โดย: Thunj Chatramonklasri, Bitazza’s Chief Economist
The past few years have seen blockchain technology and related innovations enter the mainstream, resulting in trends marked by capital deployment and big players entering the foray. This ranged from institutional investment into cryptocurrencies to more recently, blue chip companies purchasing non-fungible tokens (NFTs). One such trend is the rise of decentralised finance or DeFi, a system where financial products are offered on public decentralised blockchains. A measure of assets deployed on such network, Total Value Locked (TVL) grew from about USD1bn in June 2020 to a peak of over USD86bn mid-May 2021.
One of the first applications in DeFi came in the form of decentralised exchanges (DEXs) – exchanges which enable users to buy/sell cryptocurrencies with one another without any intermediary party, whereby a user could scour various DEXs for the best rates. The 1inch Aggregation Network provided one of the earliest attempts to improve upon this system, in the form of a DEX aggregator. The 1INCH token was launched in December 2020 as the governance token for the DAO which the Network plans to be eventually governed through.
History of 1INCH
The 1inch Network was founded in May 2019 by two Russian developers with backgrounds in smart contract security, Serjez Kunz and Anton Bukov. Bukov and Kunz jointly developed their first product, a DEX aggregator which searches for the best rates across multiple exchanges at an ETH hackathon event in New York.
The name 1inch alludes to the one-inch-punch Kung Fu technique made famous by Bruce Lee, and the notion that a relatively small force strategically and precisely directed can have devastating impact. Since the launch of this so-called 1inch Aggregation Protocol, its parent company 1inch Network raised approximately USD14.8mn in funding through November 2021, before receiving USD175mn in December 2021, suggesting that the initially small beginning has indeed transformed into a noteworthy player in the DeFi industry.
From its first incarnation, the protocol has undergone expansions and upgrades, a significant one being August 2020’s launch of Mooniswap/1inch Liquidity Protocol, an Automatic Market Maker (AMM) with a five-minute price delay designed to mitigate arbitrages and boost income for liquidity providers. Additionally, November 2020 saw an upgrade to the 1inch Aggregation Protocol, with the introduction of the new routing algorithm Pathfinder. Unlike its predecessor, Pathfinder can split swaps across multiple liquidity sources and takes gas consumption into account, as well as expanding the major liquidity protocols supported from three to over twenty. December 2020 saw the release of the 1INCH token and the 1inch DAO.
The 1inch Network which functions collectively as a DEX aggregator is comprised of three distinct, but related protocols: Aggregation Protocol, Liquidity Protocol, and Limit Order Protocol.
The 1inch Aggregation Protocol uses a routing algorithm called Pathfinder that allows 1inch to source liquidity across multiple DExs for any swap, dividing up the necessary trade across different pools of liquidity to produce the ‘best’ overall combination of trades to complete the swap. A core component of the protocol is the 1inch v4 smart contract, which performs runtime verification on transactions to ensure user’s funds are protected even in case of interaction withunsafe liquidity sources. It forms a core component of Pathfinder6.
Pathfinder itself is a software designed to find the best trading paths across multiple markets, taking gas into account; it operates on the Ethereum and Binance Smart Chain, where 1inch claims it enables users to save up to 40% on gas fees7. Pathfinder can split a single swap order between supported liquidity protocols and use different market depts within the same protocol8. Incorporating market depth was a major upgrade from Pathfinder v1 and translated into cost savings for 1inch’s users9.
Diagram 1: How 1inch Aggregator Protocol works:
As well as market depth, two other standout features are the partial and dynamic fill mechanisms. Partial fill enables a partially completed swap to be canceled and rerouted if the rate initially offered to the user via the UI changes before the swap has been completed. This prevents the user from paying a higher rate than intended and/or having a failed transaction, and the yet-to-be swapped coins are returned to the user’s wallet, with the user incurring only the swap fee. The dynamic fill mechanism also helps to prevent failed transactions by enabling portions of the swap to immediately switch to another protocol.
