Why is redistributing tokens better than destroying tokens?

Author: Pavel

Source: Hazeflow

Compiled by: Shaw Golden Finance

Abstract

We are considering which is more beneficial for the system to maintain a healthy state and the consistency of incentives: destroying or reallocating assets.

When reductions are the initial stage of punishing malicious behavior, redistributing assets is often more effective than directly destroying them.

When destruction is a core feature of the design and does not involve a reduction (for example, in a deflationary economy), there is no reason to implement redistribution.

When redistribution is a core feature of the design but seems more like a flaw, there is no reason to substitute it with destruction; improvements must be made at the foundational level.

Definition

Many people seem to be confused, thinking that when a token is significantly reduced, the reduced portion will be automatically destroyed, leading to a decrease in supply. But that is not the case.

"Reduction" describes the act of "taking away" assets from malicious actors, while "destruction" and "redistribution" describe what happens to the assets themselves after they have been taken away.

As we mentioned before, they are either burned or redistributed: one action will reduce the total supply, while the other will transfer value to another party (not always the disadvantaged one). Due to the built-in mechanism of the protocol, burning can also occur without a reduction.

Reallocation helps economic security

Let’s take EigenCloud, one of the well-known protocols in today’s cryptocurrency space, as an example. Here, operators who fail to fulfill their obligations will have their rewards reduced, which is a good thing: wrongdoers will be punished. However, before introducing the mechanism for redistributing the reduced funds, these funds will be permanently destroyed (and may still be destroyed to this day).

We believe that in such a system, destroying the reduced funds is no different from lifting a rock to hit one's own foot. When the operator's staked funds are reduced, the operator will be penalized (for good reason), but:

The victim does not receive any compensation after being harmed (imagine you were hit by a car, the driver is imprisoned and punished, but you do not receive any help).

The system has become less secure (because there are now fewer assets protecting the system).

So, since we can retain these values and transfer them to the affected parties, why destroy them and shoot ourselves in the foot? Reliable parties can increase the rewards they receive, affected users can receive compensation, and the value remains in the ecosystem; it is just being redistributed. This can also unlock a large number of use cases for applications.

The new type of on-chain insurance protocol may operate correctly in a permissionless manner.

Faster and more reliable DEX trading. If a trading request fails, expires, or is not completed on time, traders will be compensated. This will further incentivize operators to operate honestly and transparently.

Protect lenders through guaranteed annual percentage rates (APR), higher transparency, and potential fixed rates in local currency.

Economic security can not only directly ensure user safety before incidents occur (e.g., destruction mechanisms) but also protect users directly after incidents happen. Protocols like Cap have already implemented a redistribution mechanism, where the funds of affected operators will be redistributed to the impacted cUSD holders.

It is not without its drawbacks.

Destroying assets is easier than redistributing them, as you do not have to worry about what will happen to the assets afterward; they are simply destroyed, and no one benefits. The benefits of destroying assets are fewer, and the risks are significantly reduced. In contrast, redistribution can lead to major changes in the rules of the game, and implementing it (confiscating assets from bad actors → redistributing to the harmed parties) is not as simple as it seems.

Malicious operators can now collude with the malicious validator set (AVS). Currently, AVS can implement any custom slashing logic, even if that logic is unfair or subjective. With the penalty mechanism in place, malicious actions by AVS become meaningless, as operators would not stake their assets if they are aware that they could be punished without reason.

Through redistribution, AVS can transfer the rights of an operator to a malicious operator (who colludes), thereby extracting value from the system. The same would happen if the AVS key is leaked, which would also affect the overall "attractiveness" of the operator or AVS.

Additional assessment of the mechanism design is needed here. Operators should not have the option to "switch types" after creation. Instead, there should be a way to identify compromised (malicious) operators and redistribute when value falls into their hands, as well as ongoing monitoring, etc.

Although burning funds is much easier, redistributing is fairer, but it requires additional complexity.

Solve the problem of adverse redistribution

Maximum Extractable Value (MEV) can be viewed from the perspective that innocent users and liquidity providers (LPs) suffer losses for no reason. When users want to swap assets, they may be subject to front-running or sandwich attacks, resulting in worse trading outcomes (prices).

We can say with certainty that the reason they suffered losses is that they invested their shares (the assets to be exchanged) into the system (DEX), held them for a period of time (exchange time), and ultimately received an amount far lower than what they deserved.

There are two core issues here:

LP was reduced for no reason (they did not have any malicious behavior).

Users are arbitrarily reduced; they have no malicious intent, nor do they intend to profit or do good for the system, they just hope that their operations can be executed.

Here, value is extracted and redistributed, the exploiters are rewarded, while the party that did nothing wrong suffers greatly.

By establishing certain sorting rules (such as Arbitrum Boost), users can more easily solve this problem.

For LPs, this issue is more complicated because they are often victims of leverage ratios (losses and rebalancing).

Can this be resolved by destruction?

Burning can bring extensive benefits to all token holders without specifically compensating liquidity providers who have directly suffered losses due to arbitrage activities. Technically, this issue can be resolved through burning; once the profits are burned, there is no incentive for arbitrage activities.

However, once the arbitrage profits are extracted, identifying this arbitrage becomes more difficult: while on-chain transactions are visible, CEX data does not show the exact addresses of the traders.

In this case, poor redistribution design can be addressed through application-specific sorting, allowing liquidity providers to capture value that would otherwise be taken by speculators. This is one of the solutions implemented by Angstrom, and it works quite well.

In the specific case of MEV, redistribution and destruction are not viable options; they are merely temporary solutions. Changes must be made at the foundational level.

Burning may be better than redistribution

What we want to emphasize is that redistribution is not a panacea and cannot always replace burning. When there is no reduction involved (Phase 1), in most cases, burning funds is a key feature of mechanism design.

Taking BNB as an example, the BNB token is burned once a quarter, which is a core feature of the deflationary token economic model. In this model, redistribution is not achievable, as the process involves neither exploiters nor affected users.

A similar process occurs in the design of Ethereum (EIP-1559), where the base fee is burned, resulting in a deflationary effect. Given the mechanism design of Ethereum, during periods of network congestion, fees can become very high, leading some to believe that instead of burning the base fee, it would be better to transfer the base fee into a treasury fund to compensate for some fees during network congestion. However, the drawbacks of this approach far outweigh the potential benefits:

Reallocating costs may weaken the deflationary effect, leading to higher inflation, and may depress token value over time.

Improper allocation of funds leads to reduced income (how should the fund determine which transactions to prioritize for funding? Does it make sense to pay priority fees when users can be compensated with funds? Etc.).

If you know your fees will be funded, then it may be easier to disseminate information indiscriminately and cause greater congestion.

If the base fee of Ethereum is redistributed to stakers, it may incentivize validators to prioritize processing high-fee transactions while ignoring those that are unfunded or have not paid fees in advance.

There are many other situations, but the key point is that redistribution is not a panacea. If destruction occurs spontaneously (without prior reduction), then there is almost no reason to replace it with redistribution.

Conclusion

Finally, we would like to point out that, without prior reductions, redistribution is generally not as effective as destruction, while in cases involving reductions, redistribution often performs better than destruction.

The issue of incentive mechanism coordination has long been a problem in the cryptocurrency field and often varies due to different protocols. If economic value directly affects the security of the system or other key factors, it is better not to undermine that value, but rather to find a way to correctly redistribute it to those who act honestly, thereby incentivizing fair and honest behavior.