Protocol Governance

What is [Crypto] Governance?

Strong governance models have been catalysts for the golden ages of progress, while poor governance models have propelled humanity into the dark ages of regression. Governance models establish formal procedures for conducting the policy, actions, and affairs of a state, organization, or people. They enable systematic decision-making to move groups with shared interests forward.

Governance and power are closely related. The decision-making implications given to those that govern empower them to set rules for individuals in their system.

In traditional corporations, governance tends to be hierarchical. Decision-making is concentrated in c-suite executives, chosen by a board of directors, which shareholders elect. Thus shareholders with the most extensive holdings have more influence over a corporation’s strategic direction. While this correlation of holdings and power is certainly present in crypto, governance and control are less clear-cut than in traditional businesses.

Figure: Corporate Governance

Directionally, it would be fitting to assume that controlling a larger share of a token’s supply leads to more influence over that protocol’s future direction. But the nature of crypto introduces new variables that determine not only who can gain control over tokens in a network but also how that control is allocated over time and whether it even matters for the protocol’s strategic decision-making and future value accrual.

How could it not matter, you ask? In crypto, the devil truly is in the details. Token holder distribution is important, but even more significant are the organizational structures that govern these “decentralized” ecosystems. A protocol’s organizational structures determine where the actual levers of power lie and who can make decisions for a project and its stakeholders.

Similar to traditional businesses, crypto has “off-chain” entities tasked with progressing a protocol’s development and adoption. These entities are typically foundations or development companies associated with a specific token. We will cover these more in-depth later in the piece.

Crypto has also introduced what could be considered the next leap forward in the evolution of governance: on-chain governance. On-chain governance is conducted directly on the blockchain, where “code is law.” It follows the notion that if the code permits a specific action, it should be considered valid even if it exploits the protocol in a never intended manner. This notion is facing legal hurdles despite its prominence in crypto.

Running governance on-chain allows it to leverage some of the core benefits blockchains provide, such as increased transparency, decentralization, and immutability. It has introduced new ways to align decision-making and incentivize behavior. But on-chain governance procedures must first be agreed upon off-chain. This piece will dive into how governance and power evolve in crypto. 

Why Does Governance Matter?

In equity markets, governance structures are clearly defined to protect investor interests. Since real value is at risk in crypto, crypto investors should have similar protections in an ideal world. Crypto operates far from an ideal world, and it is up to token holders themselves to determine whether their interests are being taken into consideration by a project. This can only be done by understanding how a protocol’s underlying governance works, which determines a protocol’s future development.

Once a blockchain or dApp is up and running, it does not exist in a static state. There must be mechanisms to ensure the protocol can innovate and upgrade itself; this is where governance comes into play. The on and off-chain entities with interests in a protocol’s success use these mechanisms to determine the project’s strategic direction. Ultimately they aim to ensure the initiatives allow their project to remain competitive and gain users.

Governance determines how teams allocate scarce resources of developers and capital, what initiatives are worth investing these scarce resources in, and who reaps the rewards should the protocol reach its goals. As an investor, this last point is the most important. Contrary to the general market’s expectation, not all protocols distribute value created by their related products to token holders.

The Inception of a Power Structure: Token Distribution

The original governance structure is set when a team takes a new network from the idea phase into real-world development. Since networks need developer resources to bring their new blockchain idea to fruition, they must raise funds to compensate for development. This is where the team faces a fork in the road. Do they raise exclusively from the public through an initial exchange offering or ICO (gain prospective users) or from private venture investors (gain capital & business resources)? The source a project decides to raise from determines how the supply of their tokens is distributed.

Figure: VC vs. Public Sales

Since most projects want to avoid making a trade-off between gaining valuable early users or the resources from VCs, they typically mix both fundraising options. While they raise from public and private fund investors, what each type of investor receives is very different. Investors in public sales (IEO/ICO) typically only receive tokens, while VCs receive both tokens and equity in a protocol’s development company. This is where the initial power structure and value flows are established. The dynamic between the equity in the development company, which decides how to allocate raised capital to develop the protocol, and tokens that represent ownership in the protocol, lie at the core of how power dynamics in crypto play out. 