Pathfinder’s API allows the aggregator to be built atop of other blockchains (e.g. BSC) and also to be linked to centralized exchanges. Additionally, it allows users to swap using their collateralized tokens on Aave and Compound. Finally, Pathfinder allows users to choose between “Maximum return” for the best possible rates across different protocols and “Lowest gas” options without complex swap routes.
An issue inherent on many AMM exchanges is that of front-running, whereby a malicious actor observes a swap transaction being broadcast before it is finalized and places its own transaction immediately in front of the pending transaction to benefit from the subsequent increase in price. A study by Imperial College estimates front-runners extracted USD28.8mn in value over December 2018-August 2021.
The Liquidity Protocol is an Automated Market Maker (AMM) which distinguishes itself through imposing decay periods and price impact fees, which collectively are intended to increase profits for liquidity providers (LPs) and lower profits for arbitrageurs. The former refers to a period after which an order has been placed by a user during which orders in the opposite direction are assigned virtual rates that do not yet reflect the effect of said user’s trade. The longer the decay period, the longer the virtual rate’s role as a placeholder for the actual rate, and the lower the opportunity for profitable frontrunning by bots. The decay period is collectively set by voters in the 1inch DAO.
The first-ever AMM was launched in 2017 by Bancor, and innovative designs soon followed in the DeFi space such as those by Uniswap and Curve, each trying to rectify problems plaguing the offerings of its incumbents. E.g. Curve developed a pricing function incorporation both a constant sum and a constant product, allowing the AMM to switch between the two equations as appropriate to provide better prices for stable coins.
As noted in the Appendix, there are several formulas on which the Automated Market Maker (AMM) could be constructed, from the more basic linear invariant model to the constant product formula utilized by Uniswap. Different formulas result in different pricing curves, some like Curve’s are designed to have more liquidity around certain prices (e.g. 1.0 for stablecoins). As a single AMM does not update its price according to markets around it, only to maintain the formula, as trades occur on various AMMs with varying formulas and token reserve ratios, arbitrage opportunities arise. While such arbitrage opportunities exist in any market, with blockchain-based AMMs the public nature of buy/sell orders and the possibility of bot-executed trades exacerbate the issue for retail users of AMM. Introducing the decay period and price impact fees allows the Liquidity Protocol to mitigate the slippage captured by would-be arbitragers and frontrunners.
For 1inch Liquidity Protocol, the gain captured by arbitrageurs is decreased from A-Q to B-C, D-E, Z-Q. Essentially, a portion of what would be arbitrage gains is redirected to liquidity providers (LP). From 1inch’s own calculations Mooniswap/1inch offers 50% to 200% more earnings to LP vs. Uniswap V2 due to redistribution of price slippage profit.
Diagram 2 : Effects of having decay period & virtual prices on arbitrage profits
*Note that A/C/E/Q are all on the same line and hence have the same prices. The chart showssequential trades performed until real balance reached equilibrium point Q.
Limit Order Protocol
The 1inch Limit Order Protocol was introduced on 10th June 2021, replacing the previous limit order protocol 1inch offered which was based on an external 0x protocol with a native, more gas-efficient, and customizable solution. Limit order protocols allow users to buy crypto assets at specific prices. Specifically, the 1inch Limit Order Protocol does not charge a fee, reducing gas for its users by introducing the following key features.
The dynamic pricing feature means price is calculated via smart contract based on demand and supply, allowing configurations based on whatever properties users find relevant, from demand/supply to oracles. Another standout feature is conditional execution which allows specification of arbitrary conditions for executions of orders. Moreover, users can file requests for quotations (RFQs) for specific amounts of cryptocurrencies.
The customisable nature of the protocol means traders could easily implement conventional trading strategies such as stop-loss and trailing stop orders. The dynamic pricing feature could also be used to power auctions and is compatible with other protocols, such as Maker DAO’s Liquidation 2.0 Module.
