Rewritten Article:
Author: Outerlands Capital
Translator: TechFlow
Governance tokens have always been a complex and controversial topic among crypto investors, with varying opinions ranging from “innovative” to “unnecessary.” We lean towards the former and believe that well-structured governance tokens can add significant value to a project.
Key Points:
In this article, we present a four-quadrant framework for evaluating governance tokens based on the reliability of token holder rights and control over economic value. After introducing the framework, we provide case studies for tokens in each quadrant, and finally offer recommendations for builders and investors on how to build and evaluate governance tokens.
Introduction:
Governance tokens are often defined as tokens that grant holders voting rights over certain project parameters, which may include implementing product updates, fee/revenue generation, and business development decisions. While market participants often describe governance tokens as a distinct category, it is more accurate to say that governance tokens are a feature or attribute that any token can potentially have. From Layer 1, DeFi, infrastructure, to gaming, every crypto sub-market has examples of governance tokens.
In this article, we explore the utility of governance tokens and under what circumstances they can successfully or unsuccessfully unlock the underlying value of a project. We first introduce the role governance tokens play in cryptocurrencies, address common criticisms, and demonstrate their rationale for existence. This initial analysis reveals two key features required for governance tokens: control over economic value and reliability of control.
We derive a framework from these key features and apply it to case studies to illustrate the differences between projects that meet and do not meet our criteria. Finally, we summarize how projects and potential investors should consider the design and valuation of governance tokens.
Should Governance Tokens Exist?
Some market participants and builders believe that governance tokens have no reason to exist, or at least should be much fewer in number than they currently are. Newly launched venture capital-backed tokens have performed relatively poorly, with high valuations and struggling to compete against large-cap tokens and meme coins, which reinforces the above viewpoint.
Common criticisms include: protocols can function just as well, if not better, without decentralized governance (or even without tokens), and the presence of tokens only decreases efficiency. Many teams simply release tokens for early profitability without a genuine reason to create utility. The utility provided by governance tokens often has little impact on smaller investors who lack sufficient influence to truly shape the strategic direction of a project.
It is worth noting that those who broadly criticize governance tokens are not always influential individuals. Respected figures such as Ethereum co-founder Vitalik Buterin and Flashbots strategist Hasu have expressed doubts about the benefits of governance tokens.
Despite the validity of these statements in certain cases, we believe that all of these claims are incorrect. If structured properly, projects using governance tokens can retain centralized aspects that are typically favorable for startups while unlocking additional value through decentralized governance. For example, teams can retain control over project strategy and product development while providing governance token holders with control over other important parameters such as protocol revenue distribution or approval of new upgrades. Projects can also strategically distribute tokens through airdrops and other community distribution plans to align those who are committed to the long-term interests of the protocol. We believe governance tokens can add value through two main avenues:
1. Governance tokens can help applications manage inherent risks in their business models. It is important to note that they are better equipped to do so than tokenless governance systems because they provide the incentive to do so. For example, governance tokens can help mitigate vulnerabilities stemming from centralized attack vectors within a protocol. While Layer 2 networks like Optimism and Arbitrum are developing their own technologies, they have already collectively accommodated billions of dollars in TVL on-chain. If centralized actors like Offchain Labs (the company behind Arbitrum) were able to upgrade contracts or modify system parameters at will, it would pose significant risks to the network. In other words, if certain contracts suddenly receive malicious code upgrades, funds could be stolen. However, the technology is still under development and requires upgrades to remain competitive. By decentralizing these decision-making powers through a governance process, projects become more resilient as there is no single entity to target for malicious behavior.
2. Governance tokens can provide tangible economic value to their holders. One use case is GMX, which is a crypto derivatives platform that pays a certain percentage of platform trading fees to those who purchase and hold its tokens. Many centralized exchanges also offer trading fee discounts to their token holders. Tokens can also provide similar utility to other projects to offer economic incentives in exchange for development funds or adjustments to incentive mechanisms.
