As the curtain falls on Token2049, a silver lining rises in Web3, where the market players are showing their determination to conquer the bottlenecks and embrace the next breakthrough. All professionals in Web3 are striving to become the pioneers of the next paradigm upon the current market transitions from bearish to bullish. However, despite the hustle and bustle, investors’ lack of confidence and projects’ cliche business models are still in the way. When considering tokenomics and selling pressure, neither traditional finance/gaming experience nor the prevailing ponzinomics model in the past year can further help DeFi, GameFi, or SocialFi projects make the deals. Hence, when we realize that there’s great need for a more organized system and more practical values for the evolution of Web3’s financial infrastructure, builders came up with the concepts of financial engineering and real yield, hoping to build the expectations of a new consensus. 

The core value of the Web3 network comes from the combination of blockchain technology and encryption algorithm, which enables the network system and information system to turn codes into laws (“code is law”) through protocols. This evolution has significantly innovated the business contract tools, hence improved the efficiency and contract performances of financial transactions, which further improved the overall productive and operational efficiencies of society. 

While the infrastructure development of Web3 is still in its early stage, the evolution of this emerging system will inevitably be accompanied by enormous changes around the infra layer, protocol layer, product layer, and application service layer. Financial engineering will play a key role in connecting the technology and market demands. It is becoming clear that the financial system and tokenomics builders in Web3 are very similar to the macroeconomic policymakers in the traditional market. They all use systematic and engineering thinking to modularize social supplies and demands, operational flows, management mechanisms, and professional services, in order to form a systematic engineering project. Although financial engineering has already matured in traditional finance, there are still a bunch of non-standardized problems in written laws and the human processing environment. Thus, the next era of civilization is still a conceptual idea as social efficiency has not been massively improved.

Fortunately, the smart contract in Web3’s value network can solve the problem above. Protocols and contracts can encapsulate financial and trading behaviors, commercial needs, and economic strategies into codes, taking financial systems and tokenomics into the digital modularization era. Financial engineering would then transform into a financial circuit when the Internet connects the components as a loop.

Last year, I roughly thought about the principle of financial circuit and the concept of financial chips for the first time. The construction of the financial engineering system is analogical to that of electric circuits. If, regarded, the cash flow is analogically the electric current, the value difference (the concept will be explained in detail later) is analogically the battery voltage, and cash consumption is analogically the resistance, then a simplest financial circuit is formed. It looks rather simple, however, there are still concerns remained. First off, how are the relationships of these components interpreted? Do financial tools such as wallets, aggregators, staking, and alike, have clear definitions in financial circuit? Furthermore, how many more advanced financial components are there and what would their internal interactions as well as their commercial implications be like? The questions above all require further in-depth thinking, and will be explained in detail later in this paper. The evolution of financial circuit will be systematic. As the ecology of GameFi and Metaverse continues to take shape, various models in financial circuit will be incorporated by tokenomics builders. Upon that time, the complexity and professionalism of the principle will increase rapidly with the iterative market demand, and will soon change our overall perception of the traditional financial system, eventually leading to the Emergence Phenomenon (Note 1), which may further form the application scenarios such as financial AI and financial chips.

The financial circuits can inevitably improve the efficiency of financial market and commercial economy, and there would be new things of the next generation that traditional finance cannot achieve despite its long history and mature market. This would be as astonishing as how the development of circuits from the 19th century evolved to the development of chips and AI in the 20th century. There can be a complete innovation achieved in the financial engineering and incoming financial circuit industry, unbelievingly improving the social and economic efficiency. The definition and function of Finance will also experience a more advanced and complex systemization in the future with the development of science and technology, just as the creation of the first financial derivatives in the 14th century evolving to the formation of a globalized financial transaction system in the 20th century.

In this evolution, the Non-Fungible Token (NFT) is becoming a tool of critical importance to achieve the viable development of financial circuits. Although NFTs entered the market in the form of PFPs (profile pictures) such as Cryptokitties in 2017, and that the NFTs traded in OpenSea and LooksRare are still mostly PFPs as of now, its significance to Web3 is profound. In fact, an NFT can be regarded as a container. More precisely, it functions as a digital Metadata container in terms of Technology and Coding, and a value container in terms of Finance. NFT is an important tool to realize the feasibility of encapsulation of financial values in the protocol world. In this regard, cutting-edge Web3 projects such as Solv Protocol has built a relatively complete system framework, from the protocol layer to the application layer, coupled with a combination of protocol, smart contract and detachable NFTs, and is providing more advanced product services and more effective financial engineering components for the next stage of the financial market.

