Author: 0xMingyue WuBlockChain

As described in the official Aerodrome documentation: Aerodrome Finance is a next-generation AMM designed to serve as Base’s central liquidity hub, combining a powerful liquidity incentive engine, vote-lock governance model, and friendly user experience[1]. Since the official launch of the Aerodrome protocol on August 31st, the protocol has attracted nearly $200 million in Total Value Locked (TVL) within just 24 hours. Its native token, $AERO, offers liquidity mining rewards with an annualized yield close to 1000% without compounding. According to data from Defillama on September 2nd, the total TVL on the Base chain was $379 million, while Aerodrome’s TVL reached an impressive $196 million, accounting for 51.7% of the total TVL on the Base chain. What is the magic mechanism that allowed a decentralized exchange (Dex) to achieve such remarkable success in such a short period? This article will start by exploring the core mechanism of Ve(3,3) (the core of Aerodrome), providing an in-depth introduction to Aerodrome’s core mechanism, the generation of its flywheel, and its future prospects.

1 Game Theory and the Flywheel: Ve(3,3)

The Ve(3,3) mechanism originally stemmed from the Solidly protocol by Andre Cronje, the co-founder of Fantom. However, due to design flaws in the mechanism, the protocol was nearing a ‘failure’ state. Now, Velodrome, the leading Dex protocol on the Optimism chain, has improved upon the deficiencies of the Solidly protocol, and Aerodrome inherits the latest features from Velodrome V2. The core Ve(3,3) mechanism of Aerodrome can be broken down into two parts: Ve&(3,3). ‘Ve’ is derived from Curve’s veCRV model, and ‘(3,3)’ is inspired by OlympusDAO’s 3v3 game. The combination of these two parts aims to balance the holder and trader in the supply, bringing more protocol revenue to projects that join the Ve(3,3) protocol, especially initial projects. This also enhances the efficiency of rewarding when leasing liquidity[2]. In the following sections, we will introduce the ve and (3,3) mechanisms separately.

1.1 The Evolution of veCRV: veNFTs

“Ve” stands for Voting Escrow, and it represents the process of staking Curve’s governance token, CRV, to obtain VeCRV, which allows for more rewards as an LP (liquidity provider). This mechanism was initially introduced by Curve to strengthen incentives for long-term token holders.

In the Aerodrome protocol, there exist two protocol tokens: 1) $AERO and 2) $veAERO. $AERO serves as the protocol token used to reward liquidity providers and adheres to the ERC20 standard. Locking $AERO allows one to acquire $veAERO. On the other hand, $veAERO is encapsulated within veNFT, following the ERC721 standard, commonly referred to as NFT. The quantity of $veAERO acquired through locking $AERO is determined by the duration of the $AERO lockup, adhering to a linear relationship. The maximum lockup duration spans 4 years, during which locking $AERO for this entire duration yields a 1:1 ratio of $veAERO. Likewise, for a one-year lockup, one can obtain only 1/4 of the $AERO amount initially locked. In cases of extremely short lockup periods, such as one week, the acquired $veAERO amounts to only 1/208 of the initially locked $AERO. Upon the expiration of the lockup period, users are entitled to retrieve all of their locked $AERO.”

Aerodrome will release a predetermined amount of $AERO each week, with $veAERO holders participating in the decision-making process through voting to determine which liquidity pool shall receive the $AERO emissions.

1.2 The (3,3) Game

(3,3) stems from OlympusDAO’s (3,3) game theory, derived from the Nash equilibrium theory. This term originates from the standard notation in game theory, used to describe a crucial aspect of games: the strategies and payoffs of game participants. In this notation, the first number within the parentheses represents the number of available strategies for the first participant, typically the actor, while the second number signifies the number of available strategies for the second participant, usually the opponent.

In the Aerodrome protocol, all protocol participants have three options for the $AERO they acquire. These options are as follows: 1) Providing liquidity with $AERO, 2) Locking $AERO to obtain $veAERO for long-term holding, and 3) Selling $AERO. To simplify the multi-agent game, the diagram below illustrates the different behaviors of two Aerodrome protocol participants and the associated profits they receive.

figure 1.1 Aerodrome (3,3) game. In the parentheses, the first number represents the profit of participant 1, while the second number represents the profit of participant 2. Larger numbers indicate higher profits, while negative numbers indicate losses. The diagram above is drawn based on editor’s understanding and is not from official documentation.