The 1inch Limit Order Protocol is available on all chains connected to the 1inch Network, currently Ethereum, BSC and Polygon, and supporting token standards ERC20/BEP20, ERC721, ERC1155.
The 1INCH token is a governance and utility token, allowing users who stake their tokens to vote through the DAO on liquidity pool configurations such as fees and decay time etc. The token is a multichain token issued primarily on the Ethereum blockchain under its ERC-20 standard, but also with 10 million tokens issued on Binance Smart Chain (BSC) under the BEP2 standard from Binance’s participation in 1inch Network’s seed round in August 2020. The 10 million 1INCH tokens on the BSC facilitate the use of the Binance Bridge to allow 1inch protocol users to access Binance’s liquidity pools. Since these tokens were already issued, the February 2021 integration of Binance left the total token supply unchanged. As of December 2021, 1inch offered access to 68 liquidity sources on Ethereum, 39 on Binance Smart Chain, and 24 on Polygon.
The 1INCH token launched via airdrop with an initial circulating supply of 90,000,000, which was allocated to maintaining operations and security of the network, marketing, as well as community development. This constituted 6% of the total supply of 1.5 billion tokens, the remaining of which are scheduled to unlock over four years through December 30th, 2024. The allocation over the four-year period is as follows, with the largest allocation (30%) for community incentives.
The 1INCH token allows those who stake their tokens to vote on key protocols parameters, currently six in total. An instant governance system is used whereby users could affect key configurations on the 1inch network’s protocols in real-time, e.g. owner of 1INCH could stake his token and vote on the distribution of Spread Surplus to be x one day and then y the next day. Those who stake on the governance blockchain were, until the November 2021 launch of the Treasury, paid staking rewards in 1INCH tokens.
Example of 1INCH’s instant governance function being used for real-time voting on the Aggregation Protocol’s reward distribution.
Protocol’s sources of revenue
The 1inch Network’s protocols derive their revenues from two main sources: a fixed swap fee charged on each swap conducted via the protocol and a variable price impact fee also charged on each swap and determined by the price impact incurred, whereby the more illiquid a market is the higher the impact fee incurred/gained by a trade spurring from the side with the surplus/shortage, respectively.
The revenues are then paid out through two channels, as governance staking and liquidity provider (LP) rewards. The 1inch DAO governs the size of both these income streams to 1INCH token holders. Providers of liquidity to the Liquidity Protocol/AMM are incentivized with tokens in both denominations.
Current Market Position
As mentioned above, the DeFi industry, as indicated by Total Value Locked (TVL) has steadily increased its activity over the past two years, and as Table 1 illustrates, 1inch presently stands above other DEX aggregators in terms of trading volume. The 1inch Network also currently has the largest TVL amongst the top aggregators, at USD38.53mn.
The 1INCH token serves as both a governance token and a utility token, allowing those who stake it to participate in the governance of the 1inch Network, through voting via both the instant governance and the 1inch DAO channels to affect key configurations and long-term policies pertaining to the Aggregation and Liquidity protocols. Those who stake for the purpose of governance are also paid out rewards from the protocols’ revenue.
Traditional institutional voices have noted that security tokens could be valued via the income approach to security analysis, specifically via Discounted Cash Flow Modelling (DCF), where the definitive features of a security token would be the conferring of decision making and distribution rights. Examining its tokenomics makes readily evident that both requirements of decision-making and distribution rights are satisfied for 1INCH.
As noted, 1INCH owners could stake their tokens and vote via several channels, and unlike other protocols such as Dash, which prioritizes votes by Masternodes, all 1INCH token owners are granted the same voting right proportionate to the token staked and have access to the same parameters to vote upon. Moreover, the roadmap is to completely decentralize the 1inch Network by early 2022, such that decision-making rights would become even more all-encompassing.