The Web3 financial and tokenomics builders need to constantly deal with events such as cash inflows and outflows, liquidity unlocking, selling pressure, burning (consuming), and staking (pledging), among other common operations in project management. Therefore, in the tokenomics design, builders often draw financial flow charts, and design or refer various models, such as the deflation & inflation dual-token model, the staking scheme, the provision of liquidity pool and bonus pool, and the VE mechanism, etc. In fact, Web3 tokenomics builders, project managers and technical engineers are already dealing with the specific problems of financial circuits in varying levels of complexity. Some professionals have proposed the concept of Money Lego, which, in my opinion, is not suitable for building the underlying financial infrastructure of Web3. The Money Lego model can be regarded as a stack of non-standard business modules, instead of a structured theory; it can be more meaningful for project management in the future. The development of financial circuit requires a complete set of basic theoretical system as support, on the contrast, the basic principles of upper layer applications can be more non-standard.

Will financial circuit have such systematic theory characteristics that are analogical to Circuit Theory? For example, there is Ohm's law in Circuit Theory describing the relationship between voltage and current, and furthermore, there are well-celebrated theories such as Thévenin’s Theorem (Note 2) and Kirchhoff's Circuit Laws (Note 3, Note 4), as well as a set of concepts of various physical quantities and components. Does financial circuit in Economics have such similar theories and concepts as above? The answer is yes. More precisely, the financial circuit theory can be a complete paradigmatic correspondence to the Circuit Theory, and such correspondence system will be of great significance to the development of financial circuit. The correspondence will be discussed from the following aspects:

• Definitions and Explanations of the Elements in Financial Circuit – the common elements and components of financial circuits
• Principles and Meanings of the Financial Circuit – the theoretic meaning of financial circuit and the relationship between its elements and components
• Significance of Financial Circuit and Discussions of Classical Questions – using financial circuit as a method to solve Web3 problems
• Paradigmatic Differences between Financial Circuit and Electric Circuit – interpreting financial circuits from the perspective of social practice

[Definitions and Explanations of the Elements in Financial Circuit]

The essence of financial circuit is the similarity between financial cash flows and electron flows, as we analogize cash as electrons. Hence, the circuit theories can be preliminarily applied to the financial circuit theory once the concepts of Cash Quantity and Cash Flow are clearly defined. Another key component of the circuit – voltage, is a relatively abstract concept. What exactly is voltage? It is defined as electric potential difference in Physics, and hereby can be interpreted as "value potential difference" – the essence of value in tokenomics. It is the process of getting rid of ponzinomics to find the value-generating “real yield”. This is a crucial economic concept in this paper. If value is seen as an objective field like the electric field, the definition of voltage would become more evident. 

The following paragraphs will define essential elements and components of financial circuits. Understanding these definitions is the first step to build a complete system of Financial Circuit Theory; it is also a prerequisite for applying the Circuit Theory to financial circuit and find the correspondence. When defining the financial circuit elements and components, the names and symbols that are equal or similar to electric circuits are used to maintain the corresponding relationships. 

1. Basic Parameters of Financial Circuit

Quantity of Cash (q), cash for short.

Quantity of cash is the most important parameter of financial circuit. It simply represents the amount of cash in hand or the number of tokens of the project.

Intensity of Cash Flow (i), cash flow for short.

The concept of cash flow is familiar to people who have working experience in business management or learning experience in the basics of Finance. However, how to definite it specifically? The definition of cash flow is very similar to that of the relationship between current and charge, i.e. i = q / t. It is essentially a form of intensity, which is the amount of capital flux per unit of time. The direction of cash flow is simply where the cash goes, which is different from the direction of electron flows (Note 5). However, it is more explicit and comprehensive.

Value Potential Difference (v), value for short.

Value is the foundation of financial transactions, and the potential difference of value generates the cash flow. Usually, information asymmetry causes value asymmetry, leading cash to flow from low-value potential to high-value potential. This is the exact process of cash in the pursuit of value exchange. Cash, however, does not flow and exchange in the direction from high-value potential to low-value potential, as there is no value potential difference serving as supply for the cash to exchange. Here, value potential is defined as the objective height of a value in a field. This concept is abstract yet easy to understand. There is always a value potential difference between two things with different value positions, and this is the very drive of the creation of business, investment, and trading opportunities. It should be noted that information is often asymmetric in the real world of finance and business, causing some of the cash holders to mistakenly believe that they are in the state of high-value potential due to various mentalities, such as fear of missing out (FOMO), misjudgment, or being tricked by phishing. The price bias therefore occurs under information asymmetry. From the micro perspective, price bias essentially means that cash is in a value potential that does not reflect the true condition and may eventually fail to remain in that potential due to the release of information or the delay of achieving expectations; thereafter, cash would quickly flow down from the unreasonable potential accompanied by a sudden selling pressure, which is also the process of price returning to real value. In the real-world financial market, the case of financial circuit is socialized, which is different from the classic physical principle of circuits. There would be various types of cash value dislocation caused by much more severe information asymmetry and value asymmetry, where the cash (q) is positioned on the bubbled value potential, or even on the false value potential. In these cases, the hidden danger of the cash flow selling pressure is enormous. However, such circumstances can be healthy to the market in a less extreme environment, for that liquidity is a necessity for finance and value exchange. Value potential difference is an important concept of financial circuit. A system without a real value potential difference may only construct a short-term dislocated value opportunity, with the zero-sum game being the only solution for information asymmetry, which has no use for sustainable development. It is also a concern from the current investors that GameFi and SocialFi projects are constantly in the involution of ponzinomics.

