Understanding Inflationary Bias in DeFi

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

And that’s what’s happening across the DeFi world with the supply problem. Degens and cryptocurrency users make judgments or conclusions based on partial knowledge, limited samples (of tokens) and erroneous judgments based on few facts, in this case concerning the supply. I see this happening in many communities, in CT and also in the SORA community of which I am a small contributor.

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

Then we have the supply of the tokens. Each DeFi user will have a concrete experience based on the projects they have invested in in the past, with a track record of concrete wins / losses that will automatically fulfill their prophecy, in this case, about 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 even if it is fixed (max in about a hundred years) it is currently inflationary with 328.5K BTC extracted and distributed among miners every year until the next halving. Who said BTC is free?

InflationaryOn the other hand, ETH was designed in a purely inflationary way, with 4.7 million tokens mined per year in the PWO fork. Also distributed to miners. The same happens for example in Polkadot, with an inflation of 5-7% distributed to validators and nominators.

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

So, this is the big picture as a consequence of existing models and reduced knowledge of the economy. Let me quickly explain in 3 points:

  1. The biggest bias here is that an increase in supply will sooner or later collude at a lower price, as you have more tokens they will have less value / price.
  2. The second “rationale” is that a deflationary offer will raise the price no matter what, because fewer tokens will have a higher price (assuming the same market cap).
  3. Finally, a fixed supply is usually mistakenly identified with the Gold standard and with positive attributes of store of value and ever-increasing 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 amount mined each year has fluctuated depending on many factors (technology, slaves, wars …) with a huge impact on the price / purchasing power when a currency such as a dollar has been fixed on gold. The same happens with tokens.

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

And then the questions come to TG Chat:

  • What is the maximum supply?
  • Why has it increased so much?
  • What is the supply limit?

But all the cases explained are cognitive, because the mental mentality and the mainstream articles lead us to question ourselves on these topics, and because in the background, both in CeFi (dollar) and in Defi (crypto, BTC, others) there is an inflationary offer considered “bad” by definition: if the offer increases, the value will decrease because the MarketCap will now be diluted among the largest number of tokens.

And I must say that this prejudice is wrong. Because in this type of judgment the allocation of the new offer is never considered a factor, only the fact of an increase is always considered negative by nature, because this has happened to the dollar, and of course, because BTC solves it with a “supply. limited “.

A new inflationary offer proposal (with value)

So we come to the SORA proposal, where newcomers will only “perceive” an increase in supply, therefore an expected low price trend, not what everyone is looking for …

SORA brings to the table new factors that make this type of judgment partial and irrational. And it will empirically show that an increase in supply does not mean a decrease in prices.

Because the real question is: Where will the new supply be assigned?

For example, in ETH (I know the merger is coming but it’s the same) and BTC, it is assigned to miners, who will decide to sell based on their production costs and profit targets. When it comes to Fiat currencies, it is a bit different, as the new offering is normally allocated through commercial bank lending, in the stock and financial markets.

In SORA, the social contract provides that the new supply can be minted for production purposes. And when you do that, the return to the network will be greater than the output. For example, the community decides to mint development tokens and connect the SORA network to a commercial bank to provide the first Defi debit card, the SORA card. When the project is finalized (end of 2022), the output generated by the investment / new supply will pay for itself with greater and greater use of the network, generating higher value and price.

You can also apply this simple idea and instead of a higher “turnover” for the network, you will have a higher GDP for the country if the SORA network, a de facto decentralized central bank, will mint tokens to lend to a country, without interest. , for production purposes (not speculative). For a new argument on GDP and supply, you can review The Case for XOR.

So, I suggest that the next time you step into a project when doing your research, don’t just ask what the maximum supply is, what you need to know is:

  • Where the new supply is assigned
  • For what specific purpose
  • Who makes the decisions

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

PS: for deflationary tokens it is enough to understand that scarcity without real utility has no long-term value.

Also published here.

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