Why Governance Tokens Matter

Over the last two years, we’ve seen Ethereum evolve from being an investment bank-like platform for chuck-e-cheese tokens to a computing platform for permissionless financial applications.

Despite the UX being subpar, for us crypto nerds it’s difficult to not be blown away by what is now possible after you play around with the suite of DeFi protocols/applications available today.

However, with DeFi’s rise in popularity, we are now seeing more and more of these protocols offer investors equity-to-governance token conversions. The tokens are then being made publicly available via decentralised exchanges (DEXs).

For many investors, this looks and feels like the infamous ICO.

So, is the governance token yet another chuck-e-cheese token? Do they really capture value beyond speculation?

The Problem

For every business in the world, they tend to bring together three groups of people:

  1. Capital providers — those that provide the start-up financial capital and own the shares in the company. They hold all of the decision making power.
  2. Supply-siders — those that provide the human or machine capital that ultimately creates a good or service. These can include employees or independent businesses.
  3. Demand-siders — those that purchase the goods or services to fulfill their needs. They are the customers.

Each of these groups has its own set of interests that do not necessarily align. Shareholders want to maximise profit, supply-siders want to charge the highest price, and demand siders want to pay the lowest price. Thus, demand and supply work opposite to each other.

In highly competitive markets  this inter-relationship works very well. However, things begin to get ugly when a company that seeks to bring demand-siders and supply-siders together starts to attain strong network effects. They no longer experience significant threats from competition. Neither demand siders nor supply-siders have a viable opportunity to move to an alternative solution that can offer the same quality of service offered by the company, because most if not all of the value comes from the ‘network’.

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Figure 1: The three-way tug of war. Network effects give ‘capital providers’ (shareholders) an unfair advantage.

Like it or not, mass-market network effects are an insuperable barrier to entry. Once a company attains it, the end result is a shift towards monopolisation where a single company dominates the facilitation of interactions between network participants. Since capital providers (shareholders) possess all of the decision making power, the balance of power swings in their favour. Therefore, we witness value being pushed unjustly away from their natural equilibrium point to the detriment of the network participants (see Figure 1).

The Problem When Applied to DeFi dApps

Just like traditional businesses, DeFi protocols still attain their competitive advantage through network effects. Even though DeFi protocols run their logic on a decentralised IT infrastructure (Ethereum), the code that governs the application can still be tweaked by those in control of the smart contract admin keys.

Therefore, it is easily achievable to have a for-profit business behind the scenes with the power to tweak the code in order to increase their share of the transaction fees. Dy Dx or Uniswap in their current form are a good example of this.

As these protocols start to mature and attain stronger network effects, there will be a greater tendency for the shareholders of the company behind the DeFi protocol to leverage their negotiation power and extract more and more value from the network for the betterment of the shareholders.

This takes us back to square one: monopolisation.

Value extraction aside, history has shown us that the centralised management of network-orientated services either end up: restricting access to a select group of users (limiting growth) or unjustifiable censorship. For DeFi this may mean either bad actors or unjustly regulators muscling in and potentially shutting down the party for all or a select few.

The Solution: Governance Tokens

The introduction of the governance token allows us for the first time to introduce a network-orientated offering that is able to maintain fairness between the three groups of people (capital providers, demand siders, and supply-siders) even after network effects start to take hold.

What is a governance token?

Governance tokens give holders the power to influence decisions concerning the protocol and changes to governance parameters. Changes may include introducing a transaction fee and distributing those cash flows to the governance token holders. Now, I know what you’re thinking – this sounds eerily like a security. You’re not wrong… However, in this particular case, the governance token does not necessarily represent a share in a “company”, but instead a share in a “protocol”. It is due to these expected future cash-flows that give the token the same value accrual properties that are similar to something like a tech stock.

How is this not classified as a security then?

First of all, governance tokens upon launch do not promise holders cash-flows nor do the issuers explicitly state that they will be. Investors and users, however, purchase (or earn) these tokens with the expectation that sometime in the future when the protocol is progressively more decentralised, the majority of the token holders will vote and come to a consensus regarding the introduction of cash-flows.

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Figure 2: Progressive decentralisation of voting power over the protocol (from the founding team to the entire ecosystem).

Some time ago a member of the SEC unofficially announced that ETH is not a security as it is considered ‘sufficiently decentralised’. By that, they meant that according to the Howey test there was no evidence that the profits investors hope for are ‘dependent upon the work of a third party’.

Now, I’m not a lawyer so do not take my word as gospel. However, from my understanding, layer-2 protocol builders (i.e. the founding team) have the power to follow Ethereum’s lead by progressively giving executive-level decision making power to the wider community over time.

Achieving a sufficient degree of decentralisation prior to the token holders agreeing to reap ‘cash flows’ may prevent the asset from being considered a security. As it is known, decentralisation means that there is no longer a centralised authority that has the power to change the rules. Even if the regulatory authorities were to intervene following a vote in favour of cash flows, they would not be able to do anything about it. There would be no “CEO” to go after, similar to how there is no CEO of Ethereum or Bitcoin.

So, why is this model better than the legacy business model?

Unlike the legacy model, the critical decision-makers behind a protocol do not comprise solely of profit-seeking capital providers. With the introduction and distribution of protocol-specific governance tokens, they may also include the actual users (demand-siders and supply-siders).

As a result, when the time comes for token holders to vote on whether or not the protocol should introduce transaction fees, the real users now have a voice that holds weight. We start to see market forces trend towards a fairer equilibrium price point even as the network effects progressively get stronger and stronger. This is in stark contrast to our existing model that works in the opposite direction (extracting value for the few).

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