Summary
Hi ZKsync! I recently joined Butter and wanted to formally introduce ZK Nation to a new treasury allocation mechanism we are launching: Conditional Funding Markets (CFMs). Given ZKsync’s commitment to building a thoughtful and sustainable governance model, I believe an introduction to CFMs is a valuable addition to the conversation.
CFMs address one of the biggest challenges in governance: allocating a treasury effectively.
Treasury Allocation Today
Treasury allocation is a simple idea. Set an objective, find a project or activity that appears to achieve the objective, and then provide the resources it needs to achieve it.
For most ecosystems, especially as they mature, treasury allocation remains a source of contention. Many of crypto’s most memorable controversies feature a large pool of shared capital and claims of misappropriation.
When a distributed network is responsible for allocating resources, many questions arise: Who sets the objective for the protocol? How do we ensure we are evaluating the most relevant opportunities? How much should we allocate to any project? How do we prevent self-dealing? How do we collectively measure progress? Who or what holds us accountable?
These questions become even more complex when we consider the diverse nature of a large protocol’s stakeholders. Protocol networks can include thousands or millions of tokenholders who span a range of preferences, pursue conflicting goals, and possess highly variable contextual knowledge.
To rely on a simple token-weighted average of their opinions is problematic. It incorporates misleading signals while simultaneously discarding valuable insights. Token voting maximizes the interests of its most prominent or influential tokenholders or their delegates.
Another common path ecosystems have taken is to empower a small group of individuals to make decisions and allocate a pool of capital. This is more scalable than requiring every proposal to go through a token vote, however, it relies on the community maintaining a high level of trust in the individuals making the decisions. How can the community trust whether the individuals making the allocation decisions are using the power given to them to actually make better grant decisions, as opposed to using the power given to them to benefit themselves or express their biases?
CFMs aim to address these challenges by introducing an alternative mechanism ecosystems can leverage to allocate their treasury.
Conditional Funding Markets (CFMs)
Prediction Markets are known to be more effective at forecasting events than polling, surveys, and other methods. Market prices act as a beacon for the informed to “sell” their information to the market. As traders interact, private information is incorporated into the market via prices, which improves the signal in the market price.
CFMs are a type of Futarchy, a prediction market used to make decisions. CFMs estimate the probability that a funding decision will produce the desired effect before the funding decision is made. The resulting probability distribution of all possible allocations is subsequently used to allocate the funding.
CFM users set a target metric, such as protocol revenue, and allocate a pool of funding to the mechanism. By creating tokens whose value corresponds to the metric, CFMs ensure everyone’s incentives are aligned.
Benefits
CFMs are a compelling alternative to other forms of treasury allocation because they provide:
- Reduced bias: Markets are expensive to manipulate, and participants have direct skin-in-the-game;
- Continuous real-time updates: New information is quickly incorporated into CFMs; and
- Incentive compatibility: by incentivizing participants to select outcomes that maximize the effects we care about, we also increase the benefit to the ecosystem.
Use Cases
CFMs are transparent, decentralized, rules-based, and credibly neutral. They can be scaled without incurring significant information or centralization costs. A few examples of how CFMs can be implemented include:
Ecosystem and Growth Funding
CFMs can be configured to target the set of metrics an ecosystem believes are most valuable. The positions held by CFM traders are resolved as funding recipients achieve the metrics set by the ecosystem. Accordingly, CFMs create a tight incentive feedback loop to produce results as opposed to the incentives that typically drive misaligned grant funding decisions. Uniswap and Optimism recently announced the launch of the first Butter CFM’s which are both focused on ecosystem growth.
Service Provider Compensation
Token Voting typically determines which service providers are selected to serve the protocol’s needs and the amount paid for their services. The overlap between the interests of each service provider’s stakeholders and the protocol’s tokenholders often interferes with the outcome of the voting process. The market mechanism in CFMs creates natural incentives for traders to identify and trade against any attempt to manipulate the price away from the market consensus. This ensures that the most effective service provider for the work, rather than the most influential, will always be selected.
Investment Funds
The standard model for selecting projects to invest in requires sophisticated information aggregation techniques, such as interviews, applications, pitch decks, due diligence, benchmarks, market research, and reference checks, all of which culminate in a prediction about the project’s future valuation. The role of creating predictions, currently performed by experts, could equally be performed by CFMs.