Misconceptions and Value Capture About Governance Tokens

Originally published at https://www.haydonluo.com on March 20, 2023.

As an investor who observes cryptoassets closely, I find the token investment of blockchain projects an exciting field. However, I have also noticed some fallacies when it comes to investing in governance tokens. In this post, I will explore these common misconceptions and explain why many governance tokens struggle to capture value efficiently. Following that, I will delve into how governance tokens can be designed to capture more value.

The “DAO Governance Tokens Are Similar to Company Stocks” Fallacy

Investors migrating from traditional finance often invest in tokens as if in equity. This notion that “governance tokens are akin to common stocks as they both offer voting rights” can result in two mistakes: misunderstandings about the value of protocol governance, and blind assumptions that tokens will appreciate in value as the protocol grows. Let me elaborate below.

Value of Governance = Protection of Future Assets

The value of a stock is derived from current dividends and future net cash flows. Shareholders can claim future net cash flows because they own the company. Corporate governance ensures that future cash flows don’t deteriorate. Even if future cash flows did deteriorate, shareholders are still entitled to a residual claim on assets because, again, they own the company. Essentially, the value lies in ownership rather than governance. My contrarian view is, the function of governance is to preserve the value of the ownership — if the ownership has no monetary value, then the governance right of that ownership also has no monetary value. As an analogy, if you don’t have money, having bodyguards is of no value.

Now let’s consider governance tokens. Governance tokens do not explicitly represent ownership of the underlying protocol to avoid regulatory scrutiny. And if the project went bad, what can token holders claim? Open-source smart contracts? Therefore, governance tokens do not have value derived from ownership or residual claims, and the fundamental way for governance tokens to have value is to share some profit (e.g., provide cash flow). This way, governance tokens become valuable not only because of the cash flow that they bring but also because cash flow can be governed, making governance meaningful.

Unlike stocks, a generic buyback-and-burn mechanism for governance tokens does not share revenue unless there is an expected cash flow concurrently. This is because buyback-and-burn only increases the relative governance power of token holders, which alone does not have monetary value according to my argument above. Similarly, if the revenue stream provided to holders is denominated in the same token that comes from emission proportionally, then it is not profit sharing.

While regulatory concerns may exist if protocol revenue is shared with token holders, the design space of revenue sharing is vast, and I am optimistic that good mechanics will emerge.

Value of a Protocol ≠ Value of its Token, but Speculative Value of Token ∝ Protocol Earnings

Due to a lack of clear ownership, governance tokens do not necessarily appreciate in price as the protocol grows. For instance, Uniswap saw increased traction following FTX’s collapse, but UNI’s price mostly decreased (Source: Token Terminal). An article that confuses the value of a protocol with the value of its token is found here, which was well written until it incorrectly used (total present value of MakerDAO)/(# of MKR in circulation) to valuate MKR. [Disclosure: I am bullish on MKR but bearish on UNI because the former has defensibility while the latter does not.]

Nevertheless, governance tokens do possess speculative value. Governance tokens of a protocol with significant retained earnings might hold more speculative value, as token holders could potentially vote to unlock large benefits in the future, such as from project treasury. However, not many protocols can release such benefits substantial enough to attract institutional investors, because they face a dilemma — To unlock benefits, a protocol must retain earnings by extracting value from liquidity providers or users; but extracting too much value drives them away, causing the protocol’s failure.

To resolve this dilemma and enable speculations that support its token price, a protocol must charge and retain an appropriate level of fees, neither too high nor too low, and have justifiable reasons, which should benefit all involved parties, for doing so. Multicoin Capital’s post Protocols Don’t Capture Value, DAOs Manage Risk suggests that risk management is a good reason (presumably in DeFi), but I would add that other verticals may have alternative reasons. For example, in NFT exchange/gaming space, a good reason could be reinvesting retained earnings into a foundation that builds the functionality the community needs. Or, in creator economy, a platform using proceeds to fund future creations by users’ favorite artists

This strategy can serve as a temporary status until cash flow can be provided, such as when overhanging regulations become clear.

