DeFi: The Dangerous Game of Governance Tokens
Disclaimer: At the time of writing, Oxen was known as The Loki Project — this piece has been updated to reflect this name change
The last few months have generated an explosion of discussion in the crypto world about governance tokens and so-called ‘yield farming’. There’s lots of chatter around incentive structures for the variety of actors in the field. In particular, the DeFi community has settled on a rather unusual consensus about the balance between arbitrageurs, liquidity and infrastructure providers, and the viability of governance tokens going into the future.
I’m going to explore the long-term viability of governance tokens and how modern monetary theory is precipitating into the ideas we’re now seeing in DeFi. This is super interesting, and runs contrary to the popular beliefs of most crypto holders.
The great dichotomy
As far as I can tell, apart from the speculative side of things, the core appeal of cryptocurrency to many was that it existed outside of the regular financial system. A lot of cypherpunks and early adopters of Bitcoin and Ethereum have been harsh critics of central banking and the underlying monetary theories in common use. They believed the highly over-leveraged global economy, built on free-floating Fiat currencies, would eventually fall victim to a catastrophic downfall in confidence in national currencies across the world. I’m not sure how much these people actually believe the US dollar is doomed and Bitcoin is the solution, but being openly critical of the central bankers and politicians in charge of the global economy has been a pretty central activity for any cryptocurrency enthusiast worth their salt.
DeFi is perhaps the ultimate playground for economic incentive schemes and monetary policy ideas. Between lending, borrowing, exchanging, oracleization, backing, wrapping, leveraging, and the manipulation of supply and demand, the world of DeFi tokens is nothing short of paradise for economic theorists. Cryptocurrency is a great sandbox for limited scale incentive structures and monetary policies. It has given rise to an entirely new kind of business structure — one which isn’t backed by shares, but is instead funded through (and rewarded by) a free-floating currency that’s both issued for and intrinsically tied to the business.
But — what if I told you that concepts like yield farming rely not on mainstream economic ideas, but on the principles of modern monetary theory (MMT), which promotes many of the behaviors that the crypto community has traditionally pushed back against?
Money printer goes brrr….
What must be understood about governance tokens is that, generally speaking, they’re not utility tokens. In other words, holding the token does not grant you access to any service whatsoever. Usually the fees you pay to use platforms backed by these tokens don’t require you to hold, burn, or transfer this governance token in any way, shape, or form.
And yet, these governance tokens are used as a method of increasing the incentives available to liquidity providers. This is unusual, as these platform creators are essentially betting there will be enough people buying their governance tokens to offset the returns being given to yield farmers. But if the governance tokens have no utility, what’s driving demand for them in the long-term? Is it even necessary to have ‘real’ demand?
MMT states that depending on how new supply is distributed into the monetary system, the supply of a free floating currency can increase without actually causing inflation (reduction in purchasing power). MMT surmises that it is possible to pay for government spending not by taxation, but simply by creating money to spend on under-utilized human resources, stimulating job growth and real economic output, which in turn creates new demand for the currency. Using that logic, according to MMT, it is possible platform operators can increase the amount of tokens in circulation without affecting their price — but exactly how is not explicit. MMT departs from the traditional understanding of free floating currencies, which suggests that increasing the monetary supply in a given currency system would lead to a reduction in the purchasing power of that asset. Instead, MMT proposes that if new supply is used in certain ways, that currency will maintain steady purchasing power even when more of it is being created.
We have seen this in practice on the Oxen network. Miners are actually a significant contributor to short-term inflation, as they have direct costs they need to offset on a day-to-day basis. Between the hardware and the electricity, miners are not likely to be holding onto assets for long, they need to sell them on the market quickly to cover their costs. One might say the velocity of money in the hands of miners is quite high. Since heavily reducing the miner’s involvement in the emission schedule and consensus mechanism of Oxen, we have seen a dramatic reduction in sell-side pressure on a day-to-day basis.
The same cannot be said for other actors. People that are staking into various coins and projects generally hold a longer view, especially because the lock-ups these investments require can be substantial. With Oxen, we see stakers holding on to their assets for far longer timeframes, reducing the velocity of money to a virtual standstill. The emission that is created to reward stakers does not affect the Oxen purchasing power (price) nearly as much as miners.
Of course, talking about crypto in the context of MMT may seem quite far fetched. The scale at which MMT is normally applied is enormous, so to draw parallels between national economies and comparatively tiny markets with relatively few actors does seem unusual, but there’s more to this than you think.
Pulling apart an example
I’m about to pick on a particular token — but I’m only doing so because it’s a widely known example, and the many of the same arguments can be made for dozens of projects, including BAL, KNC, LEND, MTA, CRV, and so on, but for now, let’s look at everyone’s favourite governance token. Compound.finance runs a smart-contract driven lending platform. Users can lend assets to each other, and through a complex series of smart contracts, are able to borrow assets from pools using other crypto as collateral. In essence, people can earn returns for lending out crypto.
