrics for crypto, ZRX included). We really welcome this development and we hope that crypto ecosystem will get mature enough to become a serious alternative to traditional finance. And yes, we also laugh at the irony of saying this right after the BSV 200% pump.
We truly hope to inspire meaningful debates around token design and valuation. Thus we welcome any constructive feedback.
This article was written as a collaboration between Matej from Sigil and Josef from TopMonks.
Matej Galvanek (Fiskantes) is an Investment Director of Sigil Fund – private hedge fund investing in digital assets, crypto money and decentralized networks, relying on deep fundamental research. Matej also co-founded Crypkit – digital assets tracking and accounting toolkit for crypto companies.
Josef Tetek is an analyst at TopMonks – a software development house and startup incubator. Active on Twitter and Hacker Noon.
Thanks to Jakub for feedback and inspiration.
This content piece is created for information and entertainment purposes only and is not to be taken as an investment, financial or legal advice. Authors do not hold any position in ZRX token, but may hold long positions in some of the other mentioned tokens.