As depicted in Figure 1.1, predicated upon the disparate actions of two protocol participants with regard to their acquired $AERO, there exists a total of nine conceivable outcomes. Broadly, these nine outcomes can be categorized into three classes: 1) Mutual Cooperation — Both parties opt to lock or add $AERO to augment their holdings of tokens. This collaborative effort uplifts the protocol’s Total Value Locked (TVL) and participation, resulting in a mutually increased accrual of $AERO; 2) Unilateral Malevolence — In this scenario, one of the protocol participants decides to part with their acquired $AERO through a sale. However, those contributors to the protocol (liquidity providers/lockers) experience losses; 3) Bilateral Malevolence — This situation typifies the “mine and dump” model, where both participants engage in rapidly selling their acquired $AERO. The consequence is a swift depreciation of the protocol’s value. In the realm of Aerodrome, the “shovel” for mining (i.e., the token used for providing liquidity) typically comprises protocol-related tokens. In essence, the interests of liquidity providers also suffer as the protocol’s value dwindles. Consequently, under scenario 3) of mutual malevolence, author posits that neither of them stands to gain.

In reality, genuine markets are often shaped by an uncountable multitude of protocol participants working collaboratively. In contrast to the strategic interaction between just two protocol participants, the dynamics become significantly more intricate in these circumstances. For nearly all ve(3,3) protocols, Especially for some ve(3,3) protocols devoid of influential affiliations, due to the substantial annualized rewards bestowed upon liquidity providers in the early stages, the market’s gravitational pull tends to lead to the outcome 3), the “mine and dump” pattern. Only those “star” projects, bolstered by sufficient market participation and external influences such as market conditions or funding, can shift the equilibrium towards outcome 1), cooperation between both parties. This, too, represents a dynamic equilibrium that evolves with the entry of new market participants.

1.3 Analyzing Ve(3,3) Core Participant’s profit Game from the Perspective of the Prisoner’s Dilemma

When a ve(3,3) protocol has swiftly demonstrated its value and accumulated a significant number of locked-in participants, the game has silently evolved. At this point, whether it’s liquidity providers or lockers, both have elevated to become stakeholders in the protocol. In scenarios where multiple protocol participants form a complex market, this section categorizes all key players into two groups: 1) $AERO liquidity providers, and 2) $AERO lockers, long-term holders. The actions of these two groups will collectively determine the fate of the protocol, as illustrated below.

figure 1.2 The Prisoner’s Dilemma between Aerodrome liquidity providers and lockers. In the parentheses, the first number represents the profit situation of participant 1, and the second number represents the profit situation of participant 2. Larger numbers indicate greater profit, while negative numbers indicate losses. The diagram above is drawn based on the author’s understanding and is not sourced from official documentation.

As shown in Figure 1.2, the different actions of these two core participants will also result in three distinct outcomes: 1) Win-Win: Lockers and liquidity providers cooperate. Lockers direct newly emitted $AERO towards liquidity providers who contribute positively to the protocol. Liquidity providers either lock the new $AERO or continue to provide deeper liquidity. The protocol develops positively, fundamentals improve, and both parties benefit. 2) One-Sided Profit: Either the lockers or the liquidity providers engage in malicious behavior. For example, lockers direct $AERO emissions towards malicious MEME tokens, or liquidity providers sell all of their earned $AERO. This benefits the wrongdoer but leads to the long-term devaluation of the protocol. 3) Mutual Loss: Lockers and liquidity providers both engage in malicious behavior. The protocol’s fundamentals deteriorate rapidly, and the protocol’s value quickly approaches zero.

Such scenarios bear similarity to the “prisoner’s dilemma.” For individual liquidity providers or lockers, the most rational choice they can make is to engage in malicious behavior. In this case, the Nash equilibrium point[3] within this game is where the entire system incurs the maximum loss, and this equilibrium point is far from the Pareto optimum[4].