Resistance of Burning (r), resistance for short.

There are many types of resistance of burning. From the very elemental point of view, resistance exists in the Web3 financial system objectively because the operational transactions on blockchain require gas fees as payment to the miners. What’s more, in different protocols and applications, platform and project builders can customize the cost, consumption, and destruction mechanisms, which can all be regarded as different types of resistance. To operate an economic system, the macroeconomic managers or the commercial project builders usually choose certain consumption mechanisms to curb inflation. This is a critical management process. Meanwhile, on the customers and users’ side, it is also very normal for them to spend a certain amount of expenditure when they accomplish specific tasks in the system. This consumption process from the macro level to the micro level is an extremely fundamental work in the designing of financial circuits and tokenomics, requiring professional skills to design the appropriate resistance mechanism. However, the concept of resistance is not easy enough for users and the public to comprehend and directly apply in their financial behaviors. Most of the people above pay more attention to the quantity of cash or tokens burned by resistance (qr), which is the amount of cash consumed for a certain amount of cash flow per unit of time under the condition of resistance r. In other words, how much fee do users need to pay for the service after the mission is accomplished or the value is gained. This is the very concern of the users. In fact, the tokenomics or financial system builders usually adopt various kinds of liquidity management methods including specific functions and tasks to create resistance when they try to curb inflation. These methods are called deflation mechanism, designed to make sure there’s continuous consumption of cash in the system and control the operational balance of the tokenomics and financial system.

2. Important Components of Financial Circuit:

The Source of the Real Yield (y), yield for short.

A term that has been increasingly mentioned in the Web3 space is real yield, which advocates that Web3 should jump out of the cryptocurrency bubble issue occurred in previous cycles. Hence, a Web3 project is suggested to be undertaken involving value proposition with practical economic and commercial significance, as well as a solid team which could assiduously deliver real values, no matter this project is going to generate liquidity from day one, or execute a traditional Web2 business model with MVP (Minimum Valuable Product) or PMF (Product Market Fit) building. The financing or public token issuing of a project is essentially the value potential difference derived from the expectations of real yield after the provision of a value proposition narrative, and such value potential difference generates or attracts cash flows for the project (Note 6).

Yield is a relatively special financial component and can be analogically regarded as battery voltage or voltage source in electric circuits as it generates values and potential differences. This is the very reason that the cash flows are generated in financial circuits. Besides Yield, financial components can be roughly divided into two categories: linear financial elements and non-linear financial elements. Linear financial elements are relatively common and simple, which have been widely used by project builders in the current Web3 market; they include three forms as follows:

Resistance Elements (r). This concept has been explained previously.

Capacitance Elements of Cash or Tokens (c), capacitance for short.

This is a relatively easy concept, meaning the containers of cash, tokens, and digital assets. In a real-world financial circuit, the most common capacitance elements are wallets and aggregators. The wallets can be an App of DEX or an account of CEX which contains a series of addresses. In any case, these capacitance elements provide users with a place or a carrier to store the cash. Once the cash flows into these capacitance elements, users can have an independent controlling right of liquidity. Generally, users would not withdraw all the cash at one time, nor would they keep all the cash without any activity in the wallets. Although the entire financial system does not have a micro-level control of an independent capacitance element, it enjoys the buffer effect generated from the accumulation of capacitance elements, where cash flows become dispersed and asynchronous, alleviating the liquidity pressure of the financial system. The value generated by capacitance elements is different from that of staking elements. When systematic problems occur, many users of the system where the capacitance element is incorporated would adopt the same or similar strategies at the same time, such as withdraw/deposit their liquidities from/to the wallets all at once, resulting in the expectations of death spiral or flywheel effect.

Staking Elements of Cash Flow or Tokens (s), staking for short.