A short summary of this section:

Governance tokens are inherently different from equity. To make governance tokens valuable, a fundamental way is to provide holders with a revenue stream, and a speculative way is to retain some earnings in the treasury for the benefit of the parties involved. Protocols that fail to do either would render their tokens worthless.

Another concept regarding governance tokens is the idea that, in addition to governance rights, they also have utility value (e.g., pay protocol fees, buy services provided by a protocol), which stocks do not offer. However, this concept is largely outdated, unless “utility” also refers to participation in governance. I explain further below.

The “Governance Tokens Have Utility Value” Fallacy

The Departure of Utilities from Governance Tokens

Tokens that have both (non-governance) utility and governance right may create a misalignment between utility and token price. This misalignment exists under the traditional “token as money to pay” or “token as voucher to redeem” models, where token holders typically want the token to appreciate, while protocol users want to pay lower prices.

There are two solutions to address this misalignment. The first is to remove utilities from governance tokens, which is why there has been a trend of utility detaching from governance tokens in the DeFi space over the past few years. For instance, 0x shifted its protocol fees from being paid in its token ZRX to being paid in ETH and eventually to zero, leaving ZRX a pure governance token. [Side note: I’m not surprised that 0x removed protocol fees, as I mentioned above protocols need a good reason to charge fees and 0x clearly doesn’t have one. ] The second solution is to adopt alternative token models, such as the work token model (Multicoin Capital has a great article on this model), which eliminates the misalignment because it requires locking/staking for both utility and governance. Under this approach, the properties of utility should predominate, since the value of the token comes primarily from income from performing work, not from governance. Therefore, we refer to tokens as work tokens rather than governance tokens. An example is Livepeer’s LPT, a work token with governance rights.

In either solution above, it would be wrong to claim that governance tokens have value derived from their utility.

Governance as a Utility

From another perspective, the governance itself may present a utility to the token holders. The utility lies in becoming a part of the online community and gaining access to the DAO’s decision-making process. However, the value of this utility grows sub-linearly as the protocol grows, suggesting that governance utility alone is hardly a justification for institutional investment. Metaphorically speaking, the price of this utility is like an organization’s membership fee, which does not quite grow with the size of the organization.

Crypto-Native Ways for Governance Tokens to Capture More Value

Above, we discussed why most governance tokens fail to capture value effectively, including lack of revenue streams, lack of fees or compelling reasons to charge and retain fees, limited utility value for governance, and general lack of other utility functions. Now, let’s explore how to enhance the value-capturing capability of governance tokens. It is essential to note that the previous discussion approached the value of governance tokens from a stock-like perspective. However, I strongly believe that, as an innovation distinct from equity, governance tokens should have crypto-native ways to capture value, that is, in ways that stocks cannot. Let me detail these methods below.

Individual Consequence, Not Collective Consequence

For a public company, its decision-making will ultimately affect the stock price, and the price change is collectively borne by all shareholders. DAO governance can actually do something different here to hold voters individually accountable for their decisions — although the token price is still the same for all holders, on-chain governance enables individual and uneven adjustments of other attributes of holders. For example,

• Unevenly distribute revenue to token holders: Governance token can capture more value if it allows each token holder to benefit individually based on their vote. This is because conventional voting often leaves most voters unaware of how their votes move the needle, while individually consequential voting makes each vote more perceivable to holders. Curve’s mechanism exemplifies this, where veCRV holders vote on pool rewards. Each holder’s willingness to pay, anchored by individual revenue, is captured as token value.
• Directly adjust the number of tokens staked by a token holder as a reward/penalty: Vitalik Buterin proposed this idea based on futarchy (see “Solution 3” of his blog post for details), where governance voting can be designed like a bet: if you make good governance decisions (“good bets”), you receive more tokens proportionally. Conversely, if you make a “bad bet”, you lose your tokens proportionally. Augur, a decentralized prediction market, employs a similar mechanism to incentivize its users, although for business operations rather than governance.

In short, on-chain governance could unlock the individual potential of each token holder, allowing governance tokens to capture more value. As a side note, the second approach above also appears to be a possible way for governance tokens not to be classified as securities, as profits would be derived from the good decisions of token holders, rather than from “the efforts of others” as stipulated by the Howey Test.

