What is the most optimal way to return excess value in crypto? Who should benefit?  Token holders? Stackers? Locked liquidity? Long-term lockers? What risks should token holders have? How do you discriminate programmatically to distribute yield most optimal?

There is no clear answer.

In just the last few months, several protocols, including Frax, have asked these questions. Our industry is emerging from its nascent beginnings, with several incumbents now generating millions of dollars in revenue annually.

In traditional finance, excess profits are returned to equity holders when a company is no longer able to invest in growth.

But in crypto, the structures of value creation and retention are more transparent and immediate.

Just this week, a member of LSD protocol Lido proposed enabling $LDO staking and buybacks for a proportion of DAO revenue. The tepid reaction raised questions of usage of funds, growth and maturity. The protocol is just over a year old and is already signaling their transition towards revenue distribution.

During the growth phase revenue is used to find new ventures and services. Typically it's not until a company is mature and cannot find new avenues for growth that it begins to distribute profits.

Benefits and Drawbacks of Buybacks versus Dividends in Crypto

In TradFi, Dividends and buybacks are two typical methods that businesses return income to shareholders. Which one to choose depends on how companies operate

Crypto is a total different story though. It shares a lot of the same characteristics as TradFi, but the infrastructure, mechanisms, and methods can vary wildly. Let's take a look at the benefits and drawbacks of dividends and buybacks to see what they provide.

Benefits of buybacks

1. Lower supply: Buybacks result in fewer tokens circulating, potentially leading to higher prices.
2. More flexibility: Unless automated, protocols can choose how they want to use funds for buybacks. If market conditions are poor, the capital can be retained for later use.
3. Tax efficiency: based on where the token holder lives, buybacks may benefit them more dividends. Capital gains taxes are typically lower and give optionality for sales.

Drawbacks of buybacks

1. Resource misallocation: it's impossible for a protocol to determine whether prices will be higher or lower in the future. If the capital is used to buy tokens back at high prices, it could result in resource waste that could've gone to research, growth, or other activities.
2. Market manipulation worries: High prices for tokens can skew market signals and provide the appearance that a protocol is in good health, when it is actually not.

Benefits of Dividends

1. Consistent income stream: Dividends give token holders a predictable and constant revenue source. Some people like the idea of getting stablecoins or ETH streamed to their account daily.
2. Performance demands: Distributions are the primary means of seeing how healthy a protocol is. If less is being returned to investors, they might question decisions made by the DAO or leadership.

Drawbacks to dividends

1. Tax repercussions: in the United States dividend distributions are counted as income and taxed at the short term rate, which negatively affects those in higher tax rates.
2. Limited latitude: Once the DAO votes to return revenues, the protocol will be limited from using that capital as incentives for liquidity or other services.
3. Market perception: Crypto markets fluctuate wildly and a positive revenue source might shrink heavily in a bear market. Holders might dump the tokens if they believe their income might be affected.

In conclusion, buybacks provide flexibility, the ability to boost shareholder value, and tax benefits, but they can also raise issues with resource misallocation and market manipulation. Dividends offer consistent income, investor loyalty, and capital allocation discipline, but they also have tax repercussions, a finite amount of flexibility, and the potential for a bad market image. The decision between buybacks and dividends is influenced by a number of variables, including the company's financial situation, future growth possibilities, and shareholder preferences.

Brief history of Frax’s profit distribution

When Frax was launched it used all of its excess profits to buyback and burn FXS. From inception to May 2021, the protocol bought and burned almost 10m FXS.

When veFXS single asset staking was added, it no longer made sense for the protocol to burn FXS. Burns disincentivize long-term lockers. In May 2021, a proposal reduced the burn amount to 50% and eventually to 0% with a later proposal. Later a final proposal changed the process to use excess profits to mint FRAX and purchase FXS to be distributed to veFXS.

In February 2023, buybacks were paused to direct excess profits towards increasing the collateral ratio to 100% after a vote.

3 potential outcomes

Once the collateralization ratio is increased to 100%, profit distribution can resume for Frax. As FXS will no longer be used as part of the collateral backing for FRAX, any of the following methods would be usable.

frxETH/FRAX dividends to veFXS

This is a new idea that has been thrown around in the Telegram forums. Once CR is at 100%, Frax could pay out dividends to veFXS using FRAX or frxETH.

- Profit flow through to veFXS

- Hard assets with deep liquidity

- Drawback: value could leak from the FRAX ecosystem as veFXS holders could sell.

FXS Buybacks

This has been the model that was used from the protocol’s inception. It made a lot of sense while the CR was below 100%, as the buybacks would help support the peg. However, once we go CR 100%, constant demand pressure for FXS is not as important.

- FXS supply reduction, number go up

- Voting Power of veFXS relatively increases as there are fewer potential supply of FXS to be locked

- Drawback: exchanging hard assets like FRAX, frxETH for FXS (instead of giving the users the choice of what asset they want)

Balancer 80/20 LPs

One of the more innovate ideas was proposed by the Balancer team to reward liquidity providers in addition to stakers

- Increases Frax ecosystem liquidity while generating yield for the veFXS holders

- Flexible and many variation of pool composability for all risk profiles

- Drawback: The rewards otherwise would’ve been liquid and available to the veFXS holder is now locked liquidity.  VeFXS now has basically 2 locked positions (principal and yield)

Conclusion

Honestly, I don't think there is a perfect answer. Each token holder will have their own special set of circumstances and preferences. There is no way to appease everyone, and so who's questions of buybacks versus dividends, must go up for a vote.

Frax has seen good growth with Buybacks in the past, so I think they would be the default path forward as its a time tested model. However, I do see the appeal of dividends for veFXS. With frxETH growing to potentially millions in supply, distributing the revenues straight to lockers as income would also be interesting.