In the real-world financial circuit, the staking elements are embodied as staking mining, liquidity pool, linear prize pool, digital assets in the tokenomics, or other cash flow staking schemes with preservation and appreciation functions. Here are the characteristics of staking elements in the financial circuit. When the financial system and the cash flows are relatively stable, staking is not a necessary element (although practically most financial systems are unstable without the functionality of staking). When the cash flows fluctuate drastically, it is necessary to keep the cash in a certain place by various staking methods and balance the cash flows of the system by taking advantage of time difference. This usually requires the tokenomics design to involve a rewarding mechanism where users who participate in the staking activities are rewarded. The biggest difference between the staking and resistance mechanisms is that the former does not cost cash from the users, on the contrary, it subsidizes users with a certain reward when the staked cash is returned to the users after some time (The reason of resistance not being applied in here is that the users need to be motivated to maintain the stability of overall cash volume and liquidity of the financial system). On the other hand, the biggest difference between staking elements and capacitance elements is that users do not have a strong control of the cash flows in staking. Instead, the liquidity principle is signed in the protocol and smart contract created by the project/financial system. After a period, the project/financial system would perform the contract and reward the users. Upon the performance of contract, the project/financial system can obtain the management dominance of cash flow liquidity for a period, when they may balance the time differences in the financial circuit loop to prevent the system from flow depletion or flow excess.

Apart from the three basic elements above, respectively, residence elements, capacitance elements, and staking elements, and collectively as financial circuit impedance (z), financial circuits will evolve and give rise to more complex non-linear financial components, which are similar to components in electric circuits such as PN junction, as well as the diodes and triodes generated from it. This evolution may also generate a financial component marketplace and even a financial chips industry. Some Web3 projects have already applied non-linear financial components through random functions and non-linear functions by way of random prize pools, blind box lotteries, or random airdrops. These are very elementary applications that are still in the early stage, though, the market of non-linear financial components is going to a very promising one. 

[Principles and Significance of Financial Circuit - the comparison of financial circuit and electric circuit] 

According to the definitions of basic elements and key components of financial circuit in the previous section, a conclusion can be drawn that financial circuit and electric circuit are running under the same paradigm in terms of nearly all basic characteristics. Thus, a complete set of principles and paradigms of financial circuit corresponding to that of electric circuit can be created, which is undoubtedly good news for incumbents building the Web3 financial system.

The functional relationship of various elements and components of a financial circuit conforms to basic principles and laws of financial circuit that is transferred from the electric circuit paradigm. The following paragraphs will focus on selected principles and laws in financial circuit, which will be interpreted in terms of their general formulas, financial meanings, practical features, special scenarios, and extended meanings in the most explicit way.

Here, a reflection is needed on the most basic concept of financial circuit – cash flow. In financial circuit, it is defined as the amount of cash passing through a node per unit of time, i.e. i = q / t. Cash flow can be analogical to electricity, water flow or blood flow, and cash flow management can be regarded as circuit design, urban water management system or the process of blood flows delivering nutrients to the whole body. It is not only the carrier of the economic cycle but also the core drive of the operations in financial circuits.

Below is the diagram indicating how the three most basic financial components - resistance of burning (r), capacitance elements of cash flow/token(s) (c) and staking elements of cash flow/token(s) - work under a certain value of yield.

Financial Resistance Ohm's Law，Financial Property of Capacitance Elements, Financial Property of Staking Elements

Financial Resistance Ohm's Law

General Formula: i = v / r (Cash Flow = Value / Resistance)

Financial Meaning: In the presence of value potential differences, the cash flow is inversely proportional to the resistance of burning.

Practical Feature: In a market, if there are real values that users and investors are interested in, there will be demands for investment or spending; if the project or the system sets a relatively high resistance, such as high transaction fees or lots of extra costs, it will curb investors or buyers’ enthusiasm and reduce the cash flows; and vice versa.

Special Scenario: If the resistance is infinite, the cash flow becomes zero, that is, in the scenario of extreme resistance of burning, there will be no cash flow in the project for the use of its product even if it has real value; if the value potential difference is zero, the cash flow also becomes zero, which means if the project or product has no value, there is no liquidity of cash flow, even under the circumstance of no resistance.

Extended Meaning 1: Given that i = q / t, then qr = vt / r, meaning in the scenario of constant value and resistance, the loss of cash qr is proportional to time.

Extended Meaning 2: The series and parallel connections of resistance. Series connections of resistance mean chaining two (or more) resistance elements to increase the cash flow consumption. Parallel connections of resistance are more special in financial circuit: they only capture values when the project declares that the user has to complete both or all of the task lines, which equals to the parallel connection in circuits; however, parallel connections of financial resistance usually causes the user to choose only one of the circuit line (task line) to run the cash flow for the value exchange, discarding all the other circuit lines; in this scenario, a circuit switch is actually used to disconnect all the other circuit lines. In addition, the financial circuit switch needs to be defined by the project party. With the addition of the switches, the parallel connection can express a more practical situation in the real-world financial circuits. 

