Crypto’s new Craze – Governance Tokens

Most DeFi protocols rose to prominence in 2020 using valueless governance tokens. But emerging protocols are avoiding this model in favor of one which promises much more than just basic voting rights.

Giants like Uniswap and Compound have used the governance token model to fuel their growth to 10 figure market caps, but $COMP and $UNI are known to be “valueless” governance tokens. Holders get no direct economic benefit — like a right to cash flows — for holding them.

This model isn’t ideal, but was necessary to avoid regulatory scrutiny and allowed new protocols to tokenize faster. The valueless governance model has diminishing returns and lacks fundamental demand drivers. Worse, valueless governance tokens paired with large token emissions are a recipe for declines in prices. 📉

This is already playing out. Despite the continued growth for these protocols over the past year, major DeFi tokens who have the valueless governance token model didn’t perform well.

(An index of valueless DeFi governance tokens against ETH.)

But there’s a new DeFi model which has been gaining traction: the veToken. Pioneered by Curve, the veToken model is baking value into the core of its governance tokens.

Most of the information here is from Ben Giove an analyst for Bankless. I highly recommend checking out Ben’s work and the rest of the Bankless ecosystem which is full of some of the best information in the space.

The veToken model involves token-holders taking on the risk of locking their tokens for extended periods of time in exchange for specific rights, such as governance power, within the protocol.

Fueled in large part by internal governance wars over pool rewards on the Curve DEX the price of CRV, and its largest holder, CVX, outperformed the Defi Pulse Index’s gain of 12.2% in Q3 and Q4 2021,by returning 265.4% and 1085.7% respectively. Some of the tokens in the DeFi Pulse Index include Aave, Balancer, Compound, Loopring, Maker, REN, Sushi, Synthetix, Uniswap, and Rari Capital.

As a result of this outperformance, DAOs across DeFi already have or are planning on pivoting to a “veModel”

This begs the question:

• Why exactly has this model been so successful?
• And what are the drawbacks of ve-tokenomics?

Let’s find out.

The OG Ve Token — VeCRV

At a high level the ve-model is simple: Holders are trading short-term liquidity in exchange for benefits within a protocol.

Curve has done a great job pioneering this model.

Curve is a decentralized exchange that is optimized for swapping “like-assets,” which are assets that are intended to have a similar price. This includes facilitating trades between stablecoins, such as USDC and USDT, or a token and a derivative, such as ETH and sETH (or Synthetix Eth).

Similar to its peers Uniswap and SushiSwap, Curve is governed by its own native token, CRV. However Curve’s token model differentiates from the former. To participate in governance and to gain the full benefits of holding CRV, Curve holders are required to lock their tokens. Each holder can determine how long they’d wish to lock, which could be as short as one week or as long as four years, with governance power proportional to the length of time they choose.

Lockers are issued veCRV (vote-escrowed CRV) which represents a non-transferrable claim on CRV, meaning their holdings are illiquid for the entirety of the locking period.

Although holders are giving up liquidity, they are being compensated for this risk by being awarded special privileges within the protocol. VeCRV holders are entitled to a share of the fees generated from swaps made on Curve, boosted CRV emissions when providing liquidity, and as previously mentioned, governance rights.

This last perk is particularly important as emissions to Curve pools (known as gauges) are determined through a veCRV holder vote.

As seen by the “Curve Wars” control over emissions can be incredibly valuable to protocols like stablecoin issuers, as it determines the yields, and therefore liquidity of a given pool.

The Benefits of This Model

This model has several benefits, the first being:

1. Encouraging Long Term Oriented Decision Making

At its core the ve-model incentivizes long-term-oriented decision-making. This is because by locking their tokens for a certain period of time (typically up to 4 years), a holder is making a long-term commitment to the protocol.

In doing so, this provides them with an incentive to make long term decisions that are in the best interest of the protocol, rather than short term manipulation.

In the fast-moving and fomo-inducing space of DeFi, the ability to foster a holder base that is long-term oriented is incredibly valuable.

A second major benefit is:

2. Greater Incentive Alignment Across Protocol Participants

The ve-model aligns incentives across a wide swath of protocol participants and stakeholders.

