Governance Token Guide - The Good, The Bad and the Ugly

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DeFi days are upon us and the governance token is at the epicenter. Decentralized financial systems that are more secure, more fair, run by code and enforced by the blockchain are now becoming available worldwide and there’s no going back. In fact, innovation in the industry is traveling at breakneck speed. But how are governance tokens evolving to meet the challenges we encountered in the first DeFi wave?

This guide walks you through the good, the bad and the ugly of what we’ve seen so far in governance tokens. Then, we introduce you to a unique, Bitcoin-native approach for blazing the path forward.

What is a governance token?

Governance tokens are cryptocurrencies created by developers to give token holders a say in how a decentralized finance (DeFi) protocol is run. Usage of the governance token, in staking, incentivizing, and putting forth proposals, is governed in an automated way using smart contracts. Governance token holders can help shape the future of the protocol and are incentivized to act in ways that benefit the system as a whole.

In a DeFi protocol, governance tokens disrupt the traditional corporate structure with their ability to support decentralized autonomous organizations (DAOs). This enables a system in which all users are incentivized to do what’s good for the system and where rules are enforced by code and not by people. The governance token helps make it all happen.

Governance token holders normally gain rights by staking tokens, basically setting them aside in a crypto wallet. This entitles them to a share in the protocol’s revenue and voting power to steer the governance.

Sushiswap is one example of a governance token; users stake token pairs in a smart contract and by doing so earn a percentage of fee revenue. Voting rights are also programmatically assigned to stakers so they can participate in the governance system.

DeFi’s 2020 Breakout

Just one year ago, the total amount of assets locked into DeFi protocols was just over $830.8 million. Today, total locked value exceeds $23.6 billion. In 2020, the industry experienced a huge jump in DeFi use cases, including liquidity providing, yield farming, atomic swaps, aggregation of DEX orderbooks, and collateralized and uncollateralized crypto lending. While the hype was insane and risks were high, crypto traders came in droves to try out these decentralized platforms.

governance tokens listed on DeFiPulse platform

DeFiPulse - Total Locked Up Value in DeFi

As with every fast moving phase of innovation, much has been learned since the first generation of DeFi took the stage.

  • We found out that a rapid growth industry cannot necessarily scale if the blockchain it is built on cannot scale.
  • We learned that governance itself can become an attack vector in several different ways if centralization comes into play. Also, increased decentralization is often the solution for closing the gap.
  • Projects learned that to get early adoption, a token launch could supply the funds needed to incentivize onboarding and hire staff to scale the project. But these same launches came to pose threats to the communities involved.
  • We were warned about moving too quickly, without proper audits and without ways to hedge risk.
  • We also realized that Bitcoin made up very little of the value in DeFi markets, largely leaving the most massive network and committed Bitcoin enthusiasts out of the picture.

The Good - Permissionless Financial Governance

Imagine a financial system where participants have the opportunity to have a say in the direction the system takes. (What would it be like if you could help set the course for your bank or centralized trading platform?)

  • DeFi protocols align the incentives of users with the success of the protocol.
  • The community of users can vote on protocol updates and changes through the use of a governance token.
  • All users in the system are incentivized to act in the best interest of the protocol.

Quite possibly the most fascinating thing about DeFi systems is that they’re intended to run autonomously. But as we saw in 2020, many decentralized applications started out with a good deal of centralization, which led to many problems. Many still have these elements of needing to trust 3rd parties in certain interactions.

But 2020 was also the year we repeatedly saw protocols that started out with a central point of authority and moved steadily towards becoming decentralized autonomous organizations (DAOs), transforming into community-led organisms living on a blockchain. But without a governance token to autonomously and reliably manage the evolution of each protocol and incentivizing users to onboard, we might never have had the DeFi boom in the first place.

In the next section, we take a look at some of the “Good” foundational DeFi systems that are shaping the industry: MakerDAO, Compound, and Synthetix.

MakerDAO laid the foundation

MakerDAO launched its decentralized lending platform in 2015 and was an early inspiration for other DeFi protocols. Its $MKR governance token allows holders to vote on any changes that may affect the future of the protocol, such as adding collateral types, adjusting its $DAI stablecoin policy, or raising the debt ceiling. Unlike other DeFi platforms, MKR is a deflationary token because all MKR fees paid to the protocol get burned instead of redistributed.