In some cases, to incentivize platform usage and create an engagement flywheel for their burgeoning product, protocols enable token emissions to distribute tokens. These distributions are either free or with the contingency of providing economic value. The free distributions are known as ‘airdrops,’ which reward users with tokens for transacting using the related platform. Other distributions require some economic cost, such as providing DeFi liquidity. In both instances, the tokens are assumed to have value by the market due to certain governance rights they provide over strategic decisions for the protocol, including the possibility of deciding whether to begin allocating a portion of the protocol’s fees to token holders. The tokens are also viewed as a method to gain exposure to potential growth in their underlying protocols, assuming that the token will benefit from that growth even when there is no direct value flow established from the product to the token.

The development company or foundation controlling its treasury ultimately decides how to distribute a token’s supply and resources. For newer protocols, the founding teams and VC investors tend to control these entities. Token allocations to public sale investors have trended down since the initial ICO craze of 2017, when new projects could raise hundreds of millions from public investors on nothing but an idea and a dream. Due to U.S. regulations prohibiting the private sales of securities to unaccredited investors, projects offering larger allocations to VCs and development teams have become the norm. Thus projects with outsized influence from their founding teams and primary backers have also become the norm.

The core development team ultimately programs a blockchain and determines when protocol changes can be enacted. Thus the VCs and project teams with equity in the organizations that make these decisions have inherently more power than the token holders downstream of these decisions. One of the most prominent examples of this was Polygon’s most recent hard fork, which only required 13 out of its 100 validators to sign off on a major network upgrade. We mentioned that blockchains are continuously evolving, and while most projects start in this centralized manner, many continually work toward progressive decentralization.

Will the Real Uniswap Please Stand Up?

To illustrate the power dynamic between a protocol’s token holders and the various off-chain entities involved in the governance of that protocol, we will provide an overview of Uniswap and its related token, $UNI, which was recently engaged in a contentious governance predicament.

Here is how Uniswap presents the various entities working on the protocol:

Figure: Uniswap Overview

While this provides an overview of what each different entity is responsible for in the Uniswap ecosystem, it is unclear who leads Uniswap forward and who has the final say on what will happen at Uniswap. Let’s see if we can unpack Uniswap’s power structure by diving deeper into each entity:

Uniswap Labs

Uniswap Labs created Uniswap Protocol, the decentralized exchange product as it is known today. Founded by Hayden Adams, this team raised funding to pay for the development of the trading protocol. The project was initially funded through various grants, including a $100k Grant from the Ethereum Foundation. The team went on to raise three subsequent rounds of funding in exchange for equity in Uniswap Labs:

• $1.8m Seed round led by Paradigm (2018)
• $11m Series A round led by Andreessen Horowitz (2020)
• $165m Series B round led by Polychain (2022)

While the official terms for each raise are not public, the Seed and A rounds likely featured SAFT contracts providing an allocation of any future protocol tokens to VC investors.

Uniswap Labs was initially the sole entity working on the Uniswap Protocol. The protocol consisted of the on-chain smart contract programs behind the automated market maker structure that enables peer-to-peer trading on the Ethereum Network. The development team also created the web-based Uniswap Interface,allowing users to interact with these smart contracts through regular web browsers and hot wallets like Metamask. The team and its investors were the only stakeholders with influence on the strategic direction of Uniswap until 2020, when the team decided to issue an airdrop of the $UNI governance token to past users of the protocol.

Uniswap Governance

To position for “community-led growth, development, and self-sustainability,” Uniswap introduced UNI, a token to enable community ownership of the governance system tasked with moving Uniswap forward. The token represented a move to solidify the Uniswap platform as a publicly-owned infrastructure managed as a decentralized autonomous organization (DAO).

Figure: UNI Initial Allocation  

A 60% majority of supply was allocated to the ‘Community,’ past and future platform users, with 15% being airdropped directly to platform adopters before the airdrop. Within the community allocation, 43% of the supply was issued to the DAO government treasury. The governance treasury currently holds ~$3.0 billion USD of UNI tokens in its treasury at current market prices ($2.3 billion vested). Whether they could liquidate this amount is doubtful, but it nonetheless serves its purpose of funding initiatives in the Uniswap ecosystem. Treasury funds allocate UNI towards grants, partnerships, liquidity mining, and other government programs that would further the development of the Uniswap ecosystem. The Uniswap treasury is the most valuable in all of crypto, according to OpenOrgs.info (as of 2/21/23).

