Will The Market Still Value Governance Tokens During the Next Bull Market? UNI Fee Switch

By Michael @ CryptoEQ | CryptoEQ | 14 Jun 2023

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Governance Tokens

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.

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.

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.

Sushiswap serves as an apt example of this predicament, with over 75% of the maximum tokens already in circulation. CEO Jared Grey's new tokenomics plan emphasizes burns, locked liquidity, time locks, and low emissions. But how will this compare to emerging protocols that can offer a fresh supply of incentives and emissions? Sushi inevitably faces a steeper climb.

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.


UNI Fee Switch

The multi-billion dollar valuation of the Uniswap decentralized exchange (DEX) protocol's governance stems from its innovative financial mechanics, specifically its in-built fee system. The Uniswap V2 smart contract, for instance, incorporates a flexible "feeTo" variable, which allows for a proportion of transaction fees to be allocated to an address of choice, rather than going wholly to liquidity providers (LPs). This offers an opening for the Uniswap decentralized autonomous organization (DAO) to direct these amassed fees to its treasury. A multitude of proposals to initiate this shift have emerged, notably one by GFX Labs. The ownership of $UNI tokens, therefore, presents a potential financial benefit to its holders, assuming the "fee switch" gets activated and protocol revenues are shared among token holders.

As of Q2 2023, UNI only gives users the right to participate in protocol governance. However, UNI token holders can vote to turn on this "fee switch" on a pool-by-pool basis. If the vote passes for that individual pool, 10-25% of liquidity provider's fees will go to the protocol. These fees can then, theoretically, be redirected to UNI holders via buybacks and burns. While these mechanisms would turn UNI into a productive asset, they would also reduce revenue for liquidity providers, meaning that these cash flows may come at the cost of hampering the protocol’s growth.

To understand the immense potential of this fee reallocation, we need to delve into Uniswap's earning capacity. Data from Token Terminal demonstrates that if the DAO had secured 5% - 20% of the LP fees, the supplementary capital within the DAO's reach, or accessible to token holders, would range from $125M -$500M. 

However, the application of the fee switch is not without its challenges. Each action requires a proposal and full implementation across all pools could span years under the current voting process. A proposed resolution is to begin with a small trial program before extending the fee switch to other pools, as suggested by GFX. Still, the decentralized nature of DAOs, while transparent and inclusive, is relatively new and can be inefficient.

With the growth of the portfolio under the management of tokenholders, concerns arise on whether it is prudent to diversify the treasury with uncorrelated assets like stablecoins to bolster the DAO's sustainability. Unfortunately, the present governance structure is not well-equipped to manage capital allocation on a large scale. Notably, MakerDAO, another DeFi protocol, recently faced similar problems. Its proposed resolution includes the creation of six sub-DAOs, the application of AI tools, voting incentives, and a governance sidechain. Indeed, operating sizable organizations in a decentralized fashion is a complex undertaking.

It would be logical to consider transferring the fees directly to token holders, but this adds to the already complex tax and legal implications of revenue handling at the DAO level. The U.S. Securities and Exchange Commission (SEC) has recently alleged that over 60 tokens are unregistered securities, and regular disbursements tied to revenues from the underlying technology might strengthen their case. Similarly, regulatory bodies in Europe and the UK present parallel challenges. Considering these complexities, Uniswap and other platforms need to critically evaluate the regulatory environment before implementing revenue-sharing models.

Furthermore, transferring trading fees to token holders might open up the door to competition. Uniswap's open-source V2 and V3 can be easily replicated, and a reduction in LPs' trading commissions could incite a "Vampire attack," reminiscent of Sushiswap's 2020 effort. Despite such competitive threats and the existence of technologies facilitating smart order routing across DEXs, a majority of users prefer interacting with the protocol directly, indicating Uniswap's strong market position.

Maintaining consistent engagement with stakeholders and offering innovative solutions to their challenges is crucial to reinforcing network effects. Therefore, if the DAO decided to activate this fee system, it would be wise to reserve a portion of the accumulated fees for potential usage. This approach, albeit challenging in the context of a decentralized organization, could yield elegant solutions via a thoughtful and iterative process or through improved technology.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


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