Navigating governance designs in crypto economies

We see governance systems operating around us all the time — elections, shareholder meets, board meetings, local community councils etc. Each have a set of rules and laws on which they run, whether its their constitution, articles of association etc. The base rational assumption is that those rules are static, for example — no material changes have happened to Companies’ Law in decades.

In Crypto, however, assumptions of stasis don’t hold true. Every governance system is a set of evolving ideas and experiments, making its hard for participants — founders, investors (both public & private market), and employees/contributors, to declutter the noise and make informed decisions.

Fascinated by these governance experiments for some time now, I try to figure out where they are headed & what insights both investors and builders can draw to use this era of experimentation to their advantage.

Part I: The convergence of real-time markets and politics

Niccolo Machiavelli, a renaissance Italian diplomat considered the father of modern political science, made a case for extreme pragmatism in political life, often to the extent of it bordering ruthlessness.

We see his ideas play out in every social forum in full force. Except in public markets, where robust securities laws & the fear of prosecution holds back otherwise cold-blooded investors.

This restraint, however, does not exist in Crypto — an oasis where players have an open canvas to test out political experiments in parallel with active markets.

Let’s take an example of what I mean — voting on a company’s shareholder meeting happens based on a snapshot of the shareholder’s register signifying who holds how many shares, usually 15-30 days before the meeting. What if voting could be done as the shareholding pattern changes in real-time? What if you could buy shares in the market and participate in the vote in real-time, and sell shares post the vote’s completion? This would create a whole new world of new strategies, opportunities and risks that don’t exist in markets today.

Part II: Not all votes are created equal

Our intuitive assumption in a ‘1 share:1 vote’ system is that the governance value of each share is inherently equal. However, this isn’t true. Usually the value of the marginal vote is directly related the present balance of the collective vote. Think about it, in case of a split decision — the value of the marginal vote is infinite, depending on which party is willing to bid more for it. In contrast, in a vote which is overwhelmingly in a particular direction, the value of the marginal vote is near zero.

We don’t usually think about the financial value of a vote intuitively due to the fact that legal constraints like securities laws prevent creative methods of creating a market for these votes (ahem, ahem — Bribing)

What changes in crypto?

1. Votes run in parallel with free markets — an investor can buy tokens simply to influence a vote and sell the tokens immediately post the vote.
2. Votes have a financial value — Bribes are freely allowed, as well as actively encouraged by the underlying protocols to create financial incentives for token holders
3. Governance design is an open canvas — Governance structures are not limited to the constraints of companies law, allows founders to be creative in designing their capital structure and voting mechanisms.

Part III: This is no longer a theoretical experiment

You might be thinking, what is this guy on about?? Well, the truth is some of these ideas are already being experimented with billions of $ in value.

For example — the Curve Wars.

For context, Curve is the most important destination for stablecoin liquidity in crypto. Stablecoins live and die based on the deep liquidity that is available for users to freely enter and exit such tokens. Hence every stablecoin issuer has a strong incentive to make sure that they have the biggest markets on Curve.

Curve, to boost its AUM, also incentivises different pools of liquidity by distributing its own native token $CRV. But how does Curve decide which pool gets the incentives? Well its simple — curve runs a weekly vote called the ‘gauge’ where $CRV holders vote in favour which pool gets how much share of that week’s $CRV incentives.

Current incentive distribution on Curve via the guage

Emerging stablecoin issuers like Terra or Wonderland, quickly realising the importance of having deep liquidity on curve to build user trust, started offering payouts or ‘bribes’ to $CRV voters to vote for their pools in the gauge, effectively creating a market for buying votes.

The Curve DAO, realising the power that their governance votes held — introduced an ingenious improvement to their token model that made the bribing system work in their favour — voter escrow. Any $CRV holder could lock their curve tokens for a max of 4 years, to multiply their governance power. For example,

1 $CRV — not locked = 1 vote

1 $CRV — locked for 1 years (veCRV)= 2 votes

1 $CRV — locked for 4 years (veCRV)= 5 votes

This worked strongly in favour of curve as it resulted in a significant number of $CRV holders locking their tokens and increasing demand for the $CRV token. This isa powerful early example of how creative and thoughtful token design can really use new governance primitives to tokenholders’ advantage.

Part IV: Wielding the governance sword as a founder

Building an early stage crypto protocol is already a hard job, with the free market pushing and pulling the business model to its breaking point. Bad governance design in the early stage risks derailing promising projects — making them vulnerable to attacks and takeovers.

Here are some tips that I think might help provide useful frameworks for founders to think about their governance design:

1. Time — If a holder believes that their vote has long-term recurring value, maximise their governance power via long term lock-ins. Curve does this with $veCRV.
2. Concentration — Encourage vote delegation to leaders in the forum for healthy debate and informed voting. This risks creating oligopolistic control, which may be mitigated via requiring escrows by leaders to protect against malicious acts.
3. Back to basics — Split decisions into ‘day-to-day’ & ‘material to protocol’, appoint an operational committee (similar to BoD) in order to reduce the chaos involved in protocol governance. Synthetix uses councils appointed by token stakers to achieve this objective.
4. Skin-in-the-game — Bring in staking/deposit requirement to introduce a proposal (either own or delegated assets). If the proposal fails to achieve quorum of votes, the deposit is forfeited. This can protect against frivolous votes, albeit risking proposal concentration.

Part V: Maximising governance Value as an investor

As an investor, crypto is difficult to understand. Tokens are hard to value, governance forums are full of noise, and there are enough hacks and frauds to make Charles Ponzi himself blush.

But that’s where the alpha lies. The best investors & traders that can navigate through these muddy waters stand to reach a bastion of supernormal performance that tradFi investors can only dream of (e.g. Jump, Alameda etc. have had performance unparalleled in tradFi). And I believe that a new frontier for alpha generation will be to identify and exploit imbalances in protocol governance.

I’ve been spending some time on figuring out how steady state token pricing gets influenced by governance in different circumstances. While I don’t claim to be an expert, I’ve come across some frameworks that I think reasonably play out as these governance matures:

1. The kingmaker premium — When governments get hung due to no majority, especially in emerging markets, smaller voting power holders extract outsized value by becoming kingmakers. As crypto protocols mature, hung governances will become commonplace. Kingmaker positions will appear as alpha opportunities in oligarchic protocols, where economic incentives to vote in directions might create short term outsized profits.
2. The activist’s option — A large number of DAOs have significant treasuries with the implied option of distributing cashflows to users, investors holding material percentage of the protocol can value the current option price of flipping the switch in defining ‘activist’ decision making. However, we need to see how evolving securities regulation influences these choices.
3. Controlling the pipes — Few protocols enjoy being key primitives (like Uniswap) — which have an outsized systemic importance to on-chain economies. But, surprisingly, very few of their tokenholders actually vote. Active governance participators should get a premium for making protocol decisions, as this impacts downstream users of composable architecture. e.g. less than 2% of $UNI holders actually vote/delegate.

% of UNI holders that actually vote/delegate

Part VI: Closing musings

Crypto is new, it’s fun, it’s exciting, mostly it’s scary as hell — for founders, investors (both institutional and retail). The ride is bumpy — and many things keep breaking & so will the ideals around governance. But, that’s what most of us are in it for — exploring early unexplored frontiers.

It’s imperative to trust the iterative process. Crypto governance will find steady state. Nobody can say when, but it will happen. Till then we keep experimenting with novel systems and governance designs as the industry slowly marches towards battle-tested social systems.

Feel free to DM me on LinkedIn or Twitter to if you have any questions, or just want to say hi.