Of course, this can’t yield any real usage if no one wants to borrow. Unlike regular banks, you need at least as much capital to use as collateral as you want to borrow using Compound, so the type of people borrowing money are lower risk, but also lower in number. People that already have money aren’t likely to borrow more, unless they’re trying to leverage their equity in existing assets to pursue greater returns.
The interesting thing about the COMP governance token is that it is awarded to lenders and borrowers. Both users are given COMP, which for borrowers offsets some of the risks associated with leveraging their assets, and for lenders, increases the potential yields lending could deliver.
Yield farming emerged when people realised that if they borrowed from themselves (or at least opened an equivalent position either side of the pool), they could earn COMP and never risk being liquidated on their loan. It’s basically free tokens. Compound gets a bunch of liquidity and lending running through it, people start making money, and the COMP token blows up because people want exposure to the hottest thing in crypto.
But what are lenders and borrowers doing when they run assets through the platform? Who benefits?
The only fees the users pay are to each other and gas costs. The gas cost can be thought of as the Ethereum network ‘taxing’ the users for the security of the Ethereum blockchain, and the interest is paid to the lender. Compound itself — the organization that created the smart contract — is cut out of the loop. Enter: COMP.
The COMP token exists under the guise that it is a governance token. Its sole purported utility is for use in voting on proposals to add new assets, updating oracles, and so forth. The Compound team pushes it as the mechanism by which they hand over control of the platform to its users in a ‘decentralized’ structure. But someone needs to keep the Compound smart contract running, with or without the governance process — decisions need to be made, funds need to be raised, and liquidity needs to be collected and deployed. Many other decentralized governance projects have seen extremely low user participation. If COMP looks to be heading towards this fate, its makers may realise that — at least while they control a decent proportion of the circulating supply — they can maintain the appearance of decentralized governance through a system which is really just ongoing community consultation. If they need to go in a new direction without community support, they can and will without technically violating the rules underlying the governance token. (It should be noted that the COMP token currently does nothing and the ‘proposal’ system is essentially a discussion forum not related to or requiring the token at all.)
You can’t earn money with COMP, you basically can’t affect protocol changes with COMP — the only reason to hold it is because you suspect other people want it. Its actual utility is purely as a speculative asset. The crazy part is: maybe that’s okay.
As long as the Compound team can prop up the market for COMP and prevent a run on the currency, they can keep issuing tokens and expect the purchasing power of these tokens to remain strong. They were able to sell 24% of the entire supply of COMP to extremely high profile investors, and have 22.5% of the supply vesting to themselves, so clearly they have the assets at their disposal to maintain the market price.
The question remains though: how long will this last? Similar questions come from critics of MMT. Surely at some point the value of these assets will shrink, given there is nothing fundamental securing the value of the currency.
Bitcoin pays for its security through emissions and has nothing fundamental propping up its value, yet the demand for Bitcoin is undeniably enormous. Compound pays for their development expenses by creating a token out of thin air and selling it at nearly a $1bn fully diluted valuation, whilst also giving away free COMP tokens to people in order to make it look like their platform is being used for genuine lending purposes (or at least, more than it actually is). Again, nothing fundamental says this token shouldn’t go to zero. And yet, it probably won’t.
People buying COMP today for its speculative value may simply be subsidising the profits of presale investors and people ‘wash lending’ (a more accurate way to describe yield farming on Compound) on the smart contract. Speculation may send COMP higher, but there will be some limit to this demand, and as the rest of the supply starts to vest, the COMP creators will have to be very careful about how they support that market to keep it alive.
The US dollar is being created at extraordinary levels, whilst real productivity has stagnated and even declined due to COVID-19. But the US dollar will probably remain valuable regardless, because that new capital is only being used to pay down debt and purchase assets which will eventually be sold off. This isn’t MMT — this is mainstream neoliberal monetary theory.
In a sense, COMP has managed to achieve the same thing. They’ve printed currency and sold it to buy assets (presumably ETH and USD) which will, at a later stage, be used to buy back the currency to prevent inflation. The part of this plan that puts the COMP strategy squarely into the MMT camp — and beyond the scope of mainstream monetary theory — is the underlying assumption that printing more COMP to pay for user rewards is not only viable but the correct way forward. Essentially they’re positing that being able to pay for spending using currency creation is an acceptable and workable business model.
What’s wrong with this idea is that MMT doesn’t advocate for the free printing of money to solve all of your problems — that’s just an idea that has started showing up in popular culture. The theory states that you can only use new currency supply to pay for things if there is real demand for the currency, which can only be generated by using things like taxes to force the participants of the platform to spend the currency or to pay someone else to cover these taxes in the native currency — something which COMP and many other governance tokens simply do not have.