Give Variable Weights to Governance Tokens

In DAO governance, the “one token = one vote” concept can be tuned to encourage better governance decisions. There are a few ways to achieve this:

• Vote escrow (“ve”) to promote commitment: under veTokenomics, holders can lock up their tokens for a fixed amount of time in exchange for increased voting power. This mechanism can prevent short-term manipulation such as rug pull. Curve is an early adopter of vote escrow.
• Quadratic voting to discourage whales and protect minorities: In quadratic voting, the cost of casting more than one vote for an issue is quadratic, not linear. This would weaken the voting power of whales, giving more voting weight to small token holders.
• Idea meritocracy to promote expertise and credibility: Idea meritocracy is a decision-making system where the best ideas win out. Ray Dalio introduced this system, in which his employees openly rate each other’s credibility across multiple domains, and those with higher ratings are given greater weight in decision-making in that domain. While currently this system is rarely adopted, it may be helpful for DAO governance in the short future, as opinion leaders emerge in various DAOs. Note that this system appears similar to delegated voting, but many current delegated voting designs involve financial incentives that can distort decision-making. Therefore, I believe that idea meritocracy still has a unique value proposition in DAO governance, especially if weights can vary across domains of issues.

These approaches can increase the value of governance tokens by fostering a better community and leading to better products and services. However, two caveats exist. Firstly, I argued earlier that good governance is not sufficient to support the value of the associated governance token. Retaining proceeds in the protocol or distributing revenue to token holders is still desirable, as seen in Curve’s use of vote escrow in conjunction with governing the revenue stream.

Secondly, there is a sweet spot for variable weights; overly skewed weighting can be detrimental. A similar structure in corporate governance is dual-class share (DSC) structure, where one class of shares has superior voting rights. The CFA Institute conducted a report on DSC structures and concludes that companies with DSC structures often underperform over the long term (see Chapter 2.4 of the report for details). The report supports a middle ground — DSCs with sunset provisions (meaning super voting rights lapse over time) generate a premium compared to perpetual DSCs. Interestingly, this seems to support the rationale behind veTokenomics that voting power lapses over time during the lock-up period.

Constant, Automatic, and Well-Known Buyback-and-Burn in a Deflationary Environment

Let’s consider MakerDAO. I am bullish on MKR, but for different reasons than many investors. MakerDAO is an excellent protocol in terms of both governance and product, but as I argued above, the effect of governance utility on price is sublinear, and, in the crypto field, a good product doesn’t often translate to the value of associated governance tokens due to the lack of equity. Furthermore, MakerDAO has never directly distributed revenue to MKR holders (as I argued above for governance tokens, a generic buyback-and-burn alone does not share revenue), although MKR does have speculative value as MakerDAO has a large treasury.

Then why MKR is valuable in addition to speculative value? My contrarian view is, it is the constant, automatic, and well-known buyback-and-burn in a deflationary environment (rather than generic buyback-and-burn or deflation alone) that makes MKR valuable. MKR is bought back and burned when stability fees are paid or when the System Surplus Buffer reaches its cap. Since stability fees are constantly generated, MKR is also constantly burned. This process is automated and enforced by smart contracts. This constant and well-known deflation helps holders develop a conviction of a very high future price, which encourages long-term holding of MKR despite its volatility. This reduces the token velocity of MKR, amplifying sublinear price-raising factors such as good product/governance.

So why do constant, automatic, and well-known buyback and burn programs matter? If the buyback is discretionary, as is the case with many stock repurchases, holders (sellers) also have discretion as to whether and when to sell, paying close attention to the price in the secondary market. However, if the buyback is automatic with no specific timing/price chosen for execution, then sellers can be assured that selling later is better, holding until at least the buyback-and-burn price meets their willingness-to-sell. Those who are willing to sell at a lower price will sell first, so the pool of remaining sellers will move towards a higher price. Thus, the MKR token gradually captures more value through an increasingly higher price level of willingness-to-sell, which cannot be achieved if the buyback is discretionary as in traditional finance.