MKR doesn’t provide a built-in delegation function (Compound does, see below). But in their migration to full decentralization they plan to roll out:

  • Elected Paid Contributors (EPCs) and Domain Teams
  • Maker Improvement Proposals (MIPs)
  • Vote Delegates

Compound introduces next level crypto lending

Compound entered the industry with a lending platform where users could lend cryptocurrency to earn the governance token, $COMP. The token enabled them to vote on proposals on how to run the network. COMP was also trading on secondary markets and during the first week of launch (to get an idea of how avid people were to try it out), the token’s price spiked by 300%.

This wave of quick success was catchy. Compound was built as an algorithmic, autonomous interest rate protocol specifically for developers so they, too, could build open source financial applications with interest earning capabilities.

Compound currently has $3.13 billion locked up in the protocol. COMP tokens allow for a decentralized community of token holders and delegates to make proposals and vote on upgrades to Compound.

Synthetix

Another interesting DeFi protocol that made waves in 2020 was Synthetix, a platform for building synthetic crypto assets. Like MakerDAO and Compound, Synthetix is an Ethereum-based platform with a mission to go completely decentralized. The protocol enables others to lock up $SNX tokens as collateral to create “Synths” or synthetic assets. These synths can be built to track currencies and commodities while providing liquidity for derivatives.

As with many DeFi platforms, at first Synthetix had more centralized aspects, such as only a few major SNX stakeholders were controlling the treasury. The shift to having all token holders govern it began in 2019 and is still in process. The transformation involves the development of a democratic “Spartan Council” made up of 7 seats that are controlled through token governance. This proposed change stemmed from worries over a few larger votes having more weight than many smaller votes.

Even the “Good” DeFi has its limitations

The ideas behind Compound, MakerDao and Synthetix are largely part of a move towards the democratization of access to wealth building tools. Through incentivization-based community governance, all three were trailblazers in governance tokens and continue today to attract billions of dollars worth of staked digital assets.

High transaction fees

However, all three were built on the Ethereum blockchain. As we saw in 2020, the scaling troubles facing Ethereum mushroomed as these 3 protocols acted as a springboard for a DeFi tidal wave of new applications. The result was high transaction fees (sometimes $100 per transaction) that ultimately limited the number of people who could participate - thus negating some of the democratizing effects of DeFi.

The Bad - Decentralization Lost

Concentration of voting power

Even with Compound helping to set the stage, during the initial $COMP distribution, almost 46% of the governance tokens went to early shareholders, founders and the Compound team. The weighting of voting power heavily leaned towards this early group of users. With the project scaling, this voting weight continued to favor early users.

In September 2020, DeFi liquidity protocol, Uniswap, enabled users to earn its $UNI governance tokens to help guide the project’s mission, manage the treasury, and further incentivize liquidity. About 60% of the original “genesis” tokens went to current community members, creating a majority when it comes to voting on, among other things, the community-run treasury.

This is not necessarily a bad thing - the early “OG” users and team were those who provided early liquidity as well as getting the project to launch. The Compound and Uniswap teams are widely respected in the DeFi community but the projects unleashed the ability for others to create similar systems. As with all industries, there will always be a small number of bad actors.

Concentrating voting power in the early stages may help keep a project on track and may be the only way to get that early usage, liquidity and feedback. But creating governance options that can balance the early weighting with longevity scaling will help to keep DeFi protocols on the path to sustainable democratization.

The Ugly - The Wrong Kind of Incentivization

Uniswap, Sushiswap and all the “food” swaps

DeFi was built on a foundation of protocols like MakerDAO and Compound, and was swept into a fury with the launch of Uniswap and through the introduction of yield farms and liquidity mining on decentralized exchanges (DEXes). This may sound complex (it is), yet it took off like wildfire to hardcore crypto traders and developers.

Uniswap introduced a platform building decentralized, automated liquidity providing applications where users could stake tokens and make trades on a DEX to earn interest yields and a share of the transaction fees (the liquidity pool). Before liquidity mining, decentralized exchanges were struggling to provide liquidity to their users.

Since Uniswap was an open source DeFi protocol, it soon became duplicated (“forked”) by other developers wanting to create the APY-earning sensations that Uniswap and Compound had begun. It started with SushiSwap and ended with a lot of people losing money either through bugs in unaudited smart contracts or the worst yet - exit scams.

Exit Scams aka “Rug Pulls”

About 10 days into the SushiSwap protocol launch, community members of this fork of Uniswap watched as the pseudonymous founder cashed out their large share of liquidity providing tokens. Later, he vowed to give them back and relinquished management of the project to FTX Founder, Sam Bankman-Fried. Token dumps like this can leave the community members high and dry with worthless tokens and no way to get their Ethereum reminbursed.