Financial Property of Capacitance Elements

General Formula: i = c · dv / dt (liquidity = capacitance parameter * rate of change of value)

Financial Meaning: When the value changes, the cash in the capacitance element will immediately generate a cash inflow or outflow.

Practical Feature: Only if there are changes in real external value, will people consider withdrawing/depositing their cash from/to the wallets; in summary, the value changes generate the cash flows. If the external value remains constant, which means there is no investment or consumption opportunity, the quantity of cash in the capacitance elements remains constant, and no liquidity is generated.

Special Scenario: If the value is constant, i.e. dv/dt = 0, the cash flow will be zero regardless of the cash quantity in the capacitance element; If the capacitance element cannot carry cash, that is c = 0, there will be no cash flow no matter how much the value fluctuates, for there is no available capacitance element such as a wallet in the financial circuit.

Extended Meaning: c = ∫ i dt / v. When the value potential difference is found, cash will continuously flow out of the capacitance element. After a certain period, the total quantity of cash outflow will be equal to the carrying amount of the capacitance element (More precisely, it is the product of the capacitance of the capacitance element and the value. This definition may vary with the different dimensions of the capacitance element defined by different tokenomics)

Financial Property of Staking Elements

General Formula: v = s · di / dt (value = staking parameter * rate of change of cash flow)

Financial Meaning: When the cash flow changes, the staking element will carry an independent value (potential difference).

Practical Feature: Essentially, the significance of the staking process is generating stationary value. From the user’s point of view, both storing cash in the liquidity pool to obtain interest and investing money into an NFT asset to complete certain tasks are linked to the concept of periodic cash flow lock-up. In essence, it is an expression of the user's recognition of the local value within a period. From the macro standpoint of policymaking or the perspective of a project designer, if the cash flows do not fluctuate by the user’s decisions to buy or sell, the value is then controlled by the project team. Hence, there is no need to establish a staking mechanism to balance the cash flow momentum. However, usually the project team or the financial system managers can no longer control the value and price of the model holistically after the release of a certain proportion of the cash or tokens into the market. A great deal of buying and selling transactions will be conducted in the marketplace in the form of C2C. At that moment, it is necessary to withdraw some liquidity indirectly by way of staking to reduce the pressure of system management. Some financial forms in macro economy such as national debt, pensions and positive repurchases have just the similar properties.

Special Scenario: When the cash flow rate of change lowers to zero, the staking element stores no value; oppositely, if the cash flow volatiles drastically, then the value stored by the staking element can be very high, for it is proportional to the cash flow rate of change. In the real-world, there would be a threshold of the sentimental indicator, or a systematic entropy increase, which forms a singularity problem in mathematics, resulting in the staking mechanism to fail with the phenomenon of liquidity trap (Note 7).

Extended Meaning: s = ∫ v dt / i. After the staking elements take effect due to the volatility of cash flow, the sum of the relative value within a certain period is equal to the product of the capacitance of the staking elements and the liquidity flowing through the staking elements (depending on the different dimensions of staking elements defined by different tokenomics).

In the Web3 financial system, tokenomics builders usually apply various combinations of the three basic financial elements above in the liquidity management with models functioning like the series and parallel circuit connections.

One point that was not discussed in detail previously is the financial meaning of the source of the real yield. For the builders, the process of considering whether applying the single-token model, dual-token model, or introducing a new NFT digital asset (Note 8) into the tokenomics is also the process of increasing the sources of real yield in financial circuits. Different sources of real yield play different roles like a battery pack, a good example being the functionality of deflation and inflation in the financial system. Many sources of real yield are not activated or shown explicitly at the very beginning, yet are gradually generated through capital financing, such as private investment, public listing, and liquidity pool.

With the support of these models and structures, the framework of financial circuit can be drafted, and it can be referred to as a tokenomics network in Web3. The graph below a visual example of the financial circuit framework. It is a sketch of a real-world Web3 project with basic structures and is for reference only; to come up with a complete tokenomics, further justifications are needed.

Due to the intricacy in the practice of the project, non-linear financial elements already exist in this tokenomics model, where y2 is the non-linear adjustable source of real yield, and r1, r2, r3, rm1, rm2 are non-linear adjustable resistance elements. Practically, project managers tend to avoid revealing all the functions and structures of the tokenomics, especially when many conditions that trigger resistance elements consumption are hidden ones. Usually, linear components and linear parameters represent the main rules or simple rules of the tokenomics, while non-linear parts may either be published selectively by project builders and managers or soon be derived and calculated by users or researchers with data in the OTC market.