Note that this crypto-native approach also works for other cryptoassets that are not governance tokens. For example, Binance Coin (BNB), an L1 cryptoasset, uses a similar constant buyback-and-burn mechanism to maintain its price. This approach also needs to be used in conjunction with other price-raising factors, since it’s more of an amplifier in nature.

Governance Extractable Value, aka Bribes

The last crypto-native way to enhance the value of governance tokens is to extract Governance Extractable Value or Voter Extractable Value, hereafter referred to as GEV. You may have heard of bribes, which are a basic form of GEV. Contrary to the prevailing view that bribery is detrimental to a protocol, my view is that bribery mechanisms, if leveraged wisely, can help a protocol’s governance token capture more value. This is because vote bribery provides in principle a revenue stream to governance token holders.

GEV cannot be eliminated. Governance tokens are intended to be a combination of two things — the governance rights of a protocol, and the economic benefits associated with that protocol. This coupling theoretically aligns economic gains with governance efforts and can incentivize participation. However, in practice, we must recognize that token holders have varying preferences for these two attributes, which is why there are bound to be some who will trade governance rights for money. Furthermore, the composability of dApps makes the decoupling of these two attributes and transactions between them instant and effortless. For example, Convex essentially decouples CRV token into cvxCRV and vlCVX, the former representing economic interests in Curve and the latter representing governance rights in Curve; Votium, a vote-bribing platform, is designed to look a lot like delegated voting, making it far too easy and reassuring to receive bribes.

The concerns with bribery, as well as extracting GEV in general, are whether it is unethical and poses a risk to protocol security. To answer this question, first let’s consider a similar concept, Miner/Validator Extractable Value (referred to as MEV). A few years ago, there were similar concerns about the ethics and security of extracting MEV, but several projects have emerged to offer good solutions. Multicoin Capital has detailed, high-quality analysis of the situation and solutions here and here. In simple terms, MEVs can be divided into two categories — benign MEV and malignant MEV. An example of benign MEV is, when an arbitrage opportunity presents for a cryptoasset and the associated arbitrage transactions are executed by multiple traders within the same block, the block builders decide which transaction goes first and thus which trader gets the MEV. As you can see, there is nothing unethical about benign MEV, which is essentially transaction ordering. However, malignant MEV is indeed unethical and potentially dangerous. It is often characterized by front-running/back-running (e.g., sandwich attack) or censorship (e.g., delaying or excluding transactions).

Similarly, there are benign GEV and malignant GEV. I’ll use Curve to illustrate them. Curve allows veCRV holders (usually LPs) to vote on which pool rewards should be distributed to. In simple English, a governance decision is like ranking pools. For many governance votes, holders actually care little about the outcome (i.e., ranking) if they think the pools they have deposited into are unlikely to be the ones with the most votes. Benign GEV occurs when the outcome is somewhat altered due to economic incentives offered to apathetic token holders yet no one is intentionally harmed. This alteration of ranking, by itself, does not pose a greater risk to the protocol’s security than the absence of incentives. A use case for benign GEV is to bootstrap new stablecoins on Curve. Malignant GEV, by contrast, often features “rug pull” — such as stealing from liquidity pools, collateral pools, or protocol treasuries — which is absolutely unethical and dangerous. A recent example of exploiting malignant GEV is here.

It is worth noting that the above MEV-GEV analogy has limitations in fully capturing the complexity of GEV, mainly in the following two aspects. First, because actions of benign and malignant GEV may initially appear similar-more so than those of MEV-the intention behind them matters. Secondly, governance decisions can shape a protocol (that is built on top of Layer-1 blockchains) over time, whereas benign transaction ordering is constrained by the L1 consensus mechanism. Thus, even a benign GEV can have uncertain long-term effects, which could be either positive or negative.

We’ve discussed above that GEV cannot be eliminated and that intention matters, so it is imperative to have benign GEV extraction mechanisms that encourage participation, ensure transparency, and, most importantly, facilitate an organic integration with the ecosystem. Two common models of bribery are:

• bribe.crv.finance’s model, which I also call job board model. Projects looking to increase liquidity through Curve can post incentives on bride.crv.finance to let veCRV holders know.
• Votium’s model, which I also call vote allocator model. vlCVX token holders can simply delegate their voting power to Votium, and Votium will allocate these tokens to vote for pools that offer the highest incentives.

