Tl;dr: Reducing APY rewards allows KlimaDAO to improve the health and sustainability of the protocol by increasing the Risk Free Value (RFV) of BCT in the treasury. It also increases the DAO’s runway, meaning stakers will be able to enjoy rebasing rewards for a longer period of time.
This article gives market participants a deeper insight into the tools available for KlimaDAO’s policy team, the analysis that has gone into the development of KIP-3, and how adjusting available mechanisms (in this case, reducing APY) can enable KlimaDAO to fulfil its long-term objectives.
The Big Picture
KlimaDAO has launched the world’s first decentralized carbon-backed cryptocurrency. By using carbon tokens as its foundation, the protocol will increase the demand and utility of the underlying BCT and any future tokens that are accepted into its treasury.
This development will incentivise the development of more carbon projects, incentivise organisations to invest in carbon reduction and mitigation, and will grow this new, regenerative economy on Web3.
The underlying mechanic of KlimaDAO is that in order to mint 1 KLIMA, at least 1 BCT must be locked in the treasury. KLIMA therefore has a intrinsic value and theoretical floor valur equivalent to 1 BCT. If KLIMA trades below its intrinsic value (i.e. 1 BCT) then the treasury will use its BCT to purchase KLIMA to achieve the floor. However, there is no ceiling on KLIMA.
There are value creation opportunities for KlimaDAO in times of growth and contraction (which are currently theoretical at this stage):
In periods of growth, if the protocol sells 1 KLIMA for 100 BCT, since 1 BCT is needed to mint, the treasury has 99 BCT extra considering the floor mechanics.
In periods of contraction (when KLIMA trades below BCT), if the protocol might get back 1 KLIMA for 0.5 BCT. As it costs 1 BCT to back 1 KLIMA, and it has spent 0.5 BCT to get 1 KLIMA, it saves 0.5 BCT.
These examples demonstrate that each market action enables the treasury to secure more BCT and increase the intrinsic value of KLIMA. During times of growth (i.e. example 1, above), this is primarily achieved through bonds where a user can buy KLIMA at a market discount in exchange for BCT, BCT/USDC, or KLIMA/BCT.
Staking Rewards Explained
During the expansionary phase, where the protocol is focused on treasury growth, the treasury can be diluted to mint more KLIMA to be distributed to stakers as sKLIMA.
Additionally, distributing sKLIMA through a transparent dilution schedule over a predetermined period of time is useful for the DAO as it encourages (3, 3). The dilution schedule is deferred over a long period of time, as giving all the rewards in one instance would decrease the premium of KLIMA significantly, reduce the arbitrage opportunity for the DAO, and increase short-term sell pressure.
Currently, the protocol can mint the sKLIMA rewards because of the premiums on KLIMA. Furthermore, the high dilution is a prudent policy at this time in order to bring new market participants into the DAO. However, as time goes on the need to keep the high dilution rate decreases as more tokens are acquired into the treasury, and confidence in the protocol goes up. Bitcoin is a case in point of how increasing confidence should be inversely proportional to rewards. Bitcoin has the highest market cap of all cryptocurrencies, the most adoption and the greatest confidence, yet it has halved its per-block mining rewards roughly every 4 years (50; 25; 12.5; 6.25, and so on).
In the case of KLIMA, the protocol bears the burden of the dilution, because it must generate revenues to deliver the rewards on offer. The below table demonstrates the amount of KLIMA minted for rewards every 8 hours within its current parameters (a reward rate of 0.5%, and a 5-day ROI of 8.5%).
Explicitly speaking, KlimaDAO currently needs ~2950 BCT of revenue per epoch to back each KLIMA. This increases exponentially every epoch (note, each epoch is 8 hours for KlimaDAO). To retain this value creation rate (of 5 BCTs/newly minted KLIMA), the DAO requires ~44k BCT per day right now, and it will only increase.
Because of the positive growth experienced since launch in October this has been more than achievable for the DAO, and currently for every KLIMA minted there are 5 BCTs secured in the treasury. At the moment, the backing of each KLIMA is much higher than 1 BCT.
The stable or increasing number of BCT per circulating KLIMA that we have seen to-date (pictured below) adds stability and confidence to the protocol. This is ideal at this time given the protocol is still early stage.
The high dil;ution rate currently on offer can make it harder to consistently retain this value because there is a trade-off between BCT backing existing KLIMA, and BCT being used to mint new KLIMA and cover the staking rewards (sKLIMA).
One tool available for the policy team that can be used to mitigate against this risk is to increase the capacity of bonds. The issue with tweaking bonds however, is that it can dilute stakers’ market share of the protocol. For instance, if over a 6-month period a stakers’ token balance increased by 6x but the total supply increased by 12x, the actual balance would be worth 50% less in terms of market share.
Ultimately, staking is designed to retain a holder’s % share, even at times of high reward rates. Poor policy decisions that leads to too many bonds being issued can compromise the incentive to remain staked.
It is imperative for the KlimaDAO’s policy team to manage this delicate balance between optimizing revenue, and staker dilution. KIP-3 seeks to fine-tune this balance.
KIP-3: Good Policy Design
By marginally decreasing the reward rate through KIP-3, KlimaDAO can adjust its risk and moderate the daily revenue required to both retain the healthy growth that has been seen since launch and still issue attractive rewards.
The saved revenues from reducing the APY will be used to back KLIMA with more BCT and accelerate the virtuous cycle of growth.
In addition to this, there are other effects of reducing the dilution rate at this point:
Reducing the dilution rate decreases the overall emissions of the protocol (and the rate of inflation), ensuring each KLIMA retains its value for much longer. This makes it more attractive for other protocols to integrate with KlimaDAO as a long-term partner and lay the foundations for the on-chain carbon economy.
Reducing the dilution rate hypothetically decreases the selling pressure from stakers, as high reward rates can make holders feel more inclined to sell their staked rewards into the market.
Finally, a point of clarity as there are some misconceptions around the concept of APY. The decrease in APY essentially impacts a staker if they only stake for 1 year. However, for long-term holders, the reduction in APY builds out the capacity for long-term growth of the protocol, and means that their rewards will compound further into the future.
Ultimately, tapering staking rewards today is less about short-term reward opportunities, and is more about growing the long-term incentive for Klimates to stick around (3, 3).
If you are an existing Klimate, please sign up for voting on our Snapshot to participate in KIP-3: https://snapshot.org/#/klimadao.eth. If you are interested in learning more about how KlimaDAO can enable coordination and financial activism to tackle climate change, join us on Discord and follow us on Twitter.
Follow Krian on Twitter, the lead author of this article.
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