Using money printers properly
What got me thinking about all of this was my own approach to this challenge in our goal of creating an economic foundation for our own DeFi product. At Oxen, we’re supporting the development of Chainflip, a cross-chain layer to add to the network of liquidity pools forming (Uniswap, Curve, Balancer, and so on). Chainflip offers a seamless method of swapping assets across chains with no wrapping, special wallet software, or complex integrations. You’ll be able to send Bitcoin directly from an exchange and get whatever token you want connected to Chainflip, Curve, or Uniswap.
In designing the cryptoeconomics for Chainflip, considerations must be made about who pays for the costs of keeping the system alive and healthy. For Chainflip, 4 types of actors and how they interact with the system must be considered: Liquidity providers, infrastructure providers, regular swappers, and arbitrageurs.
The emerging field of DeFi wisdom will lead us to believe that the most important people to incentivize in this scheme are the liquidity providers. As swapping is only sensible if fees are relatively low, and more liquidity leads to lower fees, obviously liquidity providers should be paid to keep their capital deployed on Chainflip.
Although this idea is nice, it’s also flawed. Nothing comes for free — and the only people who should be paying for Chainflip are those that use the service, not unsuspecting holders of a governance token. So how can the token economics be engineered to strike a good balance between the various demands of the different actors?
Liquidity providers under the Uniswap model are paid via slippage based fees. Impermanent loss is limited by these slippage based fees, and arbitrageurs are paid to ensure that the trading price on Uniswap is as close to the rest of the market as possible. If the fee structure is changed to further mitigate impermanent loss, that change is paid for by reducing arbitrage profits, which in turn increases the likelihood of price divergence on the liquidity pools. However, arbitrageurs only need to be paid the bare minimum amount to prevent price divergence — and since better liquidity means less slippage, arbitrageurs shouldn’t be much worse off if this approach is taken.
The next demand that must be met is around infrastructure and security costs. Uniswap has no native infrastructure and security, as Ethereum handles that, and the swappers are the ones who end up paying for those fees in the form of gas.
Cross-chain solutions are always going to be more expensive, as securing funds as they move between chains is going to have a cost associated with it. Whether that’s done using collateral, as is the case with atomic swaps, lightning networks, and other ‘dispute’ based ideas, or is done using some kind of decentralized custodial service (Chainflip, REN, THORChain, etc.), the capital that is used to secure the cross-chain transfers has to be paid for by someone.
Forcing users to provide that collateral themselves severely limits real utility, so the cost of collateral has to be socialized in some sense. In Chainflip, vault node operators are paid to put up their own collateral to secure the vaults used to create a trustless custodial service, and that payment comes in the form of coin emission.
How can the cost of that emission be offset? Once again, nothing comes for free, and fundamentally, we don’t want the project to wind up in the same position that COMP and other tokens are in — paying for things by creating new tokens with no practical mechanism of impeding or combatting inflation by stimulating demand for the currency. As such, this emission is paid for by requiring Chainflip users to pay a fee in Oxen — which is burned. This way, security will always be paid for automatically, and the inflation potential created as a result of that is paid down by users of the platform.
So that just leaves the most critical element of it all: the regular user. Chainflip won’t have a monopoly on cross-chain swaps — the lion’s share of that role goes to Binance. It’s just horribly inconvenient — creating accounts, setting up security, 2FA, depositing, withdrawing, and so on. Chainflip offers convenience. It’s the only solution being proposed that allows for cross-chain swaps with no special software, no wrapping, no coin-side integration, accounts, or user-provided collateral.
Chainflip only needs to exist if there is a market for it, and if there is, users will accept slightly higher fees for that experience. Further, if everyone — infrastructure providers, liquidity providers, and arbitrageurs — is incentivized to get more users performing swaps, this will drive Chainflip’s adoption.
The notion of sending fees to zero to inflate usage statistics is very common in crypto. The majority of volume seen on exchanges comes from zero-fee accounts, which increases the prestige of the coins being traded as well as the exchanges themselves. To compete, you have to accept that absurdly low fees are the only way to succeed in a sea of near zero-fee business models. But like I keep saying — nothing is free, someone always pays, and in the case of exchanges, listing fees being extorted from projects has been a very popular business model. Perhaps governance tokens give users and yield farmers a good deal — but it’s paid for by people buying the token.
In the end, it’s ensured that if Chainflip is a valuable product, demand for the native currency behind it is stimulated, instead of simply printing tokens to pay people with poorly aligned incentives. The trend in DeFi at the moment doesn’t seem to care about this idea at all, regardless of whether or not I’m okay with it — this is how it is, and people are making money (for now). But in time, we will see if these practices, market attitudes, and economic designs actually hold water.
MMT is an economic theory which provides a different way to approach macroeconomics. It has often been severely mischaracterized as saying you can just print money without consequence, and we see that mischaracterization being applied in governance tokens (whether intentionally or not). Chainflip is pursuing a different strategy, aiming to develop a robust solution with sensible economics rather than value built solely on speculation.
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