Explained: DeFi Governance Tokens
In this Multi Explained series article, we cover the basics of governance tokens and the various governance models used by some of the better-known DeFi projects.
We will provide an overview and analyze the pros and cons of governance implementations of Kyber Network, Uniswap, Compound, Curve, and Maker.
What Are DeFi Governance Tokens?
DeFi governance tokens allow token holders to govern a blockchain protocol, and in some cases enable them to capture value directly from DeFi application usage.
This model is similar to traditional stocks: individuals can vote on board decisions and profit from dividends when issued.
While the traditional finance implementation is standardized, the implementations in DeFi can vary drastically from each other with new models being invented multiple times a year.
How Do DeFi Governance Tokens Work?
DeFi governance tokens function as regular ERC20 tokens on the Ethereum blockchain, with a key difference — the issuing project creates special purpose applications that allow the token holders to decide on critical protocol parameters.
The protocol developers normally create a “staking contract” where token holders can deposit their tokens in order to vote on dynamic parameters. In some instances, they can vote on a specific proposal and determine the primary focus of the project’s development resources.
Token holders can “govern” dynamic parameters such as trade fees for decentralized exchanges, asset listings and asset risk parameters for money markets, and protocol inflation schedules.
These protocol parameters are then adjusted by the governance platform’s multisignature smart-contract. The voted-on changes have a time delay to allow those that disagree to part ways with the protocol and tokens if they wish.
The time delay also prevents administrators or malicious actors from making any changes to these parameters without the community’s consent or at least give enough time to escape.
Where Does Governance Take Place?
Popular DeFi protocols with governance tokens feature platforms that allow for public discourse to take place within the crypto community. This includes a governance forum where community members can pitch ideas or proposals, a well-organized Discord channel where the community can continue the conversation, and the actual voting platform, where votes can be cast through smart-contracts.
The voting platforms connect the governance process to the blockchain. In order to avoid spam submissions, proposals that can be voted on usually must be submitted by an administrator of the project or a community wallet that contains a minimum threshold of a set requirement.
These minimum thresholds for on-chain proposals have raised controversy, as the requirement is always out of the reach for a regular user. Those in support of these thresholds argue that the popular proposals discussed on the public forum and Discord channels have always made their way to the voting platform as a result of this community interest.
Do All DeFi Governance Tokens Have Yield Rewards?
Currently, not all DeFi governance tokens have a clear reward structure, and many of today’s most popular DeFi tokens like COMP, UNI, and AAVE are still developing one. The more mature protocol tokens like KNC, ZRX, and MKR have a defined reward structure that can be used to form real PE ratio (Price-to-Earnings) formulas.
Each project is unique in the expected return for the token holders, and for those that stake in the governance platforms. In the near future, we expect all DeFi tokens to have an expected return.
Mature vs Rookie DeFi Governance Tokens
While DeFi governance token models can feature many different design approaches, we believe that more mature models reward only the token holders that participate in the governance platform from network fees generated by the protocol. In contrast, the “rookie” models reward all token holders or stakers through the use of inflationary reward schemes.
In mature governance token models, the protocol fees are split between a “project treasury” that supports the ongoing development of the protocol, and the “stakers” that stake their tokens in the governance platform. These stakers may also be exposed to additional risks that provide a back-stop in case funds need to be liquidated, in the event that the protocol is attacked and regular users lose funds. The stakers are then rewarded for “locking” their tokens to be put at risk of being liquidated in those rare events.
The ethos of being a “decentralized finance application” has now reached a threshold shift. In order for the protocol to be classified as a true DeFi application in today’s maturing ecosystem, token holders must now be involved in the governance process of the protocol and provide value to the users of the application.
In the next section, we will break down the top DeFi governance tokens in the ecosystem. Our evaluation will cover how they work, relevant pros and cons, and their reward (yield) structures.
Kyber Network (KNC)
Kyber Network is one of the first decentralized exchanges launched on Ethereum, entering the ecosystem in 2017 during the ICO craze. The Kyber protocol quickly became one of the most-used decentralized exchanges with a meaningful volume.
Throughout 2018–2019, over 100 “dApps” began integrating with the protocol, thus solidifying the open nature of the exchange’s liquidity as an integral part of the Ethereum dapp ecosystem.
Today, the Kyber Network’s exchange averages over $5M in daily volume, and features one of the highest participation rates for its governance platform.