Curve is like other DEXs in that it uses third-party providers as its source of liquidity. Like its competitors with active liquidity mining programs, Curve LPs receive indirect exposure to the CRV token, since CRV emissions make a portion of the yield paid out from each pool.

However, where Curve differentiates itself, and where the ve-model shines, is that Curve LPs are incentivized to hold their CRV tokens, rather than sell them into the open market. That’s because if Curve LPs lock their CRV, they’ll receive a boosted CRV yield that is up to 2.5x greater than LPs who do not lock.

This mechanism serves a valuable role in that it has the potential to place a greater amount of CRV in the hands of liquidity providers. In doing so, it helps to align incentives between tokenholders and liquidity providers by increasing the overlap between the two groups.

This incentive alignment is incredibly valuable because the two groups often have competing interests.

For instance, in the case of a DEX, both liquidity providers and tokenholders generate income by taking a share of the same swap fee. This can create conflict within a DEXs community, as they risk losing liquidity, and damaging the quality of their product, by redirecting a portion of said fees to tokenholders.

In not directing fees back to their native token, a project runs the risk of upsetting and disengaging their core supporters who want to see a direct economic benefit.

The third benefit of the ve-model is:

3. Improved Supply & Demand Dynamics

While it can be dangerous to focus too much on token price, a token is a gateway into the community. Buying a token is how people participate, support, and share in the upside of a project. Because of this, to attract and retain talented, value-add community members, it’s important for a protocol to have sound tokenomics.

As mentioned before, the first iteration of DeFi governance token created perpetual sell pressure with no underlying demand to help stem the downward tide.

Although ve-tokens are not immune from market weakness, they still help in addressing both the supply and demand problem by providing an economically-sound foundation for these protocol tokens.

One the supply-side, vote-locking serves as a mechanism to remove tokens from the open market. We can see here existing ve-tokens are being locked at very high rates.

Although reflexive, the ve-model has also shown to generate demand for the underlying token.

With all this being said, veTokens aren’t without their drawbacks.

Downsides to veTokens

One downside to the ve-model is a

1. Lack of Liquidity

Although removing liquidity from tokenholders provides an incentive for them to make long-term-oriented decisions, it can also pose challenges for a protocol.

For example, it runs the risk of concentrating ownership in apathetic stakeholders.

Were a bunch of holders to lose faith in the protocol, they would have no way to exit their investment thus throwing the incentive alignment out of balance.

Another downside is

2. Vote-Selling or Bribes

Bribes have exploded in popularity across DeFi, with platforms such as Votium and Hidden Hand facilitating tens of millions in bribes from various protocols for the Curve, Convex and Tokemak ecosystems.

Although they have proven useful in providing a cheaper way for protocols to attract liquidity, bribes have the potential to introduce new systemic risks for a protocol that undermine the long-term oriented incentives that come with vote-locking.

For example, were a monolithic lending market such as Compound to switch to a ve-model that enabled bribery, it would be possible for a sketchy project to buy their way into becoming collateral on the platform increasing the chance of an insolvency event and undermining the protocol’s safety, stability, as well as trust among users.

Price Performance Among ve-tokens

In this table we can see the price performance of each token since either the launch date of the implementation of their ve-token, or the date of a public announcement stating their intentions to switch to the model. It also measures the price performance of two benchmarks, ETH and DPI, during that same period.

As you can see, seven of the eight tokens have outperformed both ETH and DPI since their launch or announcement date. Although this data may be skewed in some respects, as many of the launch announcements have come in recent weeks, it does suggest that there is validation for the ve-model among the market and investors.

The Future of ve-tokenomics

The ve-token model has emerged as a popular alternative among DAOs to the valueless governance token MODEL by encouraging long-term-oriented decision making, aligning incentives across protocol stakeholders, and creating more favorable supply and demand dynamics for price appreciation.

Despite coming with clear tradeoffs which we’ve yet to see the full extent of, such as illiquidity and vote-selling, the ve-model feels like a step in the right direction for DeFi token design.