There are many governance tokens that meet at least one of the above criteria, and we are optimistic that there will be more tokens like these in the future.
Outerlands Capital’s Governance Token Evaluation Framework
We view governance tokens through four quadrants. The Y-axis represents reliability, which reflects the strength of the rights granted to token holders. Tokens with strong reliability set clear rights for holders that are not easily changed, allowing holders to have greater certainty in their control over given parameters. On the other hand, tokens with weak reliability only nominally grant voting rights to holders, with significant uncertainty as to whether holders’ rights will be respected by the team or protocol. Chris Dixon also made a similar point in his book, “Read Write Own,” emphasizing the importance of a protocol’s ability to make strong commitments.
The X-axis represents control, defined as the economic value or other utility that token holders possess. Tokens with strong control provide ecosystem participants (users, investors, etc.) with many reasons to hold the token, while tokens with weak control have little incentive to do so.
We have the following attributes in our evaluation framework for tokens with strong reliability:
1. A strong, well-defined charter that aligns with the core essence of the project’s model. The threshold for amending the charter should be higher than other governance votes (e.g., a 2/3 supermajority and 10% statutory quorum).
2. A comprehensive governance process that includes:
– Providing multiple tracks for proposals that balance efficiency and democracy based on urgency and importance. Daily operational functionalities (e.g., appropriations, wages, etc.) should be directly controlled by the team or delegated to specific committees to allow for faster decision-making than standard governance allows. Token holders should still have visibility into these functionalities and the option to dissent when necessary.
– Key decisions (e.g., major technical deployments, fiscal investments above a certain amount, or risk management functionalities) should undergo longer-term (over 1 week) multi-stage discussions.
– A dedicated forum and voting platform that is easily accessible and interactive for token holders.
– Token holders should have the option to delegate their governance power to knowledgeable/aligned parties.
– An emergency DAO/security committee with democratic elections to respond to critical events such as hack attacks. The DAO should have the ability to modify or remove this committee.
– On-chain execution/enforcement of important decisions (so that token holders do not have to trust the team to follow through with voting outcomes). This must be rigorously audited and properly constructed to avoid governance attacks, and on-chain execution should include reasonable time locks.
3. A foundation or other legal entity that represents the DAO in the real world (may not apply to fully anonymous teams). This limits the legal liability of governance participants and makes it easier for others to conduct business with the DAO (as they can interact with more traditional corporate structures).
4. Strong control over any specific utility promised to token holders (e.g., revenue distribution or regular buybacks). Ideally, this can be achieved directly at the protocol level or through smart contracts (the strongest form of commitment), but legal protections are also an option.
Tokens with Strong Control Attributes:
Broadly speaking, tokens with strong control give holders the power to control important economic parameters. The most obvious mechanisms investors look for are those similar to traditional equity. Projects that distribute income to holders (with holders having control over the distribution method) or buy back tokens on the open market are easy to evaluate based on their cash flows. As the underlying business grows, the token also shares in its success, meaning investing in the token is a simple way to bet on the business. Investors can use traditional metrics such as discounted cash flow analysis or relative valuations based on revenue/profit multiples.
However, in addition to capturing value similar to equity, there are several other important control factors that may incentivize holding tokens. These include:
– Other forms of economic utility, such as protocol fee discounts or priority access to products for users holding a certain amount of tokens.
– Control over technical upgrades and deployment of new protocol versions, which may impact stakeholders’ economic interests.
– Control over changes related to token economics, including inflation/deflation and distribution, which may affect the voting rights of existing token holders.
– Influence over business development decisions that may impact the protocol’s financial success, such as team salaries, partnerships, incentive programs, fees paid to third parties like exchanges and market makers, etc.
Evaluation Framework Case Studies:
The following case studies showcase tokens in the four quadrants where governance can enhance and/or weaken the fundamental value of the projects.