Kyber Network Governance
When the network first launched, the KNC token had little use; but in July of 2020, the KyberDAO officially launched with the token at its center. The KyberDAO allows for KNC token holders to participate in the governance of the protocol’s key parameters and receive corresponding rewards.
Participation requires token holders to “stake” their KNC tokens for a length of 2 weeks (1 epoch on Kyber Network) to be eligible for the network’s rewards. After each “epoch”, the stakers must vote on the allocation of the network fees and any other active referendum in order to be eligible for that period’s rewards.
Kyber Network Rewards
After each “epoch”, the stakers must vote on the allocation of the network fees and any other active referendum in order to be eligible for that period’s rewards. On each epoch, the KyberDao stakers must vote on a 3-way split of the network fee between staker rewards, a rebate applied to integrated applications, and a token burn that removes KNC from the circulating supply.
In most epochs, the Kyber community has chosen to award themselves 65%-70% of the network fee, which equates to about 5%-8% APY for participating stakers.
Pros
- Currently, 27% of the KNC token supply is being staked in the KyberDao governance platform.
- Kyber Network has a competitive trade fee compared to the other DEXs in the ecosystem.
- Voting participation is required in order to be eligible for rewards, and stakers must not move the staked balance for a minimum of 2 weeks.
- Network participants can delegate their stake without having to provide custody. This allows them to earn rewards without having to vote every 2 weeks.
Cons
- Each individual vote requires an Ethereum transaction that consumes “gas”. (Users can delegate their vote so that they don’t have to spend this gas every 2 weeks.)
- The community voting process for the same allocation of network fees, which takes place every 2 weeks, can seem repetitive.
- Delegates may take a fee for providing the service, and therefore diminish the yield that an individual staker can earn.
Kyber Network Governance Links
- Forum: https://www.reddit.com/r/kybernetwork/
- Discord: https://discord.com/invite/NfFMVz6
- Voting: https://kyber.org/vote
- Dashboard: https://tracker.kyber.network/#/
Uniswap (UNI)
Uniswap is the highest volume decentralized exchange in the world, with spot volumes commonly matching those of Coinbase Pro.
Uniswap popularized the automated liquidity pool model that allows any token holder to become a market maker for any supported ERC20 token. This innovation sparked the DeFi bull run that allowed new projects to gather support and liquidity without the need for centralized exchanges or large VC backers.
Today, Uniswap’s volume continues to exceed expectations even after the alt-coin market has slowed down. Uniswap’s stablecoin pairs against ETH and WBTC exceeded $50M trading volume per day, placing it as a top 5 exchange for liquidity depth and daily trade volume.
Uniswap Governance
The Uniswap protocol was first introduced without a token in early 2018, and in September of 2020, the UNI governance token was launched. At launch, 150M UNI tokens were distributed to over 80,000 previous users, which a day after was valued at $1,200 per user.
The Uniswap governance model allows token holders to submit governance proposals if they hold or have been delegated 1% of the UNI supply (10M tokens). Then, the community has 7 days to vote on any of the submitted proposals.
The governance platform has implemented many advanced ecosystem features, including delegated voting, ownership and control of the community treasury, and a 2-day time-lock delay to any protocol smart-contract changes.
Uniswap Rewards
The Uniswap protocol just finished rewarding their liquidity providers with a daily distribution of 333k UNI tokens to the exchange’s 4 most important pools (ETH/USDT, ETH/USDC, ETH/DAI, ETH/WBTC).
All rewards came from the allocated 60% community supply (600M tokens). At the prevailing distribution rate schedule, Uniswap could continue to offer rewards for the next 3.6 years.
But the current reward program finished on the 17th of November, 2020, meaning now UNI could be moving from a rookie model to a more mature model unless UNI token holders create and pass a proposal to start another distribution.
Although the Uniswap protocol fee of 0.3% per trade is delegated to the pool’s liquidity providers, a configured parameter allows for a 0.05% administration fee to be implemented.
Governance can vote on enabling this fee and on deciding the fee’s distribution mechanism. There has yet to be any meaningful discussions regarding the governance of the protocol fees.
It’s important to note that any changes to the protocol fees are subject to a special 180-day time-lock delay (other protocol changes are only subject to a 2-day time-lock delay).
Pros
- 60% of the UNI supply is allocated to the Uniswap community members; 15% of that was unexpectedly distributed to past users as a “surprise”, creating the most widespread “governance token airdrop” in the ecosystem.
- Proposals to lower the minimum proposal threshold have been put forward, though the proposed changes are still quite high (3M UNI tokens).