With regard to income distribution, the 1INCH token provides economic value to its owners in three main ways. Firstly, through the governance rewards issued to token holders, and now deposited as collective income to the Treasury controlled by the 1INCH-governed DAO. Following 90% support amongst voters (non-binding sentimental poll) the Treasury was set up to be under direct ownership of the community and governed by the DAO and all protocol, revenues are redirected from governance incentives to the Treasury. 1INCH allows holders to stake his tokens and vote on not just the Instant Governance and DAO, but the newly established 1inch Network Treasury management channel as well.
Secondly, through voting through the Instant Governance and the DAO, a token owner directly affects the income he/she receives from the Network, e.g. by adjusting the price impact fee and swap fee the user incurs, which in turn affects the Network’s income and yield for liquidity providers.
Thirdly, the mechanism through which income generated by the Network is distributed to those who staked their 1INCH tokens – and now to the Treasury instead – means that the Network’s income directly impacts the price of tokens. Specifically, part of the Network’s fee revenues is used to market-buy 1INCH and distribute the token to those who stake on the governance blockchain. This continuous buying pressure ceteris paribus reinforces deflationary economics for 1INCH.
Given the aforementioned points, the author would argue owning 1INCH shares many key characteristics with owning shares of equity in a non-dividend paying company, and one which is engaging in continuous stock buybacks. This would allow for a DCF-based fundamental approach to valuing the tokens. Indeed, Messari uses a similar approach for valuing MKR tokens for the MakerDAO.
Discounted Cash Flow Analysis
The discounted cash flow (DCF) analysis will examine 1INCH token holders’ income over a 10-year period, under a bull, base and bear scenario to construct a probability-weighted fair value. The decision to have a 10-year forecast period is in line with industry standards for the length of time for which one could reasonably expect excessive return for a company operating in a high growth industry with high barriers to entry.
Regarding the discount rate, for stablecoin project MakerDAO Messari uses 25% in its analysis. Stablecoins arguably face greater underlying risk than the general cryptocurrency market, as it relies both on the continuous growth of the cryptocurrency industry, and a continued faith in the collateralisation of the issuer. However, data with the tech VC space suggests that 25% may be too low, as industry-insiders have suggested discount rate of 10% for SaaS and 15-20% for earlier stage startups, and some would argue the cryptocurrency industry is a particularly high-risk segment of the startup industry. From KPMG’s compilation, one could see that an appropriate discount rate could be in the 30-35% range, as the company has passed the second-stage in terms of its operations, but operates within a high-risk space. Consequently, to maintain a conservative approach, the discount rate utilized is 35%.
The terminal value is computed using the Exit Multiple Model, whereby the multiplier over last year’s FCF is 10x, the same as Messari uses for MakerDAO, and is slightly lower than for traditional banks.
For computing ‘fair value’ using DCF a standard approach is to do so with free cash flow (FCF) to equity. However, for 1inch Network, the income going into its treasury already has expenses deducted and what remains which goes into the Treasury is exclusively distributed/under the discretion of 1INCH token holders. Consequently, effective FCF, or income to 1INCH holders is simply the governance rewards (and now the revenue going into the 1inch Treasury).
Compiling the 1inch governance rewards over the first year of distribution, the projected full- year income for 1INCH token holders staking on the governance blockchain is USD31.78mn. The growth rate of this income is then extrapolated using the projected growth for the DeFi industry over the next 10 years as a base line.
Net value locked in Ethereum DeFi (ETH and all other ERC-20 tokens, without double-counting).
|Date||USD (million)||Growth rate (%)|
|02 January 2020||319.95|
|02 January 2021||13,860.00||4232%|
|07 December 2021||83,600.00|
|02 January 2022||89,411.67||545%|
Of course, this exceptionally high growth rate of the last two years could not be expected to last into perpetuity, or even 10 years. However, even if growth rate continues to fall at the current rate, the ETH DeFi ecosystem would still grow 626% over the next 10 years, or at a constant annualized growth rate (CAGR) of 122%. From the DeFI growth rate under the bull and bear scenarios, the corresponding CAGR for 1inch’s governance rewards/Treasury revenue have been forecasted (Table 3).
