Token Buy Backs
What they are and how they work
TLDR:
Aave’s the latest Web3 project to implement token buy backs. A host of other large DeFi projects do this too like MakerDAO/Sky, Raydium and Jupiter.
Token buy backs in principle have a positive effect on price by increasing demand and lowering supply of the token on secondary markets.
However, they don’t always work out well and can therefore be seen as a risky way to use a project’s revenue, which could be used elsewhere to guarantee growth.
Nonetheless, buy backs can be a powerful tool to drive price growth to token holders, much like stock buy backs in traditional stock markets.
Aave has recently announced that they are going to begin doing token buy backs and it’s been generally well received by the market.
It’s become ever more common for Web3 projects to implement buy backs, so this week I decided to discuss what buy backs are, why projects do them, and how they can be beneficial.
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Token Buy Backs
There’s been a growing trend in Web3 projects announcing they are doing token buy backs, the latest example being Aave with their new governance proposal that includes a token buy back of $1M/week for the next 6 months of their $AAVE token.
When the proposal went out $AAVE jumped up 21% in price in 24 hours, although it’s since corrected back down along with the rest of the Altcoin market.
It’s important to note though that this proposal included a lot of other mechanics beyond the token buy backs, which are nicely summarised in this hyperlinked post, however the buy back was one of the most important points discussed.
Fundamentally buy backs are exactly what the name implies, they are when a project *buys back* more of its own token on the secondary market, usually in a bid to spur price movement upwards.
Aave is the market leader in the DeFi Lending space, and has the largest TVL of all DeFi Protocols together with Lido, both of which have almost $18bn in TVL.
Aave are also doing big numbers in revenue, having made over $360m this last year alone, and appear comfortable in spending some of that revenue on buy backs.
It’s not just Aave though, we’ve also seen other high revenue earning DeFi protocols like MakerDAO/Sky, Raydium and Jupiter implementing similar buy back programs.
So given several projects do it, let’s take a look at how buy backs actually work.
Dynamics of Buy Backs
Token buy backs usually involve a project taking some of the revenue they’ve generated and using it to buy up part of their own token supply from the secondary market.
It’s essentially a signal of strength to the market that the project is so confident in it’s own success that they are willing to part with their revenue to buy up more of their own tokens. Consequently buy backs in principle have a positive effect on both the demand and supply of a token.
On the demand side they literally increase demand because the project is actively buying up tokens from the secondary market. This signal of strength will then generally incentivise others to buy the token too generating further demand.
Meanwhile on the supply side, the tokens bought are generally taken away from exchanges to be used further down the line to grow the ecosystem, reducing the overall supply available on secondary markets. In some cases these tokens are even burned in which case they constrain the token’s supply forever!
Some may question if buy backs are a good use of a project’s money, obviously the outcome isn’t perfect to predict but it represents the company taking a risk on itself and shows strong alignment with its own success.
In traditional stock markets companies that have excess revenue and feel very confident about their continued growth can do something similar called a stock buy back, which follows the same principles.
Importantly, it aligns incentives throughout the board as this revenue essentially gets spent to grow stock prices benefiting all shareholders. These can be employees, customers, investors and company directors, anyone who’s committed their own money at risk for the success of the company!
The higher stock valuations then generally mean companies can raise more money, and continue to serve their customers, employees and shareholders further.
So it seems like a good idea right?
What’s the down side?
Firstly, although the project’s intentions may be good, it might just not be a very significant amount of money to make any real impact on token price.
In Aave’s case for example the $1M/week for 6 months is *only* 6x4=$24M in total over 6 months. Considering $AAVE as of today has a market cap of over $2.6bn, this is just a drop in the ocean.
It’s therefore a risk with a project’s revenue that may not be worth taking, as the market may simply have more sellers than buyers for their token and the project can lose out. This has been the case with Raydium’s token buy backs where they currently have over $80M in unrealised losses at today’s $RAY prices.
Moreover, this revenue could instead be used in other ways to ensure a project’s growth and cement it even further as a market leader. In Aave’s case for example, DeFi is still incredibly young and although they are the market leader today, they could quite easily be disrupted by a new player and shouldn’t get over confident.
Another point is that while Aave does indeed have money *spare* to allocate to this, many projects attempt buy backs when they aren’t even earning enough revenue, and that’s a recipe for disaster.
Burning revenue needed to keep the project afloat with buy backs is essentially giving handouts to the market, as large token holders can sell their tokens and essentially syphon that company revenue immediately back into their own hands.
Furthermore, while many projects have wanted to do buy backs, the regulatory environment has generally been very hostile to crypto for quite some time.
In the past 4 years the SEC under Gary Gensler went after pretty much any and every big crypto player. So most projects were fearful of doing anything that remotely mirrored traditional stocks and that returned value to token holders.
The SEC ironically created an environment where it felt *safer* for a founder to launch a memecoin with no intrinsic value than a real profit generating business!
Thankfully this is clearly changing under the new Trump administration, and this proposal from Aave to do buy backs is almost definitely a reaction to the new administration being more pro-crypto hence signalling projects don’t need to be as fearful.
Giving Back
The stock market has successfully continuously grown up and to the right for as long as anyone can remember (over large enough windows of time) predominantly because of the fundamental growth in company profits.
More companies with more profits represent a growing economy and therefore a growing stock market.
In the stock market these profits are either re-invested into the company to grow it further, or returned to share holders through dividends and/or stock buy backs.
Web3 projects have been largely unable to do much in terms of dividends and buy backs for fear of getting deemed a security and attacked by the SEC. This has predominantly left crypto as a space that’s almost entirely focused on speculation rather than fundamentals.
The tides are appear to be changing now though with the new administration and we may hopefully begin to see a shift.
Effectively it’s through *giving back* to shareholers that the stock market has continued to grow on a fundamental basis, and if projects in crypto are able to use these same tools we’ll undoubtedly see the same sort of fundamental growth in the crypto space too, moving it away from being a mostly speculative space.
We can only hope that Aave’s token buy back move is a signal of what other Web3 projects will do more and more, and marks a shift towards a more mature market that will be supported by regulators to grow and be able to give back and drive fundamental value back to their token holders.
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