In addition to the basic principles above, there are more in-depth theorems in the Circuit Theory that are also applicable to financial circuit. The paragraphs below take Thévenin’s Theorem and Kirchhoff's Law as examples, corresponding their paradigms to the fundamental theorem of financial circuit:

Financial Thévenin's Theorem

Theorem Description:

Any linear tokenomics network that contains independent sources of real yield and linear financial circuit impedance can be replaced by an equivalent combination of a source of real yield y in a series connection with a financial circuit impedance z.

Financial Meaning:

Similar to Thévenin's Theorem in Circuit Theory, Financial Thévenin’s Theorem is an analytical method for simplifying the toekenomics network, which can be used to convert the complex financial circuits and tokenomics networks into simple equivalent networks. It will bring much convenience for project comparative analysis and investment analysis in the future.

Financial Kirchhoff's Laws

Theorem Description:

Financial Kirchhoff's Cash Flow Law

For any node in a financial circuit, the total cash liquidity entering the node is identical to the total cash liquidity exiting in the node. 

Formula expression: Σ ik = 0 (k=1,2,…,n).

Financial Kirchhoff's Value Law

The algebraic sum of all value differences around any closed loop is zero.

Formula expression: Σ vk = 0 (k=1,2,…,n).

Financial Meaning:

For the law of cash flow: This is very comprehensive. For any node, such as a wallet address, the total amounts of cash inflows and outflows are equal. Assuming the inflows are positive, and the outflows are negative, their sum of the two amounts will be conserved to zero. (Do tokens or NFTs issued by a project break this rule? No, as these assets are not nodes but sources of real yield.)

For the law of value: In a close cycle tokenomics system, the sum of the cash flow value potential differences is zero as the events all occur in the inner loop. This leads to two potential results: the sum of value potential differences is ultimately balanced; or the sum of value potential differences remains zero due to the constancy of information asymmetry and value asymmetry within the closed system, which means that there will always be someone who misjudges his/her own value potentials.

Apart from Thévenin's Theorem and Kirchhoff's Laws, there are many other theorems in electric circuits, such as Norton's Theorem, which can also be transformed into financial circuit corresponding theorems such as Financial Norton's Theorem.

Below is the comparison table of parameters between financial circuit and electric circuit for reference:

Comparison Table of Parameters of Financial Circuit Theory and Circuit Theory

[Significance of Tokenomics and Discussions on Classical Questions]

The above financial circuit principle can be effective for structural analysis of tokenomics, which can further contribute to the engineering and quantitative design and management of Web3 projects. The pattern can be generalized to conduct market data research from a micro-to-macro perspective. Additionally, it can also be used for module classification to perform quantitative analysis of the local structures in finance and commerce.

According to the real-world projects described above, the economic model can be clearly expressed by the tokenomics network diagram on a basis of the financial circuit theory. Financial circuit can also be used for project management and data synchronization, team communication, work allocation, and task adjustments. In addition, on a certain time scale, the tokenomics network simulated by financial circuits can be used for numerical simulation of financial circuits, numerical calculation of financial circuits, and sandbox simulation of tokenomics to predict trends of the financial market, the commercial value, and digital economy.

In the past few years, we have seen lots of projects encountering problems in the initial stage of their tokenomics designs due to their lack of systematic strategies from day one. In their project development, only urgent adjustments are made in partial areas, which makes it challenging to achieve an overall balance. Some projects are popular in the market as some of their specific application functions are innovative; however, the lack of project completeness makes it hard to maintain their leading market position, especially when more problems arise during their middle-to-late development phases. Unfortunately, there are no remedies when they lose the advantages.  

The above phenomenon is coming to an end with the initiation of Web3. When the tokenomics tools are continuously evolving with the development of Web3 financial engineering, the entire market will usher in a new development stage.

Financial circuit and tokenomics networks are essentially a way of thinking that help explain value propositions, business models, and market behaviors. The Q&A below will discuss some fundamental questions:

Q1: How is the selling pressure formed?

A1: This question is quite classical and has already been explained to some extent when defining the value potential difference. Selling pressure usually occurs due to information asymmetry or unexpected events that lead to value dislocation, resulting in a price deviation, that is, cash is in an inappropriate value potential. Cash holders originally thought they were at a high value position, however, with the release of information and occurrence of emergencies, or when the overall expectations could not support the high value potential, they would soon discover the problems, hoping to quickly move the cash to a reasonable value potential. This process of cash dumping is selling pressure. It is essentially the process where prices return to the actual values.

Q2: Do some projects add invisible consumption in the tokenomics design?