Strong Control, Strong Reliability: dYdX
Decentralized derivatives exchange dYdX (token: DYDX) is an example in the quadrant of strong control and strong reliability. Founded in 2017, dYdX offers perpetual contract trading for 66 trading pairs (as of June 2024). In November 2023, dYdX upgraded to its v4 version of the trading software, which included a migration to its own Cosmos app chain and significant improvements to the token economic model through changes in the governance process, token utility, and revenue accrual.
Today, the DYDX token provides the following control mechanisms:
– DYDX is a staking token for the app chain, meaning stakers earn rewards through transaction fees to compensate for the security they provide to the network. Like most PoS blockchains, DYDX stakers earn fees in proportion to the amount of tokens they stake, creating a linear relationship between earnings and token holdings. Token holders who do not wish to stake can delegate their DYDX to others in exchange for a small portion of the earnings they generate. At current activity levels, the chain generates over $43 million in annualized fees for validators.
– DYDX token holders have the right to propose and vote on decisions that directly impact the development direction of the dYdX chain. Recent proposals have included the introduction of new perpetual contract markets, trading incentive programs, funding for the dYdX Foundation, and technical upgrades.
Through the aforementioned upgrades, the DYDX token provides many benefits to stakeholders, including access to governance and control over protocol revenue.Please find below a creatively rewritten version of the article:
**Reevaluating Governance Tokens in Crypto Projects**
**Introduction**
Cryptocurrency projects leverage governance tokens to empower stakeholders in decision-making processes, yet the outcomes vary significantly. This article explores three projects across different governance reliability spectrums, detailing their impacts on development and community engagement.
**Strong Control, High Reliability: dYdX**
dYdX, known for its decentralized derivatives trading platform, exemplifies strong governance with robust reliability. Beyond technical advancements, dYdX’s pivotal move from Ethereum’s rollup to Cosmos was motivated by enhanced decentralization. This shift minimized centralized risks associated with validator sets, allowing direct protocol revenue distribution to token holders via staking rewards—a commitment difficult to reverse. All proposals, once successfully voted upon, are autonomously executed on-chain.
**Weak Control, Strong Reliability: Ethereum Name Service (ENS)**
ENS, a decentralized naming service for wallets, websites, and operations, typifies weak control yet maintains strong reliability. Despite generating $16.57 million in revenue last year (as of May 2024), positioning it among the top 25 revenue-generating projects tracked by Token Terminal, its token ranks outside the top 100 by market capitalization. This is due to its mission-driven DAO framework, prioritizing preventing domain name squatting over profit maximization. ENS’s fee structure, significantly lower than Web2 providers, sustains ecosystem development while allocating excess revenue to broader Web3 initiatives.
**Strong Control, Weak Reliability: Hector Network**
Hector Network emerged in 2021 as an Olympus DAO fork on Fantom blockchain, initially positioned as DeFi’s future reserve asset. It enabled users to stake assets for new tokens while controlling critical protocol parameters. However, operational missteps and market downturns in 2022 hindered its product viability. Dissatisfaction among stakeholders mounted as governance restrictions tightened, culminating in a contentious fund liquidation proposal that saw a drastic token value decline.
**Weak Control, Weak Reliability: Aragon**
Aragon, providing legal, technical, and financial infrastructure for DAO operations, illustrates a case of unreliable governance control. Initially exploring multiple use cases for its ANT token, Aragon shifted focus to general governance utility. However, token holders lacked meaningful control amid sparse community engagement and delayed governance transitions, leading to discounted ANT trading and investor discontent.
**Considerations for Builders and Investors**
Designing governance tokens requires clarity and commitment. Projects intending to integrate decentralized governance should ensure stakeholder rights are legally protected. A clear roadmap towards decentralization avoids governance ambiguities and enhances stakeholder confidence.
In conclusion, while cryptocurrency governance design challenges persist, projects embracing clear governance frameworks benefit from enhanced stakeholder engagement and project sustainability. As the industry evolves, adapting robust governance frameworks becomes imperative for sustained growth and investor trust.