How to break the “prisoner’s dilemma”? From the perspective of lockers, ve(3,3) protocols typically establish a whitelist mechanism at the protocol level to prevent lockers from engaging in malicious actions. From the perspective of liquidity providers, protocols usually offer lockup rewards to liquidity providers. When liquidity providers acquire a significant amount of locked assets and become the mainstay of lockers, the game between liquidity providers and lockers is no longer a zero-sum game. In pursuit of their own interests, liquidity providers will make greater contributions to the protocol. At this point, the Nash equilibrium shifts to the Pareto optimum, where the protocol’s interests are maximized.

2 The Operation of a Flywheel: The Upward Spiral and the Downward Spiral

The previous section provided a detailed explanation of the game theory behind ve(3,3). So what is the “magic” that allowed the Aerodrome protocol to attract $200 million in TVL in just one day? In this section, I will explain the “flywheel” mechanism of Aerodrome.

2.1 The Flywheel Effect and the Secrets of Attraction

The term “flywheel effect” is derived from the mechanical field of a flywheel, which is a rotating device that becomes increasingly difficult to stop or change direction as its rotational speed gradually increases. In business, this concept means that once a company or organization has established some competitive advantages, these advantages accumulate and strengthen, much like a spinning flywheel.

In Aerodrome, the protocol’s fundamentals (TVL, trading volume, and the total amount of external protocol bribes) and the protocol token $AERO make up a two-tiered flywheel. Imagine that when the price of the protocol token $AERO rises, liquidity providers earn more income, and they provide more liquidity; improved liquidity depth leads to increased trading volume, resulting in higher protocol revenue, and more people choose to lock $AERO to earn protocol income; the protocol’s popularity increases, attracting more external protocols to participate in the protocol’s operation. And all of these (fundamentals) continue to drive the rise of the $AERO token, creating an upward spiral in the protocol’s value, as shown in the diagram below.

Figure 2.1 Aerodrome’s positive feedback flywheel

On August 31st, when Aerodrome officially launched, the Aerodrome team provided nearly 7% of the $AERO emissions to the $AERO-USDC pool by controlling their $veAERO. Since there were very few $AERO tokens in circulation on August 31st, when the first $AERO trade occurred, the $AERO token was priced. At that time, due to the substantial LP (Liquidity Provider) rewards and the extremely small LP pool, the LP APR (Annual Percentage Rate, not compounded) for the $AERO-USDC pool reached as high as 10,000% (this is what I observed, theoretically, it could have been even higher due to the small pool and high rewards). This situation led to a scarcity of $AERO tokens, as liquidity providers purchased more $AERO to provide liquidity, driving up the price of $AERO. The rising price of $AERO, in turn, enabled liquidity providers to earn more rewards, creating a positive feedback loop. In just one day, on August 31st, the Aerodrome protocol attracted $200 million in TVL (Total Value Locked), establishing its dominance in the Base chain’s total locked value.

2.2 The Upward Spiral and the Death Spiral: How to Break Them?

As Aerodrome continues to captivate attention with its upward spiral, it’s worth considering when this spiral might come to an end. We all know that money doesn’t materialize out of thin air, so in this mining feast (earning $AERO rewards by providing liquidity), how does the flow of money work in the short term?

Due to the linear emission of $AERO tokens for providing liquidity, the circulating supply of $AERO gradually increases in the market. When it reaches a critical point, astute market participants realize that as the depth of the $AERO-USDC liquidity pool grows, liquidity mining rewards are no longer profitable. At this point, these market participants choose to sell their $AERO holdings, leading to a decrease in the $AERO price. When selling pressure and buying pressure reach equilibrium, the upward spiral is broken. The $AERO price no longer rises, and the yield from the $AERO-USDC liquidity pool stabilizes. Over time, as more $AERO is released, if selling pressure outweighs buying pressure, the $AERO price will decline, ushering in a downward spiral, as depicted below.

Figure 2.2 Aerodrome’s downward spiral flywheel

In the current market, there are many ve(3,3) tokens that are currently in a downward spiral. One example is the CHRONOS protocol on Arbitrum, as shown in the chart below. Its project token, $CHR, has fallen from its peak of $1.81 on May 4th to its current price of $0.0168 in just four months, marking a staggering 99% decline.

figure 2.3 $CHR token price bar chart

Despite Aerodrome having a seemingly reliable team and a partnership with Base, its token $AERO may still find it challenging to escape the descending spiral. How to break this descending spiral? In fact, the parent protocol of Aerodrome, Velodrome, has already provided an answer, and the core of this answer is to increase the lock-up rate, firmly aligning the interests of protocol participants with the protocol’s development. Since its launch on June 1, 2022, Velodrome has maintained a high lock-up rate through various bonus programs, with the outstanding business capabilities of the Velodrome team and a cumulative total of up to 7 million $OP tokens from the Optimism Foundation. According to statistics from the Velodrome official Discord channel[5], on September 2, the lock-up rate for the protocol remained as high as 79.03%.