- Uniswap administrators have set up a “network fee” switch that can be enabled by the governance platform. This can enable the governance platform to adopt a more mature model in the future.
Cons
- The current community distribution mechanism rewards users that do not participate in the governance process. This incentivizes “yield farmers” that are looking to only farm the UNI token for short-term profits, rather than farming to increase their weight in the governance system.
- The minimum proposal threshold of 10M UNI tokens is excessive; virtually no entity outside of the team can meet this requirement. There was a recent community proposal submitted by the Dharma team to get the threshold lowered to 3M UNI tokens instead.
- Currently, there is no robust dashboard for token holders to explore delegates. This centralizes governance around the team and venture capitalists, as the community cannot properly organize around other parties.
Uniswap Governance Links
- Forum: https://gov.uniswap.org/
- Discord: https://discord.com/invite/XErMcTq
- Voting: https://app.uniswap.org/#/vote
- Dashboard: https://info.uniswap.org/
Compound (COMP)
Compound is the largest money market protocol in the DeFi ecosystem. At launch, the protocol revolutionized decentralized lending by removing the antiquated peer-to-peer markets and replacing them with liquidity pools of funds, thus allowing anyone to borrow or lend without having to wait for a counterparty.
Today, Compound has over $2.6B in their decentralized lending smart-contracts and provides easy access to margin loans for the most popular ERC20 tokens in the ecosystem.
Compound Governance
The Compound protocol initially launched without a network token; in June of 2020, the team launched the COMP governance token that would play a critical role in the onboarding of new assets and risk parameters.
The Compound governance platform allows token holders to vote on proposals and even create their own proposals if they manage to have 100,000 COMPs ($10M) delegated to them by being an activist investor in the community.
Proposals can be executable codes that interact directly with the existing lending markets or add a newly-supported ERC20 token from their standardized templates.
The Compound governance process is one of the most advanced platforms in the ecosystem with its use of executable code, time-lock delays, and limited administrative privileges.
This model has now become the standard for new and existing projects seeking to implement smart-contract governance.
Compound Rewards
Currently, Compound only features an inflationary reward that gets awarded to every lender and borrower on the platform. The Compound protocol does not currently feature any network fees, though it has been confirmed that this can change through governance.
When the COMP token was launched in June of 2020, 4.2M tokens (42% of the supply) were reserved for community distribution through the emission of 2,880 COMP tokens daily. This reward distribution is set to last 4 years and is evenly split between all markets according to the depositor’s or borrower’s balance size.
Pros
- Compound’s advanced governance smart-contracts control the onboarding and risk parameters of all lending markets on the platform.
- All protocol changes must go through a minimum 2-day change delay, preventing even administrators from making changes without consent from the community.
- On August 31st of this year, Compound’s governance successfully passed a proposal to lower the community reward distribution by 20%. This effectively proved that the community has a voice in the protocol’s important economic decisions.
- Through the governance platform, critical changes proposed by the community were constructed according to DAI and USDT markets interest rate models. Additionally, new assets were onboarded and a community-controlled oracle was implemented.
Cons
- The current community distribution mechanism rewards users that do not participate in the governance process. This incentivizes “yield farmers” that are only looking to sell the COMP token.
- Currently, there is no direct incentive for regular COMP token holders to participate in the governance platform. For this reason, votes are centralized to large venture capitalists.
- The minimum proposal threshold of 100K COMP tokens is excessive; there are currently less than 10 entities that qualify to propose governance changes.
Compound Governance Links
- Forum: https://www.comp.xyz/
- Discord: https://compound.finance/discord
- Voting: https://compound.finance/governance
- Dashboard: https://compound.finance/markets
Curve DAO (CRV)
Curve is a decentralized exchange featuring liquidity pools that are solely composed of stablecoin pairs.
The most popular pool features the USDT/USDC/DAI stablecoins; traders can exchange between the pairs with deep liquidity and very low slippage, making the rate more competitive in comparison to the largest centralized exchanges.
The exchange has also become the go-to venue for trading tokenized Bitcoins like the wBTC, sBTC, and renBTC pairs.
Today, the Curve decentralized exchange is in the top DEX rankings with daily trading volume exceeding $50M.
Curve DAO Governance
The Curve protocol launched their CRV governance token in August of 2020, and their distribution method raised much controversy in the cryptocurrency ecosystem.
