Practical Protocol Funding on Ethereum
Overview
Decentralized protocols have many strengths
- Composability (money legos!)
- Ability to attract large amounts of liquidity
- Regulatory insulation for founding teams
To me, it has looked like so far there has been a tradeoff between being able to launch a truly decentralized protocol and having financial upside for the launching team. I believe the main issue with this comes down to 3 things that are not usually explicitly mentioned when discussing decentralized protocols.
- Need for seed capital to build & launch
- Desire for monetary upside by founders
- Desire for monetary upside by investors
Below is my proposal for a new model that can be deployed widely for large or small scale protocol development.
Some Groundwork
Options For Launch
Examples of how protocols have launched in the past.
ICO — Needs big $ to ensure compliance if it's even possible. Big expectations on token accruing value.
Traditional Funding — Not much investor desire for small money fundraising. Large raises mean large expectations for return.
Grants — Great but is a very inconsistent method and the grantor may want some control over the project
Self Funded — Few founders can do this for an extended period of time
If the asset sold in the first two options is a governance token than there is a large expectation for that to accrue value and it is still unclear if pure governance tokens should or do accrue value in the long term. It has been made clear that they do not in the short term. I think the main job of governance tokens should be governance, not value accrual.
There are more complex systems like Maker that use the governance token to also align the incentives and actions of participants. I think that makes sense for protocols that require active participation (like maker adjusting stability fee and DSR rate) but for more simple protocols where most proposals are for upgrades or changes needed for new integrations, there isn’t a shared “goal” the protocol is trying to meet (like making 1 DAI = $1) that requires second-level incentives.
Definitions
Terminology can get murky
Protocol — Maker is a Protocol, Compound is a Protocol, Uniswap is a Protocol, etc. Basically any smart contract-based system that can run autonomously and facilitates value storage and transmission. For this post, I am talking about protocols built on a base chain (Ethereum).
Application — uniswap.io is an application, app.compound.finance is an application, dharma is an application that uses compound protocol. There is generally an application launched on top of any protocol built by a team. Often the app idea comes first and then a protocol is built to make building the app possible.
Tools
I am not advocating for changing any existing or creating new components. The change is a matter of distribution and incentive alignment. This proposal would not have been possible without the countless experiments that have already been tried (with various levels of success). There are two common elements that I am advocating for continuing to use but in a different way.
Protocol Fee — A % of the value of transactions on or assets held by the protocol (dydx, uniswap v2). There was a time when any protocol fee was frowned upon but it seems like the attitude has shifted to appreciating the cost in time but also value (infrastructure costs, audit costs, etc.) associated with launching and maintaining a protocol (at least until it is ready to be handed off to decentralized management).
Governance Tokens — Required for voting on enacting proposed protocol changes (MKR, COMP). Governance tokens and DAO shares can really be used interchangeably but tokens are easier to manage if you are going to have a large number of holders/participants.
Proposal
Below are the three main problems I see with the funding of new decentralized protocols and specific solutions to address each of them.
Problem — Founder & Investor Upside
It is beneficial for founders to take risks, that's how great things are created. Some will take the risk inherent in building a new protocol even without a monetary incentive. The reality is that there will be more experimentation if there is a path to similar startup-type upside building a protocol as there is starting a traditional company.
Solution — Founder Pool
A smart contract that receives a portion of the fees built into a protocol. The founders of the protocol are sole owners of the founders pool. They can issue new shares thus diluting themselves, sell their tokens, burn + redeem them, etc. Controls put around those decisions can be managed as strictly or loosely as needed. Founder tokens have no special voting rights, and they can be sold/minted to investors at founders discretion.
The size of the protocol fee and they % that flows to the founder pool is set at the outset of the protocol and can be managed by protocol governance (either from the outset or after time/milestone X) or locked forever (although this may incentivize forking if the founders stop bringing value).