A2: Yes. In addition to gas fees, project-defined transaction fees, and various declared consumption scenarios, there are many invisible resistances hidden in the tokenomics of projects. Some invisible resistance particularly lies in non-linear financial elements. There are many hidden details covering the adjustable resistance in the seemingly simple business model, and such approach has been widely used in traditional finance and business.

Q3: Will Automated Market Makers (AMMs) repeat the same mistakes of Luna/UST, and is there an effective way to solve the loss of balance of UST's AMMs?

A3: I think there are ways to solve the issue. Simply define in the protocol that non-linear incremental resistance can be added after the transaction volume is overly large or the price bias reaches a certain level (such as 0.5%).

Q4: Is it possible to prevent the problem by setting up a special hysteresis resistance in the protocol that can be triggered when the selling pressure causes severe price slippage?

A4: This question is a derivative question that I posed on a panel based on Q3. My answer is yes. In future finance, this may be a solution like the slow-release circuit breaker.

Q5: Will financial circuit and tokenomics networks imply the things that only be achieved in Web3 instead of “traditional finance + Web2”?

A5: There’s a lot. The launching of OpenDAO’s $SOS is adding a source of yield to the tokenomics network after OpenSea’s decision to not issue tokens. Same principles apply when projects like People capture value from the traditional world and Klima DAO capture value from the blind spot (Note 9) of the classical macroeconomic theory.

Q6: Is it only a short-term solution for the projects when they provide staking mechanisms?

A6: No. Just like the importance of inductance in the Circuit Theory, staking in the financial system is an important part of stabilizing the system cycle by taking advantage of the time difference of cash flows.

Q7: Many Web3 projects have realized that issuing linear rewards in the form of POW would accelerate their way to the death spiral in ponzinomics. How can the liquidity be better managed in this issue?

A7: Fundamentally, tokenomics with no real yield is generally driven by ponzinomics, which would eventually encounter the problem of death spiral. Thus, can the project better control the liquidity before it finds the real yield? In fact, a slight modification to the POW linear reward model would greatly alleviate such pressure. At present, many projects have abandoned the linear incentives and are using a fixed amount of daily or weekly incentives to motivate their users. This approach encloses the non-linear source of yield and ensures that the controllability of the total external releases.

Q8: Is the single utility token model likely to resist inflation?

A8: This question is a derivative of Q7. Also, in the absence of real yield, these are just empty talk. Also, moving away from linear POW incentive schemes can mitigate the timing of inflation.

Q9: What are the attributions of bonds, options, and financial derivatives in financial circuit?

A9: Many basic financial derivatives such as bonds can be regarded as staking elements or combinations of such elements. Futures, options, warrants, and put warrants can be regarded as various combinations of staking elements and the switch. Further questions such as how to define the execution rights of the switch, and whether the execution rights are linked to credit and cash, will not be discussed here, however, your feedback is most welcomed.

(There are many more questions that can be asked, and we welcome your letters)

Based on financial circuits and tokenomics networks, the marketspace for financial circuit components is likely to grow rapidly, and that the Web3 financial derivatives market also has a huge potential due to its flexibility. Generally, financial derivatives may witness the following three scenarios in the next stage. First, there can be corresponding versions of financial instruments and commodities in traditional finance created and rapidly expanded in Web3 in the next few years, such as bonds, options, and other financial products mentioned in Question 9. Second, there can be more advanced financial products and derivatives converted to Web3 through the various arrangements of protocols. The market adoption period of these products is about ten years; however, they can embark a very bright future. Finally, there can be pure Web3-native financial derivatives that are built on financial circuits and tokenomics networks and can be completely detached from traditional finance models. Examples include separable financial units, AI financial units, and non-linear and non-analytical financial units.

[The Paradigm Differences between Financial Circuit and Electric Circuit]

Finally, let's look at the paradigmatic differences between financial circuit and electric circuit. When applying economic theories to practice, especially those inherited from physical theories, rigidity and dogmatism should be specifically avoided as there are significant differences between physical particles and people, objects, and events in the social and economic context; the latter carry the characteristics of individuality, discreteness, and randomness. In fact, the theoretical models can only be reflected in practice on a relatively mid-to-macro level. 

To that, it is vital to choose the appropriate time scale in financial circuit. Managers and builders of different tokenomics networks should choose the time scale according to their project economic scale. Similarly, each model has a different amount of cash flows required to form different scale effects. Therefore, concepts such as the minimum applicable scale and the minimum grid scale should be taken into consideration throughout the numerical simulation and sandbox simulation. (Note 10).

