“Code is law”ForksUtility and Governance TokensThe Rise of Decentralised Autonomous OrganisationLimitations of DAOs and the FutureConclusion
Thursday, 15 April, 2021
Governance Tokens: Coordinating the human element
The Decentralised Autonomous Organisation (DAOs) run by the holders of the governance tokens performs the role similar to the upper management of an organisation. They vote on strategic decisions, democratically altering the protocol to perform and grow in a fast-developing ecosystem. Blockchain systems are constantly changing with new users, needs and applications, and code needs human intervention to keep up. DAOs and governance tokens transparently coordinate this human effort and align the interests of all stakeholders.
“Code is law”
The ideal case for blockchains is that “code is law”, that is, the rules of the open-source code of the blockchain or smart contract solely define the scope of what is possible, and everything done within it is fair play. This is derived from the trustless ethos of blockchain, where any interested individual can read and verify the source code themselves, requiring no middle party or mediator to transact. In the early days of crypto, this philosophy worked well when the primary use of crypto assets was as a medium of exchange and there were a smaller number of users to support. “User-beware” and “not your key, not your coin” worked well as the simple rules of the game.
However, as the crypto ecosystem grew with more diverse use-cases and more significant sums of money became involved, differing factions with differing interests and priorities came to be. Any irreconcilable difference among these factions would result in the splitting up of the protocol through a fork. Two of the most prominent examples of this is the Ethereum fork of 2016 and the Bitcoin fork of 2017.<br<
Utility and Governance Tokens
As decentralised applications (dapps) became popular during the Ethereum ICO boom of 2017, utility tokens first gained prominence. These tokens are used as currency within a protocol in exchange for the service the protocol provides. For example, for every data request to the ChainLink Oracle, a fee in LINK has to be paid. Utility tokens provide no other rights or risks and therefore suffer from the problem of value accrual. A protocol's success does not mean that the utility token will have any share in the value generated. Protocols have tried to solve this by burning the tokens earned, decreasing the overall supply, and indirectly increasing the value of remaining tokens. While the problem of value accrual may be partially addressed, utility tokens still do not give the holders any control over the protocol or its direction. Investors remain dependent on the development team, who may not be as motivated to maximise the value of utility tokens as much as the company's equity shares.
The Rise of Decentralised Autonomous Organisation
DAOs have come up to coordinate the efforts of governance token holders and manage the protocol to be more effective in tackling the changing needs of the ecosystem. A DAO enable its governance token holders to participate in a voting mechanism to make decisions when the underlying code is silent or itself needs to be changed. The rules of the DAO define the scope, rights and responsibilities of governance token holders. It also establishes the process by which changes can be implemented. For protocols that earn revenue like some DeFi applications or retained some tokens during distribution, the DAO also controls how the treasury is utilised.
Figure 1 - The treasury size of various protocols
Source: open-orgs.info, zapper.fi
Instead of raising funds through an ICO, governance tokens are usually distributed to users and contributors of the protocol to incentivise protocol adoption and decentralise the governance among the most interested participants. During the fair launch of YFI tokens, Andre Cronje, the founder of Yearn Finance, famously called it to have "no financial value" as no payment had to be made to acquire YFI. However, control over the direction of a multibillion-dollar protocol and its treasury is desirable, and therefore the tokens are valuable.
Figure 2 - The price of the governance token of Yearn Finance – YFI that has “no financial value” according to its founder Andre Cronje
In effect, DAOs perform the role of the upper management of an organisation. Governance token holders vote on strategic decisions, democratically altering the protocol to perform and grow in a fast-developing ecosystem. Blockchain systems are constantly changing with growing users and needs, and code needs human intervention to keep up. DAOs and governance tokens transparently coordinate this human effort and align the interests of all stakeholders.
DAO governance process
The DAO defines a process that must be followed for changes to proposed and implemented. We will use the example of Uniswap governance. All token holders get one vote for each UNI token held. This has a dual purpose – large token holders are more invested in the success of the protocol and therefore should have a higher say, and attacking the governance process through acquisition of majority tokens becomes expensive. To propose a change, the individual typically posts it first on the discussion forumdiscussion forumlink1 to get feedback and gauge whether there is enough interest. Then they must collect the support of holders of 10 mn UNI or 1% of total supply to propose a vote officially. Once the vote is proposed along with the new code, it will pass if it has both a majority and at least holders of 4 mn UNI tokens voting in favour. If it passes, there is a minimum of two-day time lock to ensure the code is safe to deploy, after which it is deployed to the contract. Some DAOs have a non-binding signalling vote before the actual vote to gauge whether there is interest in a proposed change and towards which direction it is leaning.
Figure 3 – Flow chart of a UNI governance proposal
Limitations of DAOs and the Future
DAOs function well when the tokens are evenly distributed. However, in most cases, a few large wallets control a significant part of the tokens. For example, for Compound, just six addresses control more than 52% of the voting powerjust six addresses control more than 52% of the voting powerlink1. These six addresses can out vote more than 150,000 total addresses that have a positive balance. While it makes sense as they are the ones most invested in the protocol, adequate representation of minority investors is also a must-have for good governance and to achieve the blockchain ethos of decentralisation. Quadratic votingQuadratic votinglink1, where the number of votes granted per unit of token held decreases exponentially, may be a solution. This gives small voters more meaningful participation in a proposal, and the cost to a single large entity to control the majority of votes becomes much higher. However, this requires proof-of-humanity to be successful, as without it the system can be gamed by breaking up large wallets into multiple smaller wallets to gain disproportionate voting power.
Governance tokens provide a way to coordinate the human effort required in running a multibillion-dollar decentralised autonomous organisation. The token holders underwrite the protocol risk, and the token accrues value based on the revenue earned by the protocol. Governance tokens have been able to align the interest of all stakeholders, but their distribution and control often lie with a few large players. We look forward to a future where these problems are programmatically solved, and governance tokens and DAOs become the fair controllers of the largest value-creating protocols in the world.
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