3 ve(3,3) Development Plan: Regaining the Upward Spiral

In this section, we will discuss some methods to increase the lock-up rate for the core health indicator of ve(3,3) tokens and help the protocol regain an upward spiral.

3.1 Granting Lockup Rewards

Providing a one-time reward to protocol lock-up participants is the simplest and most direct approach, as seen in Velodrome’s case. Since its launch in June 2022, Velodrome has been providing new protocol lock-up participants with nearly 15% of their lock-up return, thanks to funding from the Optimism Foundation. As of now, Velodrome has been successful, with its TVL on the Optimism chain surpassing that of all the star protocols, such as Uniswap and Curve.

3.2 Launchpad: Empowering Lockup Participants

When I wondered why Binance Exchange didn’t list the token of a star project like Velodrome on the Optimism network back in June, I was greatly surprised by a statement from Velodrome’s co-founder on Discord. They said, “We welcome you to list $Velo, but we won’t provide support.” Initially, I was puzzled by the team’s behavior, but later I realized the reason behind it. Centralized exchanges (CEX) often attract a large number of short-term speculators whose sole aim is price manipulation. They don’t participate in the protocol’s operation or game theory; they’re only interested in speculative trading. For ve(3,3) tokens, such speculation can be fatal. Price manipulation leads to an increase in circulating tokens and a decrease in lock-up volume. This, in turn, can trigger a downward spiral after the speculative price rise, often spelling the death of the protocol.

This also made me realize the grand narrative of ve(3,3) protocols. A successful ve(3,3) protocol firmly holds pricing power within the protocol’s grasp. It can serve other protocols, acting as an alternative liquidity solution. It represents a novel way to compensate for impermanent loss, offering rewards to liquidity providers in protocol tokens. And in favorable market conditions, it can compete with mainstream centralized exchanges as a launchpad for new tokens.

ve(3,3) protocols offer liquidity providers a certain amount of protocol tokens as rewards. This endows ve(3,3) DEXs with an innate capability to launch new tokens. New protocols that are looking to list their tokens don’t need to hire market makers. They only need to inject ve(3,3) protocol rewards into their token’s liquidity pool, and users will provide liquidity to that pool. Here, ve(3,3) protocols can also empower token lockers through a Launchpad, thereby increasing the protocol’s locking rate and enhancing its overall health.

4 Summary and Outlook

This article began by explaining the ve(3,3) mechanism and briefly introducing its game theory. It then discussed the underlying principles of the upward spiral and downward spiral caused by the ve(3,3) protocols, followed by some methods to address the protocol’s downward spiral. The vision of ve(3,3) is grand, and different ve(3,3) protocols often make slight modifications to their mechanisms. Due to limitations in my energy and abilities, there may be errors and omissions in the article. Feedback from readers is highly appreciated.

I have learned from various sources that many participants in ve(3,3) protocols still do not know how to maximize their profits through such protocols. Additionally, there have been several external protocols thriving based on ve(3,3) protocols, such as Sonne Finance, Tarot, Extra Finance, fbomb, USDR, and more. I still hope to write an article on how these protocols have grown and developed based on ve(3,3) protocols and their current status. Stay tuned!

Reference：

[1] https://aerodrome.finance/docs

[2] https://www.oklink.com/academy/zh/2022/01/27/hot-ve33-curve-olympus/

[3] https://zh.wikipedia.org/wiki/%E7%BA%B3%E4%BB%80%E5%9D%87%E8%A1%A1

[4] https://zh.wikipedia.org/wiki/%E5%B8%95%E7%B4%AF%E6%89%98%E6%95%88%E7%8E%87

[5] https://discord.com/channels/967319632530767924/993229082538029187/1147532036328923286