The unfortunate part was that SushiSwap led to a number of other “rug pulls” where scammers rode the hype and took advantage of traders wanting to earn quick APYs without checking into a project beforehand.

Dozens of additional Uniswap “food” forks quickly followed, using largely unaudited smart contracts and trying to get in on the DeFi APY earning craze. The governance tokens issued by some of these DeFi protocols were at times secured only by multi-signature (multisig) wallets, which contained the protocol’s treasury - a precarious system of treasury governance at best.

The community of liquidity providers and yield farmers grew exponentially, as they poured their ETH into higher yield token pairs (the higher the yield, the lower the liquidity of the tokens). This not only drove up gas costs, but it also put users at risk for problems due to unaudited bugs in the code, early centralized control, and exposure to clever scammers. Clearly, moving closer to decentralization and protocols governed by code as soon as possible could be seen as beneficial to all involved.

There were three challenges in the yield farming craze that cropped up to threaten the safety of these protocols:

  1. One was that yield farming consisted of many steps on protocols with complex UIs. Because the phenomenon was so new, you didn’t have much supporting documentation (yet). Yield farmers that were confused, had support issues, or had trouble using DeFi protocols could potentially create a deficit in the governance token running the particular platform.
  2. Secondly, it was the speed at which the “Food Token Fiasco” developed and the buzz created by the DeFi sensation spread. It opened the door for sophisticated scammers who could quickly throw together a yield farm, get an audience and have them stake their tokens, only to learn that the project was a fake and their crypto was worthless.
  3. Flash loans became possible whereby attackers could exploit a DeFi protocol by borrowing capital, spending it, and returning it within one smart contract transaction without any collateral, little risk, and potential for quick returns.

Many of the challenges faced by early DeFi protocols are already being addressed through the incentivization of long term participation as opposed to short term gains incentivization. Much of this has already been achieved through the Sovryn governance token, $SOV.

Qualified Onchain Governance with Sovryn

What is Sovryn?

Sovryn is a Bitcoin-native decentralized trading and lending platform. Through layer-2 technologies and RSK merge mining, Sovryn enables DeFi applications to be run via its unique governance system, the Bitocracy. Through Sovryn, users from anywhere in the world gain access to Bitcoin-class wealth building tools. Sovryn users remain in full control of their Bitcoin while growing their portfolio, while all transactions are programmatically made and enforced by the Bitcoin Blockchain.

Sovyn’s token governance system, the Bitocracy, closes the gap on many of the issues we encountered with first generation DeFi platforms.

how a Bitocracy changes the governance token industry

$SOV Governance Token

The SOV governance token allows for the management and future development of the Sovryn protocol. Rules for making changes are hardcoded into the protocol and enforced on the blockchain. This governance system improves the DeFi experience for users globally in many ways, including:

  • Early adopters gained the option to purchase SOV tokens in the Sovryn Genesis Reservation Sale, helping them to bear the risk in case of bugs in the code in the early releases of Sovryn.
  • SOV holders are incentivized increasingly in relation to how long they stake their SOV tokens as the tokens are weighted by the length of time of staking. Conversely, they are disincentivized to unstake early, although it is possible should they choose to do so.
  • Early adopters and founders have a strict lock-up period to reward long-term participation. The Founders’ vesting is 3 years.
  • During staking, liquidity is suspended, removing the threat of flash loan exploits.
  • While anyone can hold and trade SOV, only those that stake may participate in the governance.
  • A system of quadratic voting calculates the amount of tokens staked and the duration of the staking period to program the weights of each vote. This automatically enables the Sovryn protocol to distribute fees from the trading platform in direct relation to the weight of SOV tokens staked by users.
  • In this system, all staked tokens represent a voice in the Bitocracy, with the added leeway of being able to exit the system if users are not happy with the direction of the protocol.

Participation in the Bitrocracy governance model requires only a browser wallet with zero verification, so is completely permissionless, bringing the monetary sovereignty that Satoshi envisioned into the realm of financial sovereignty. For that to happen, we must be able to use our Bitcoin without giving up our sovereignty by interacting with censorable, centralized exchanges and platforms.

A Bitcoin-native governance approach like the Sovryn Bitocracy ensures that users can trustlessly trade, grow their wealth, and have a direct say in the performance of the platform while enjoying complete financial sovereignty.

Throughout the DeFi experience, each phase we go through strengthens the next. Sovryn is capturing all the learning to create the next generation of DeFi using governance tokens to incentivize the good, while disincentivizing the bad and the ugly.

Learn more about the $SOV Governance Token:

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