Instead of minting the total supply and allocating the supply in vested contracts like most projects, the team decided to implement a daily minting schedule that distributes an unvested 1.9M CRV tokens to the community, team, and early investors.
With a total token supply of 3.3B CRV tokens, the distribution schedule is set to last 6 years. This distribution schedule effectively begins the token supply at 0 and increases the circulating supply gradually on every Ethereum block (daily minting).
Currently, the daily distribution of the CRV token is set to be divided between these 5 parties:
- 753k Community (37.85%)
- 415k Early Users (20.87%)
- 548k Founders (27.58%)
- 148k Investors (7.45%)
- 124k Employees (6.26%)
All token holders — including the team and founders — are free to participate in the Curve DAO governance platform.
The Curve DAO features a unique staking mechanism that locks CRV tokens in exchange for voting power in the governance system. Each locked token generates a “veCRV token” with an amount that corresponds to its locked schedule:
- 1 CRV locked for 4 years = 1veCRV
- 1 CRV locked for 3 years = 0.75veCRV
- 1 CRV locked for 2 years = 0.50veCRV
- 1 CRV locked for 1 year = 0.25veCRV
- 1 CRV locked for 6 months = 0.13veCRV
- 1 CRV locked for 1 month = 0.02veCRV
- 1 CRV locked for 1 week = 0.00veCRV
Users with a voting power of 2500 veCRV tokens can create new proposals. While there is no minimum voting power required to vote, those without a meaningful locked term have little effect when they cast their vote.
This mechanism provides the most power over the protocol to those that are “locked-in” with their CRV investment, as staked CRV tokens cannot be traded or moved from the governance platform until their lock-term ends.
Curve DAO Rewards
Token holders that are staked (locked-in) in the governance platform can decide on the weekly allocation of the 753k CRV tokens that are distributed daily to the liquidity pool providers.
Instead of the system splitting the rewards evenly between the pools, the allocation is decided through a weekly gauge vote from the veCRV token holders.
If you provide liquidity to the wBTC/renBTC pool, you want most of the rewards to be distributed to that pool; therefore, you lock your CRV token to increase the voting weight of that pool, thus increasing the community rewards.
The gauge voting also rewards those veCRV token holders with an added boost from the share of the rewards. Those that lock their tokens for an extended period have a possible max boost of 2.5x. The boost is calculated according to the other staked veCRV on that pool — a 1–2 year lock provides the maximum boost in most liquidity pools.
In addition to the standard 0.3% trade fee that goes to all liquidity providers, a 0.1% admin fee is split 50/50 between the community treasury and veCRV token holders. These fees are collected and used to buy CRV on Uniswap, which is then distributed to veCRV holders according to their weighted balance.
Pros
- 25% of the circulating supply is locked for an average of 3.66 years. This indicates that the daily rewards keep making their way back to the governance platform, and fall into the hands of committed, long-term holders.
- Governance participation requires CRV token holders to commit their investment in order to earn high rewards, attracting long-term liquidity providers to the platform.
- The enabled “admin trade fee” generates a healthy APY for veCRV holders, at the current rate of 33% APY.
- The Curve DAO features one of the best reward structures in the ecosystem, where network participants are rewarded for their long-term commitment to the platform. It also includes a “network admin-fee” that provides attractive returns without the need for inflation.
Cons
- The high inflation rate caused by the unique distribution schedule has caused the token to trade with very high volatility, keeping most buyers away after getting “wrecked” from the first week of trading. Therefore, high inflation has given little reason for new market buyers of the token. As the circulating supply changes at a faster rate than the market can agree on a price, buyers are finding themselves “underwater” very regularly.
- Currently the founder and team control over 70% of the voting power on the governance platform. This effectively makes the critical decisions centralized, where assets with little community support were approved due to the team’s voting power.
- The inflation schedule cannot be changed and may only be diverted to a burn address. The team has also stated the founder, team, and investor distribution schedule will not be altered in any way.
Curve DAO Governance Links
- Forum: https://gov.curve.fi/
- Discord: https://discord.gg/9uEHakc
- Voting: https://dao.curve.fi/
- Dashboard: https://www.curve.fi/combinedstats
Maker (MKR)
Maker is the leader among decentralized lending protocols, with over 2% of the entire Ethereum circulating supply locked in their smart contracts. The Maker Protocol functions differently from other lending protocols by allowing users to borrow only one asset: the system’s derivative dollar called the DAI stablecoin.