Forecasting 1inch Network’s growth rate (10-year CAGR) from expected DeFi growth rate.
|Annual DeFi growth rate||60.96%||121.92%||30.48%|
|Elasticity of 1inch’s revenue to DeFI revenue||0.75||1.00||0.50|
|1inch Network governance rewards CAGR||45.72%||121.92%||15.24%|
Bull scenario is CAGR if growth keeps falling at current pace, base scenario is if CAGR is 1/2, and the bear scenario is 1/4.
Under these assumptions, the governance rewards under the three scenarios were projected (Diagram 4) and their present values computed. Adding the discounted terminal value yielded the enterprise value (EV) of the governance system/Treasury under each scenario. Dividing up the EV by the total supply of 1INCH, 1.5bn tokens set to be in circulation by December 31st 2024, results in the fair value per token under each scenario.
Diagram 4: Governance rewards (USD) under different scenarios
As illustrated in Table 4, to compute the probability-weighted fair value, a conservatively high probability of 30% was assigned to the bearish scenario, and 10% to a blow-up scenario where 1inch suffers from critical blockchain system failure and/or there is widespread and permanent cryptocurrency market collapse and the token becomes worthless. This results in a scenario-weighted fair value per token of USD128.4, considerably higher than the present market price of USD2.49.
Scenario-weighted fair value for 1INCH token (USD)
|EV/token (USD)||Probability (%)||Weighted Value|
|Fair value for 1INCH token||128.4|
A more conventional, albeit less precise gauge of DEX valuation is Market Capitalisation divided by Total Value Locked (TVL). Compared to Uniswap’s ratio of 1.11, 1inch’s ratio of 26.75 seems exceptionally high, however, the latter figure is in line with DEX aggregators, such as Gnosis Protocol, which has a ratio of 24.44. The disparity could be seen as presuming the equivalent amount of asset is put to greater work (generating more revenue) on an aggregator of DEXs as opposed to a simple DEX. This would be true if, for example, a given amount of token staked to provide liquidity on an aggregator’s platform is utilized much more than when staked on a simple DEX.
Additionally, 1inch Network recently closed its Series B funding round where it sold tokens to raise USD175mn. Reportedly, the network sold 8% of the total token supply – in addition to some private investors selling their pre-existing holdings – to raise the amount. This indicates more than 120mn tokens were sold for USD175mn, capping the private valuation of 1INCH at USD1.46/token. Of course, the investors bring a plethora of contacts and synergy and could be expected to receive discounts from the market price, and their investments would be made with high ROIs in mind.
Important future development/upgrades
As noted by co-founder Sergej Kunz upon the launch of the 1inch Limit Order protocol, said protocol could be utilized to power a lending business via an automated trigger of presenting users with the option to swap for debt tokens. As 1inch expands its userbase and TVL, this represents a potentially lucrative business expansion.
On December 1st, 2021 1inch announced it raised USD175mn in what it called a Series B funding round. Rather than selling a stake in the network, 1inch sold USD175mn worth of tokens in a private sale. The tokens sold came from the 1inch Growth & Development fund, which has been allocated 14% of the total 1INCH supply, 8% of which was sold in this Series B funding round., as well as from investors in the previous rounds.
The round was led by Amber Group, with around 50 investors participating, including Jane Street, Alameda Research, and Gemini Frontier Fund. Hong-Kong based Amber Group was founded in 2017 by Wall Street bankers such as those from Goldman Sachs and Morgan Stanley, and offers a range of crypto-financial services with a cumulative trading volume of USD200bn. Similarly, Alameda and Gemini are big players in the space, whereas Jane Street is a quantitative trading behemoth of mainstream finance. As such, the deal leaves 1inch well-placed to receive a bigger share of global crypto trading traffic.
