You are reading an excerpt from our free but shortened abridged report! While still packed with incredible research and data, for just $40/month you can upgrade to our FULL library of 60+ reports (including this one) and complete industry-leading analysis on the top crypto assets. 

Becoming a Premium member means enjoying all the perks of a Basic membership PLUS:

• Full-length CORE Reports: More technical, in-depth research, actionable insights, and potential market alpha for serious crypto users
• Early access to future CORE ratings: Being early is sometimes just as important as being right!
• Premium Member CORE+ Reports: Coverage on the top issues pertaining to crypto users like bridge security, layer two solutions, DeFi plays, and more
• CORE report Audio playback: Don’t want to read? No problem! Listen on the go.

Intro

Protocols often issue rewards in their own protocol tokens, which roughly represent shares of ownership in the protocol. Holders of protocol tokens are typically entitled to participate in governance by voting on proposals, but governance isn’t within scope for this post–we could do a whole series on it.From the depositor’s perspective, the strategy of allocating deposits to earn protocol tokens is often referred to as Liquidity Mining. Some protocols allow holders of protocol tokens to stake their tokens for further rewards.In the following sections, we explore how protocol tokens are distributed as rewards in three interesting protocols: Liquity, AAVE V2, and Compound. We then conclude by offering a generalization of the concepts, illustrating how the three implementations share the same underlying concept.

 The pursuit of decentralization within the blockchain ecosystem often inadvertently compromises security. This compromise, however, is not inherent to decentralization. Rather, it arises from a lack of understanding of fundamental economic designs and incentive structures. Entrusting the community with direct control over key elements such as the treasury, security parameters, or pivotal smart contracts in a bid for decentralization can invite catastrophe.

To explain this conundrum, consider this: if protocols allow community control, they inadvertently create opportunities for malevolent entities to seize control. From the perspective of a potential exploiter, one must consider the cost of acquiring enough governance tokens to manipulate a vote for transferring treasury assets. Beanstalk’s loss of $182 million provides a sobering illustration of this risk (Blockchain News).

The Role of Governance Tokens

Most protocols have attempted to mitigate this risk by creating a buffer between DAO governance and execution. However, this does not entirely eliminate the potential threats associated with governance tokens. If the governance token plays a significant role in the protocol's design—such that a drop in token value to zero would drive users away—it introduces a risk tantamount to complete protocol failure.

Moreover, this incentivizes the implementation of a “financial security” feature that may be subject to regulation in various jurisdictions, including the United States, where the SEC could potentially intervene. This implicit incentive compels the protocol to support the token's price and deliver value to its holders or else face platform failure while simultaneously risking regulatory scrutiny.

Addressing the Challenges: Creating Value and Separating Functions

To mitigate these risks, protocols need to design valuable applications that can effectively utilize the token. This could be anything from sharing revenue with governance token liquidity providers, as exemplified by GMX, to creating what some might refer to as 'real yield.' It's worth noting, however, that these solutions could also be seen as a security by certain regulatory bodies, necessitating careful consideration.

A potential alternative is to separate the governance token from the 'dividend' token. However, vote-only tokens are often perceived as less valuable since they do not provide substantial value to holders. This lack of value tends to diminish demand and, subsequently, liquidity, as few are interested in providing liquidity to a token that does not attract substantial trading volume in decentralized exchange (DEX) pools. This lack of liquidity then circles back to the original problem of an attacker potentially acquiring enough governance tokens to manipulate governance.

Examining DAO Governance and Decentralization

Returning to the common practice of inserting a buffer between governance and execution, one is led to question if this is genuinely reflective of DAO governance and decentralization. These tokens often function more as 'community suggested votes' (CSV) than as actual decentralized governance votes.

Consider a scenario where a low-value proposal is accepted. How and when is it implemented? What mechanisms are in place if it is neglected? The protocol's development team can potentially disregard community wishes, particularly if the token is merely a vote-only token. If the token is discarded by the community, the impact might be negligible.

The common rebuttal that the team is compensated with the CSV token and, therefore, should care does not necessarily hold. Many projects set a vesting period of three to five years for their tokens, and team members are likely to sell during this time. Additionally, receiving a stablecoin and/or fiat salary could reduce the incentive to manage in favor of token holders, especially as they offload their allocations.

In such a scenario, management decisions might favor venture capitalists who fund their salaries over community holders. This could lead to venture capitalists proposing or voting on measures that benefit their investment strategies rather than the long-term health of the protocol. While innovative governance mechanisms are being designed to address this situation, as seen with private voting on Aztec, a universal solution remains elusive.

The Long-Term Sustainability of Protocols

In the absence of real yield, protocols often resort to incentivizing borrowing through inflation. While this may be effective in the short term, a fully vested and offloaded token from the team, investors, emissions, and so forth, without any mechanisms to burn or lock up tokens, is likely to depreciate in the long term.

When all tokens are in circulation and the only demand is for governance, which might not even have many proposals at this later stage, one might envision low trading volume and a re-emergence of the low liquidity problem. The protocol may then be left with only basic market demand and supply for borrowing and lending, struggling to compete against lending platforms that offer real yield, token burns, lock-ups, or other incentives to attract greater demand.

The Function of Governance Tokens

Given these considerations, governance tokens should not be perceived as a shortcut around regulations, a means to offload team/investor allocations onto the public, or a magic wand to create “decentralization”. They are simply tools in the economic design of a protocol.

If a lending protocol's only means to attract and retain users is through inflationary incentives, bear in mind that such users are essentially rented. The venue of launch—be it on a layer two to attract retail users seeking lower transaction fees is insignificant if there isn't a tangible demand for borrowing. It would be more strategic to develop mechanisms that encourage users to borrow tokens on your platform for use on another, as opposed to merely incentivizing them to recursively borrow and dump the governance tokens.