The State of Governance token distribution: the missing piece for sustainable protocol’s development
Governance token has been optimized and thought through for decentralization by fairly distributing token to users to defend design features and control mechanisms’ immutability. Although a good start, it’s only one part of the equation, as those systems need strong incentives to attract active contributors to ensure projects’ sustainability and development.
A quick definition: Governance tokens confer holders the power to influence decisions concerning the protocol, product or feature roadmap, and changes to governance parameters. Those projects have mechanisms that need to be updated over time, such as the codebase and token design. Tokens with governance rights confer holders some degree of influence over these issues, typically through a voting process.
The governance token frenzy started when Compound launched its COMP token, which allowed the community to propose, vote, and implement changes to the protocol. Compound’s goal was to decentralize the protocol fully and to do so, it distributed COMP to users of the protocol. This has proven to be a great way to bootstrap liquidity (aka network effect), with users of the protocol, borrower and lenders, rewarded for their usage with token directly distributed to them. Since launching COMP, the platform grew from $98 million to $600 million TVL in a week. From there, many DeFi protocols have followed suits. Yearn Finance, a decentralized asset management platform with multiple uses ranging from liquidity provision, lending and insurance, launched YFI token to reward its users from the fees it earns on its platforms as a form of a dividend. Balancer, the automated market maker, offers a liquidity mining campaign, in which Balancer users are rewarded with BAL on a running basis. The list goes on. This trend essentially created a template for layer two protocol token model in which you end up with a smart contract at the center where the supply side provides some service, and the demand side pays for it, and the governance token holders capture some share of the payment, all in a way that’s entirely automatic where a contract just divides up the fee that’s being paid and distributes in many ways.
As noted above, rewarding users token have proven to be a great way to bootstrap some early traction, rushing speculators to earn the maximum reward. This behaviour was even coined “yield farming” where users go to whichever protocol has the highest yield. Bootstrapping network effect is the most challenging endeavour for those multi-sided platforms early on. As liquidity gets built, the products get better for users, which attracts more of them, and a flywheel starts to creates. For Compound, the more supply of capital (lenders), the better for borrowers, in the form of lower cost of borrowing. Similarly, the more demand for capital (borrowers), the better for lenders, in the form of yields. As both supply and demand increase, the protocol’s stability increases, which is attractive to both parties. The same applies to YFI, where the more capital is poured in, the lower the spreads on any transaction. It helps protocols reach a critical mass that improves their offering and bet on the protocol’s reflexivity to convert some of those early speculators to community members.
Hence, governance token reward distribution has thought about bootstrapping network effect, but is it sufficient to guarantee long-term success? Is it the end game?
The current governance token reward mechanism promotes the bootstrapping of liquidity in those multi-sided platforms, optimizing their product in their current form. However, no mechanism has been thought through to incentivize the active contribution to those projects’ development. At this point, token holders can submit and vote on any proposal for the protocol, but they are not (directly) financially incentivized (aka paid for their contribution) to improve or create new features for the protocol. The only incentive is indirect, as by voting on improving proposal, the value of tokens should increase. Note that with this current mechanism, non-token holders are not incentivized at all to contribute.
Conversely, those are dynamic projects that should be updated overtime to keep up with innovation. Thus, they need dynamic, human, subjective inputs to ongoing operations, which need to be incentivized. A mechanism of token reward for active contributors to the protocol should be put into place, as those are paramount for the protocol’s survival.
Let’s take the example of Uber. It has been cited many times that early Uber drivers didn’t get any of the upsides from Uber’s growth, even though they were strategic early on in providing liquidity to the platform. Here, you could imagine a token reward distribution to the drivers for their labor, similar to DeFi’s protocols. This would undoubtedly have increased the liquidity of the platform early on. However, the Uber app’s critical contribution has not come from drivers, nor riders, Uber’s supply and demand side, it came from its employees that made the strategical decision and made the app what it is today. Those executives were rewarded stock options for their active contribution. Without those incentives in place, I doubt Uber would have been able to attract the brightest mind to work on its platform. The same line of thoughts should exist in DeFi protocols today. Taking the Uber metaphor, DeFi protocols reward drivers and riders for providing liquidity and expect them to steer the ship through community governance.
Thus, the missing piece of DeFi protocols is those stock options for active contributors that enable the protocol to grow and improve their offering. Ryan Watkins, from Messari, proposed something along those lines with his proposal for YFI, where he said that contributors such as strategy writers, protocol politicians, developers, content creators and liquidity providers should be awarded a predetermined amount of YFI for their contribution. This should be evident.
Coming back to Compound and comparing it to its closest competitors, Aave. Both are money markets where lenders provide capital to borrowers. Even though COMP token has enabled the protocol to attract liquidity, Aave has rolled out many new features such as offering stable interest rates, allowing users to switch between stable and variable interest rates, enabling flash loans, uncollateralized loan, that helped it to grow substantially more than Compound, although it launched its token later. This might not have been the case if Compound had incentivized active contributors. (not to say that Aave is currently doing it).
Rewards could be a predetermined amount of token for realizing an action. This enables contributors to know beforehand the amount of their reward for their labor. Plus, a variable reward could even be implemented if the contribution has increased profits, thus sharing the upside with the contributors and giving them skin in the game. The difference in reward between contributors comes from the impact each has on the future of the platform. Active contribution (developers, employees, etc.) to adapt the protocol to a changing environment is paramount to the platform’s future. In contrast, liquidity (drivers and riders) contribution is more mechanic and less defensible.
I’ve tweaked the flywheel Ali Yahya used during the Crypto Startup School early this year to accommodate for DeFi protocols and rewards to active contributors.
Here, the protocol itself is a common ground that enables the direct interaction between all of these participants. With four different sides, this multi-sided platform, the investors, the governance participant (token holders + delegators), the active contributors and end-users, can directly interact and trust each other due to the enforceable rules and game-theory incentives put in place. The more financial capital enters the ecosystem through outside investors, the greater the token value, and the more incentives (aka stakes/skin in the game) to provide thoughtful governance for delegators. A better governance system attracts active contributors that want to build on a reliable platform, in addition to being rewarded in a token that has more significant upside potential. As more active contributors join, the networks become more useful to users because there is now a better / greater offering that users can leverage. As the platform becomes more valuable and has more users, there are same-side network effects because external contributors want to join the platform with the most activity. The same thing for users; they prefer to join the platform with the most engagement. Those feedback loops are paramount in growing the platform and should result in a winner taking all dynamics. Those network effects are so powerful that it’s hard to bootstrap elsewhere and the token end ups capturing a monetary premium.
In DeFi, considerable effort has been spent defending the immutability of the design features, the control mechanisms that govern the system and the token distribution to ensure decentralization. The lack of incentive to attract active contributors hinder those protocol’s ability to evolve and improve, which is paramount for long-term success, especially for dynamic project.
