About 87% of node operator rewards (or 60% of total inflation) is currently paid for collateral levels above 10%.This represents the biggest expense of inflation by a good margin. At the same time, there seems to be no good understanding why we are distributing rewards this way. The goal of this post is to examine some of the justifications put forward, exploring an alternative and hopefully sparking a productive discussion.
Bootstrapping the Protocol
People have argued in the past that node operator rewards are necessary to bootstrap the protocol. But does the current system actually incentivize desired behavior? I would argue that people are making a portfolio allocation choice between ETH and RPL based on their expectations about future prices. And a choice about how much RPL to stake and how many minipools to run with that portfolio based on liquidity considerations.
If someone is naturally not interested in holding RPL, NO rewards provide some incentive to buy a bit of RPL anyway in order to run minipools.
If someone is already looking to hold RPL, there is some incentive to create minipools to the point that RPL can be effectively staked. There is some disincentive to create minipools that put your collateralization below 150%, because it hurts your ability to unstake and thus liquidity of assets. Importantly there is no incentive from these rewards to create minipools that put you below 150%. One minipool at 150% gets the same rpl rewards as 15 minipools at 10%.
Overall, current node operator rewards do a poor job of bootstrapping minipools.
Security: Protection against MEV Stealing
So far RPL is not used like this. Maybe this will happen in the upgrade after Atlas. Assuming that’s the case, we should be selecting the ETH bond and minimum RPL requirement in a way that is safe against MEV stealing. If we do so, additional RPL beyond the minimum does not contribute to security because malicious actors would only provide the minimum.
Security: Protection against Black Swan Events
RPL collateral is only used after the node operator’s ETH collateral is exhausted. For the effective balance to drop below 16 ETH (or even 24 ETH with LEB8) and RPL to come into play, it would take a massive black swan event of mass slashings or validators being offline for a long period of time. If RPL is ever slashed, it will be slashed on many minipools at the same time. In such a scenario, the limiting factor on ETH recovered will be the available exit liquidity for RPL, not the amount of RPL staked. Currently the effective staked is ~7.2 million RPL. The available exit liquidity is less than 2000 ETH/120k RPL. During a black swan, we should expect that liquidity to quickly disappear in anticipation of massive amounts of RPL being dumped on the market through the auction process.
There is no scenario in which RPL staked at high ratios is adding security to the protocol.
Privileged Speculation
Valdorff has put forward the idea of maximum collateral being a limit on privileged speculation. I don’t understand why this is something the potocol wants and should pay for.
Alternative: RPL Rewards per Minipool
Rewards are split according to number of minipools eligible node operators have. There still is a minimum collateral requirement that needs to be achieved to create new minipools. You also need to be above the minimum at time of reward snapshot to be eligible for rewards. You can freely choose to overcollateralize to hedge against price volatility and dropping below the minimum.
This creates a direct link between desired behavior (more minipools) and rewards. Minimum collateral level, protocol security and implications for token value remain unchanged.
Impact on Minipool APR
With the current ~9k minipools we have, this would translate to ~73 [18859621*.035/9065] RPL per minipool per year. Combined ETH and RPL APR for a minimum collateral minipool would be 11.65%.
Currently combined APR for a minimum collateral minipool is 5.6%
Token Value
Some people might be wondering about the implications on token value. I believe that long term collateral is trending towards minimum and this proposal does not impact the long term collateral ratio. Fundamental token value is driven by the amount of capital the protocol is able to attract. This proposal makes better use of protocol spending and increases incentives for protocol growth. I am convinced that this would be very beneficial for token value.
I don’t think that many people would be dumping their RPL in response, because I don’t think that holding is about APR. Rather, it’s conviction about future value appreciation, which should only be strenghted by better tokenomics.