Due to the discreteness, randomness, microscopic volatility, and instability mentioned above, it might be necessary to introduce stochastic mathematics theories and fuzzy mathematics theories in the quantitative simulation applications of financial circuit and tokenomics networks in the future. As the market matures, pulse equations and relevant methods can also be introduced for simulation and resolutions.

[Annotation]

Note 1: Emergence Phenomenon

Emergence was mentioned in the book Life3.0 written by Max Tegmark in 2018, and its extended meaning is adopted here: When there is enough amount of basic particles and components, the whole thing composed of such components will form a new phenomenon, which will be a process of quantitative change to qualitative change from micro to macro.

Note 2: Thévenin’s Theorem

For any linear electrical network containing only voltage sources, current sources and resistances can be replaced by an equivalent combination of a voltage source Vth in a series connection with a resistance Rth.

Note 3: Kirchhoff’s Circuit Laws

Kirchhoff's Circuit Laws are the basic set of law of voltage and current in electric circuits. It was proposed by German physicist G.R. Kirchhoff (Gustav Robert Kirchhoff) in 1845. Kirchhoff's laws include Kirchhoff's Current Law (KCL) and Kirchhoff's Voltage Law (KVL). Kirchhoff's laws can be used for the analysis of both DC circuits and AC circuits, as well as non-linear circuits containing electric components.

Kirchhoff's Current Law

This law, also called Kirchhoff's first law, or Kirchhoff's junction rule, states that, for any node (junction) in an electrical circuit, the sum of currents flowing into that node is equal to the sum of currents flowing out of that node; or equivalently: The algebraic sum of currents in a network of conductors meeting at a point is zero.

Kirchhoff's Voltage Law

This law, also called Kirchhoff's second law, or Kirchhoff's loop rule, states the following: The directed sum of the potential differences (voltages) around any closed loop is zero.

Note 4: There will be non-linear financial components such as financial chips in a complex financial circuit system. The financial Thévenin’s Theorem, which will be covered later in this paper, cannot deal with the problems of non-linear financial components.

Note 5: The current flow direction in an electric circuit is the direction of positron motion. Given that the electrons in the metal conductors on the Earth are mostly negative electrons, the current flow direction is reversed, that is, the current flow direction in the circuit is opposite to the electron flow direction.

Note 6: Attracting cash flows and investments is also a native source for real yield in the Web3 system, just like the token issuing. Assuming that the Web3 system is an independent economy, attracting production funding and production materials from the Web2 world or traditional financial market and transferring them into the Web3 world can be regarded as opening a wormhole in a semi-closed system, transforming supplies from other space systems, and becoming the source of its own in Physics.

Note 7: Liquidity Trap

The liquidity Trap is a hypothesis put forward by Keynes, which states that when the interest rate level in a certain period is reduced to the possible lowest level, the elasticity of demand for money will become infinite, that is, no matter how much money is increased in society, it will be stored by people. The corresponding meaning of the paradigm in financial circuit is relatively abstract: when the project team or managers fail to manage the violent fluctuation of liquidity, staking and various value assets cannot carry cash, at which point the liquidity will return to the staking elements or cause the value depreciation of the system - inflation.

Note 8: NFT will be a very special tool in financial circuit. It is a special container, which can be active or passive. When NFT is active, it becomes a battery that acts as a source of yield of financial circuits; when NFT is passive, it can either be a capacitance element or a staking element (more of a staking element in practice), depending on its specific definition in the tokenomics design in the project protocol.

Note 9: Traditional Macroeconomics states that non-market industries like ESG, urban planning, and elderly care need subsidies to form a cycle like market-oriented industries due to their characteristics of public welfare. I regard it as a point where the traditional theoretical system of market economy is incomplete, in other words, it is a blind spot.

Note 10: Grid scale is a common concept of numerical calculation in numerical simulation of physical models, which refers to the spatial scale size of the smallest calculation unit. Numerical calculations can only simulate the environment above the grid scale, whilst many random or unmeasurable factors in mathematics are ignored due to their high levels and small quantities below the grid scale. As a result, such numerical calculations often incur errors after a certain time, which are caused by the overflow of uncertainty within the scale.

[Extended Reading]

Before writing this article, I also associated kinematics with electronic circuits and was highly inspired by their similarity. In kinematics, tie rods, dampers, and springs also comprise the essential three elements, showing a mathematical differential progression relationship. In addition, the mechanism of gravitational potential difference and gravitational field is very similar to the electric potential difference and electric field. However, it is challenging to generate comparative discussions between graviton and graviton flow due to the lack of relevant resources.

Gary Yang 杨歌

Founding Partner, SkySaga Capital 

Managing Partner, Eureka Meta Capital

Investment Partner, Solv Protocol 

October 3rd, 2022