Understanding Inflationary Bias in DeFi

By September 3, 2022Polkadot
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Cognitive bias is a well-known pattern of deviation from a rational judgment or conclusion. So everybody creates his own permanent bias through their experience and previous knowledge. And of course, this also happens in DeFi: every day. We can choose examples of successful results with incorrect arguments that many times lead us to an irrational judgment misaligned with the arguments.

And this is what is happening all around DeFi world with the Supply issue. Degens and crypto users are drawing judgments or conclusions based on partial knowledge, limited samples (of tokens), and wrong judgments based on a few facts, in this case regarding the supply. I can see this happening in many communities, in CT and also in the SORA community where I am a small contributor.

This inflationary bias is present in DeFi inherited from the CeFi world. The “go brrrr” or “printer” argument that demonstrates the loss of value of a currency, let’s say the dollar, is the first notch in our knowledge. So the “self-evident” reasoning is that the more supply the less value. Because the reasoning is that supply has an inverse correlation with price, which is the thing that usually matters to most of the users in DeFi. So more supply, less price, and the opposite should also be true, the less supply, the higher the price.

Then we have the supply of the tokens. Each DeFi user will have a concrete experience according to the projects where he will have invested in the past, with a concrete win/loss track record that will auto-fulfill his prophecy, in this case, regarding the supply.

The Rabbit Hole

In crypto, we have 3 standard cases considering the type of supply, aka Tokenomics.

Fixed: the best example is BTC, but while being fixed (max in a hundred years approx) is at this moment inflationary with 328.5K BTC mined and distributed among miners every year until the next halving. Who said BTC was free?

Inflationary: On the other hand, ETH was designed pure inflationary, with 4.7M tokens mined per year in the PWO fork. Also distributed to miners. The same happens in Polkadot for example, with a 5-7% inflation distributed to validators and nominators.

Deflationary: these tokens are always apparently very attractive, as they are associated with the scarcity concept and therefore also with an increase in price expectation due to the scarcity.

So, this is the overall framework as a consequence of the existing models and reduced knowledge of economics. Let me explain fast it in 3 points:

  1. The biggest bias here is that an increase in supply will collude sooner or later in a lower price, as you have more tokens they will have less value/price.
  2. The second “rationale” is that a deflationary supply will bring the price up no matter what happens because fewer tokens will have a higher price (assuming the same market cap).
  3. Finally, a fixed supply is usually identified, wrongly, with the Gold standard and with positive attributes of a store of value and evergrowing price. Note that Gold has never had a fixed supply, and even in theory it would be limited to the total amount available on earth, the quantity mined every year has been fluctuating depending on many factors (technology, slaves, wars…) with a huge impact on price/purchasing power when a currency like a dollar was fixed to Gold. The same happens with the tokens.

Many DeFi participants are using this information, together with their own experience and profit/loss over the years to rise conclusions to use in the next bull run.

And then questions arrive at the TG Chat :

  • What’s the max supply?
  • Why has increased so much?
  • What is the limit of the supply?

But all the explained cases are cognitive biased, because the mental mindset and mainstream articles lead us to ask about these topics, and because in the background, both in CeFi (dollar) and in Defi (crypto, BTC, others) an inflationary supply is considered to be “bad” by definition: if supply increases, then the value will decrease because the MarketCap will be diluted now between the biggest amount of tokens.

And I must say this bias is wrong. Because in this kind of judgment the allocation of the new supply is never considered a factor, just the fact of an increase is considered always bad by nature, because this has happened to the dollar, and of course, because BTC fixes this with a “limited supply".

A New Inflationary Supply Proposition (with value)

So we arrive at the SORA proposition, where newcomers will only “perceive” an increase in the supply thus an expected low trend in the price, not what everybody is looking for…

SORA brings to the table new factors that make this kind of judgment biased and irrational. And will demonstrate empirically that an increase in supply doesn’t mean a price decrease.

Because the real question is: Where the new supply is going to be allocated?

For example, in ETH (I know merge is coming but it’s the same) and BTC, it is allocated to miners, that will decide to sell according to their production cost and profit targets. If talking about Fiat currencies, it’s a bit different, as the new supply is allocated normally via commercial banks lending, into stock and financial markets.

In SORA, the social contract states that new supply can be minted for productive purposes. And when doing this, the return for the network will be higher than the output. For example, the community decides to mint tokens for development and to connect the SORA Network to a Commercial Bank to provide the first Defi Debit Card, SORA Card. When the project is finalized ( end of 2022), the output generated by the investment/new supply will pay back with higher and increased use of the network, generating higher value and price.

You can also apply this simple idea, and instead of higher “turnover” for the Network, you will have higher GDP for the country if the SORA Network, a Decentralized Central Bank de facto, will mint tokens to lend to a country, at no interest, for productive purposes (not speculative). For a fresh argumentation on GDP and supply, you can review The Case for XOR.

So, I suggest that the next time you jump into a project when Doing Your Own Research, don’t just ask what is the max supply, what you need to know is:

  • Where the new supply is allocated
  • For what exact purpose
  • Who takes the decisions

Forget all your previous judgments and open your scope. If you conclude that you can really participate in the increase of the supply, and in the allocation, then you are really in a Decentralized Finance project.

P.S: for the deflationary tokens, you just need to understand that scarcity without real utility has no long-term value.

Also published here.

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