DAI is a crypto-backed stablecoin that is created by the protocol when one of the supported assets — like ETH or WBTC — is locked in Maker Protocol vaults. Users can then borrow 66% LTV (Loan-to-Value) of the locked asset’s value in the form of the DAI stablecoin. DAI can then be used across the entire crypto ecosystem for payments, trading, and other DeFi transactions.
Today, the Maker protocol and the DAI stablecoin are an integral part of the Ethereum ecosystem with over 2.15B in locked assets and $950M in DAI minted. The DAI stablecoin can now be used in every large centralized exchange and almost every decentralized application that exists on the Ethereum blockchain.
Maker Governance
MakerDAO, the Maker governance platform, was initially launched in July of 2019 and allows for MKR token holders to vote on key protocol parameters.
The most important parameter is the interest rates (stability fees) that are charged to DAI stablecoin borrowers. MakerDAO is also used to onboard new assets, increase/decrease the system’s global debt limits, and implement any key changes to the protocol. This can include the addition of new price oracles or improvements to the governing process itself.
Due to the widespread use of the DAI stablecoin, MakerDAO is now one of the most important governance platforms in the Ethereum ecosystem, and the protocol’s decisions can affect the greater decentralized economy on the Ethereum blockchain.
The borrowing rates set by MakerDAO have a direct effect on the DAI lending rates across the other lending protocols; even the DAI price peg can impact decentralized exchanges.
MakerDAO features one of the most robust governance discourses in the DeFi ecosystem. The team has multiple weekly community calls that discuss the new assets to onboard with the project’s team and detail the risk environment of specific assets or the overall ecosystem.
Maker Rewards
The Maker protocol does not currently distribute any direct rewards to token holders or those that vote in the governance platform. Instead, the system uses all of the DAI collected from the interest rates to buy back the MKR token from the open markets and burn these tokens from the circulating supply.
This mechanism has an impact on all token holders — when the overall supply is diminished, the remaining supply gains more value. This buy-burn model has been compared to that of a stock buyback, representing a more flexible way of returning money to shareholders.
The Maker protocol uses the MKR token to provide a back-stop in the event that a collateralized loan cannot be liquidated by the system, and new MKR tokens are minted for auction in order to cover the un-collateralized DAI in the system.
Since the minting of new tokens affects all token holders equally (inflation), the same argument is made to keep the buyback burn (deflation) reward model.
Pros
- The MakerDAO governance platform votes on all important parameters of the Maker protocol and all changes must all go through a 24hr time-delay enforced by smart-contracts.
- The importance of the DAI stablecoin in the DeFi ecosystem has made many governance proposals go viral by getting coverage from the major cryptocurrency publications.
- MakerDAO’s transparent governance process has set the gold standard on how other projects community calls should be conducted, and how governance forum discourse should be handled for new proposals and ideas.
Cons
- The current reward structure does not benefit token holders directly, thus not providing most crypto buyers with a strong enough reason to accumulate the MKR token.
- Despite MakerDAO being the largest lending protocol in the ecosystem, voting participation is extremely low. Most votes are cast by just 25 unique addresses, with only 50k MKR tokens for the weight (5% of the supply).
- There are currently not enough incentives to get the larger part of the crypto community involved in the governance platform. The current “buy-burn” incentives only attract large venture capitalists, keeping the governance centralized to a few large entities.
Maker Governance Links
- Forum: https://forum.makerdao.com/
- Discord: https://chat.makerdao.com/
- Voting: https://vote.makerdao.com/
- Dashboard: https://explore.duneanalytics.com/dashboard/maker-dao---mcd
Summary
DeFi governance tokens are finding a suitable product-market fit; in most cases, they now provide a real reason to “invest” in the underlying protocol.
Over the last 6 months, the market has undergone a maturing process as these reward models have begun to materialize. We expect this market trend to continue.
Soon, these tokens will not simply be considered as alt-coins. Instead, they will be classified in their own category based on the unique characteristics that set them apart from other cryptocurrencies.
In order to ensure that their token has a sustainable reward structure, existing and future protocols can provide crypto investors with a reason to buy and hold their network token by giving the token power over the protocol parameters and a share of the generated network fees.
As the cryptocurrency market matures, the days of “payment tokens” are over; today, cryptocurrency investors expect a piece of the action when looking to invest in a new token.
In the coming years, we will also see governance tokens’ legal standing be challenged, as questions arise concerning what separates a governance token from legal securities that are entitled to a dividend.
For this reason, 2021 will undoubtedly be an important year for DeFi governance tokens.