Comparing these two models, I would conclude that the vote allocator model will gain popularity and create a flywheel effect, while the job board model will gradually be obsolete. Although many bribe givers and takers continue using bribe.crv.finance because it was the first to emerge, it is nothing more than a “job board”, which does not manage any risk nor add much value to the ecosystem. However, the vote allocator model has several important actors, each tightly integrated into the ecosystem and managing some risks:

• Governance token stake pool: Stake pools serve to amass governance tokens to condense governance rights and create conditions favorable for extracting GEV (e.g., Convex ). In general, staking pools assume risks to provide supplementary yield, create value by coordinating proposals that generate GEV, and extract some fees.
  [Sidenote: I noticed that Convex appeared before the prevalence of bribery and primarily aimed to enhance Curve’s cumbersome locking process (in addition to yield). So I wondered, if the base protocol does not necessitate locking/staking for voting or already provides a user-friendly native locking/staking, will large third-party staking pools still emerge in a GEV ecosystem? My initial thought is “likely yes”, for the reasons stated above — third-party staking pools will emerge because they can charge fees; they can charge fees because they bear the risk of offering additional yield and thus are more motivated to coordinate proposals that are favorable for GEV.]
• Vote allocator: The vote allocator automates voting and aims to receive the highest incentives per token (e.g., Votium). Vote allocators undertake risks to vote for high incentives in a dynamic setting, create value by saving holders’ time and effort, and can levy fees.
• Reward manager: The reward manager collects all rewards from all users, and swaps them for the most common tokens, which are further put into an autocompounder until claimed by original governance token holders (e.g., the Union by Llama Airforce). In contrast to MEV, which is typically delivered as the L1 native cryptocurrency or close variants like ETH and stETH, GEV in DeFi can consist of multiple tokens from various projects. Claiming these rewards is not only sensitive to rates but also gas intensive. As a new actor emerging in the GEV ecosystem to solve this problem, the reward manager takes on the risk of volatility of swapping and gas, creates value by saving holders’ cost, and thus is able to charge for services.

The GEV-related interactions between these actors in the Curve ecosystem are illustrated in the diagram below. These interactions create a closed loop (e.g., ① — ⑦ below) that tightly integrates various actors and achieves a flywheel effect.

Conclusion

By correcting the misconceptions of “governance tokens are akin to stocks plus utilities”, I elaborated in this article why most governance tokens fail to effectively capture value — lack of revenue sharing, lack of fees or compelling reasons to charge and retain fees, limited utility value for governance, and a general lack of other utilities. To make governance tokens valuable, founders can get inspired by stocks — providing holders with a revenue stream or retaining some earnings in the treasury. Furthermore, there are a few crypto-native ways to enhance the value — giving variable weights to governance tokens to encourage better decisions, adopting individually consequential voting to keep each voter accountable, introducing automatic and well-known buyback-and-burn to reduce token velocity and capture holders’ willingness-to-sell, and providing an additional revenue stream by facilitating GEV extraction. On a related note, GEV is also an interesting niche for further research and institutional investment in the next few years.

About the Author

With recent experience in both investing (as an angel investor) and operating (as a product manager for a startup), Haydon Luo [ website, LinkedIn, Twitter] has developed well-rounded skills for both sides of the same coin. Previously, Haydon began his career at AECOM, a multinational infrastructure consulting firm.

As a dedicated fitness enthusiast, Haydon is also committed to the blockchain space through volatile cycles for many years.

Haydon holds a BEng from the Hong Kong Polytechnic University and is currently an MBA candidate from the Carlson School of Management at the University of Minnesota. He speaks English, Cantonese, and Mandarin Chinese.

DISCLAIMER

The analysis in this document is for general information purposes only. While I endeavor to keep the information up to date and correct, I make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the document or the information, products, companies, or related graphics contained in this document for any purpose. Any reliance you place on such information is therefore strictly at your own risk.