Problem — Seed Funding & Investor Upside
Some founders are able to build a protocol on the side or fund it out of their own pockets. The reality is that most cant and ideally the need to pay rent shouldn’t keep the next great protocol from being launched. Applying for grants is a very inconsistent method for funding and most VC type investors will only be looking for investments with massive upside
Solution — Protocol Bonds
Fixed return instruments where the return is sourced from protocol fees. The return on the instrument is capped.
- Fixed Return — 20% of the bond value (regardless of how long it takes to pay back)
- Fixed APY — 10% APY for as long as it takes to payback
- Dynamic APY — DSR + 5% for as long as it takes to payback
Buyers of protocol bonds would also receive governance tokens. I prefer the fixed return option as it incentivizes holders to get as much volume through the system as possible. Individuals can buy these bonds as investments and projects that may benefit from the new protocol can have a lower (the protocol could bring in 0 fees). Protocol Bonds can also be sold for services like pre-paying for an audit (either for launch or even issued by the protocol on the fly for continual audits). Issuance can be fixed or distributed in some sort of auction (where the % return is what is being bid on). Protocol bond fees are fixed (can't be changed through governance).
Problem — Commitment to Decentralization
There have been countless promises to “decentralize” the governance of a protocol and many examples of how it is hard or impossible to do so after the fact. Setting the intention into the code of the protocol at the outset and accepting a “path to decentralization” over time can give users an assurance that those promises will be met.
Solution — Diversified Governance Token Distribution
Governance tokens will be distributed across 3 parties
- Founders
- Protocol Bond Buyers
- Protocol Participants (capital providers, distributors, etc.)
Distributions to 1 & 2 are done at the launch of the protocol (for simplicity sake its best to not issue any more gov tokens after this to founders fo bondholders). A point is then selected in the future at which time the protocol should be ready to be handed off to decentralized governance. This could be 6 months or 3 years. At some point along that path, the holdings of Protocol Participants should be enough to block any vote by protocol bond buyers and founders.
For example, lets say gov tokens are distributed — Founder=30%; BondHolders=30%; Participants=40%. The participants tokens are distributed over 1 year. The approval threshold for any vote in the protocol is 67%. In this scenario sometime near the end of the year protocol participants can always block any proposal.
The governance structure can be as simple or complex as needed. I think some model where there is a “board” that handles votes and each board member must have (or have pledged to them ) some value of tokens but have equal weight votes makes some sense. This is not the main point of the post, distribution is.
Example
These components all work together
By selling protocol bonds with fixed returns with the governance tokens the tokenholders aren’t obsessed with driving value to the token, potentially risking the integrity of the protocol. Founders tokens can be as much or as little in control of general protocol governance.
5 founders, 6 months build, 1-year post-launch to decentralization (New options trading protocol for example)
- 5,000 founders tokens (1k each)
- 10,000,000 Governance Tokens (600k to each founder)
- Sell $100,000 in protocol bonds with 20% fixed return + 3m Governance Tokens
- .3% transaction fee (.1% to founders pool, .2% to repay protocol bond)
- 333,333 Governance tokens issued each month for the first year to liquidity providers and distributors relative to the usage of the protocol
The bond fee is not under the control of governance and stops once $60 million in volume is reached. It could also be structured that the % fee for the founders increases at this point or only kicks in after the bonds are paid. It should be easy to configure solutions to align all parties.
Conclusion
Building decentralized applications is at the same time both easier (out of the box infrastructure, composable open-source protocols & applications) and harder (No clear slam dunk business models, regulatory uncertainty). Founders should have some upside but if something that can be built that is small and quick and brings some value it would be great to have even a small portion of that value flow to the creator. Investors want upside potential but also the ability to have some control over the protocol and a clear path to getting their return. Users of want to know where a fee is going and that something claiming to be decentralized at least has a reasonable plan to get there. Finding the right inputs to the above structure brings these desires into alignment and can hopefully enable more protocol experimentation.