A notable recent upgrade was the November 17th launch of the 1inch Treasury, discussed above, whereupon launch rewards for staking on the governance contract would, instead of being paid out directly to token holders, be directed into the Treasury. Since the Treasury is theoretically under full control of the DAO, in turn, controlled by 1INCH holders, the economic justification for the demonstrated fundamental valuation of the 1INCH token remains intact.
The introduction of the Treasury – a Gnosis Safe smart contract wallet on Ethereum mainnet – opens 1inch Network up to new vulnerabilities, as there is now a centralized pool of funds, which serves as a target for malicious actors. This platform risk is somewhat mitigated by the multi-signature setup, whereby malicious transactions could be vetoed in a 7-12 fashion.
An important counterparty risk is that USDC – the denomination in which Treasury earnings are held – would lose its value. While USDC is supported by major players such as Coinbase and Circle, the de-pegging of stablecoins has long been highlighted as a ‘black swan’ event in cryptocurrency. This could come about from a variety of factors, such as the loss of confidence in the solvency of stablecoin issuers, AMLO measures by the SEC, etc. This risk is mitigated by the fact that USDC’s issuer Centre has its reserves attested monthly by top-five accountancy firm Grant Thornton. This stands in stark contrast with some other issuers of stablecoins.
There also exists regulatory risk for 1inch Network as a whole, as seen in the case of US KYC and AMLO regulations leading to the network geofencing US IP addresses. Having said that, the instance also illustrated the network’s willingness to adapt, where it has geared a significant part of its Series B funding towards developing 1inch Pro specifically for the US market and global institutional investors. It is worth noting, however, that 1inch Pro will operate separately from 1inch Network, with distinct liquidity pools, and should global policymaking shift towards more stringent KYC/AMLO regulations, that may significantly hinder the markets in which the network could operate in and generate revenue for the Treasury from.
Finally, there is the protocol and technology risk that the 1inch Network fails catastrophically. However, given the extensive external audits the protocol has gone through – nine in November 2020 – as well as the reputation of the core team and investors, this risk is likely minimal. Moreover, the DCF valuation has conservatively assigned an overweight probability to such a scenario to account for this associated risk.
Under conservative assumptions, this study utilized a DCF approach to determine a fair value for the 1INCH governance token, which would suggest that the market is presently discounting the future cash flows due to token holders too heavily. This does not preclude the not insignificant possibility of a complete collapse in the token’s value, however, our scenario-weighted approach does explicitly take this risk into account. More pertinent perhaps are counterparty and regulatory risks, especially as they pertain to the US SEC.
The year 2022 will likely prove a watershed one for the network in terms of establishing the sustainability of its business. with intensifying global regulatory efforts and the recent downturn in cryptocurrency markets on one hand, and on the other, freshly injected capital to develop compliant solutions and business expansion opportunities through its investor networks and substantial progress made towards becoming a fully decentralized organization.
Decentralized Exchange Mechanics
Generally, DEXs consist of numerous liquidity pools representing different trading pairs, e.g. ETH/ADA. Liquidity pools could be set up as automated market markers (AMMs) when constructed as a smart contract holding reserves of at least two token types which allows anyone to deposit/withdraw from the contract, but only according to specific rules. E.g. an AMM could be designed with the constant product formula x*y = k where x and y are reserves of tokens A and B. To withdraw an amount of A, one must deposit an amount of B to maintain the constant k before fees. Unlike traditional order-book-based exchanges, traders on AMM trade against a pool of assets, not a specific counterparty.
From x*y = k:
y = k/y = k*y^(-1)
The derivative (dx/dx) of which is:
dy/dx = -k*y^(-2)
This relationship is captured in the diagram below where the price of A in terms of B is simply the gradient of the purple plotted hyperbola.
The constant product and constant sum approach switches between maintaining the former and the latter, whereby closer to the midpoint where the exchange rate is 1 to 1 a constant sum is maintained, but further out the system switches to maintain a constant product to allow for reasonable swap prices. This is the approach used by Stableswap, which accommodates the stablecoins it focuses on providing markets for.
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