Figure: Uniswap Treasury

After the airdrop, Uniswap Labs was still in control of the Web Interface, which provided users a way to interact with the protocol. Once establishing the UNI governance structure, the Uniswap team stated they would no longer contribute to v2 protocol development (although they were still involved in building v3). They also handed development, auditing, and other matters regarding the v2 protocol over to the community.

While the distribution of tokens enabled community ownership of the protocol’s future direction, the initial governance framework limited the scope of contributions to developing the protocol and its ecosystem.

According to the airdrop announcement, UNI holders were given ownership over the following assets:

• Uniswap Governance
• UNI community treasury
• Protocol fee switch
• Uniswap.eth ENS name
• Uniswap Default Life (tokens.uniswap.eth)
• SOCKS liquidity tokens

While it is true that the UNI token is used to enable governance over these assets, the token in its current form provides no other utility than voting on proposals in Uniswap’s current governance process:

Figure: Uniswap Proposal Process

When a new proposal is presented must follow this process to be approved. The proposal then moves through the following tooling to gain approval:

1. Gov.uniswap.org – forum to discuss merits of each proposal (request for comment)
2. Snapshot – a voting interface where votes are tallied off-chain and weighted based on the number of UNI delegated for each voting address (temperature check)
3. Governance Portal – the final step in the governance process where a proposal is officially voted on through the Uniswap app interface

Community members voted to enhance the governance process and reduce friction by creating the Uniswap Foundation in August 2022. The organization aims to streamline all aspects of governance, including the grants process, treasury management, and developer relations. The foundation was established with $74m in funding from the Uniswap treasury.

As Uniswap continues to decentralize from its roots of a developer and VC-controlled protocol, it has introduced various stakeholders that work towards growing Uniswap, all facilitated by its governance token, UNI.

Governance Tokens and Value Accrual

Governance tokens that promise to provide holders a voice in shaping the future of their respective protocols have become prevalent in cryptocurrency ever since UNI’s airdrop. Sometimes, the governance tokens may even have their influence programmed automatically into the smart contracts they oversee. There is an ongoing debate on whether governance tokens should be valuable, given that many aren’t entitled to cashflows of the protocols they supposedly govern. UNI is one of these platforms, which despite being the third-most fee-generating platform in crypto, has never passed a single penny of those fees to UNI’s token holders (Revenue).

Figure: Token Terminal All-time Fees Leaderboard

Uniswap’s UNI token trades at $7.03, constituting a ~$5.4 billion market cap, or $7.0 billion fully diluted. Yet, in its current form, the token does not entitle holders to equity in Uniswap Labs or fees generated by Uniswap’s protocol. The value of the token is purely derived from its ability to influence decision-making in the governance process laid out above, and speculation that the token will benefit from Uniswap’s continued dominance among decentralized exchange volumes, even if how that value will be transferred, isn’t clear.

But markets assign value based on future expectations, not current conditions. The future expectation is that Uniswap will eventually flip the ‘fee switch.’ The fee switch alludes to Uniswap diverting some of the fees it pays liquidity providers to token holders. At its core level, Uniswap has clearly found product market fit, delivers value, and generates fees for that value. Currently, only liquidity providers are entitled to those fees. Still, investors hold UNI, anticipating that one day it will be able to eventually leverage its dominant position in dex volume to benefit token holders. While Uniswap has begun experimenting with the fee switch, the question remains whether they could enable these fees and maintain the liquidity and market share the protocol has accustomed to having.

Figure: Uniswap Market Share of Weekly Ethereum DEX Volume

The Illusion of Governance

We have covered the theory of governance tokens and how they should work. Still, as always, theory and real-world application can be very different. Recently there was a high-profile example of the interplay between governance tokens and the development team behind them, illustrating how far these tokens still have to go to truly give power to their holders over a project’s future path.

Curious Case of dYdX

dYdX is a decentralized exchange that provides popular financial instruments to traders, such as perpetual, spot markets, and lending services. The platform was built on Ethereum and has been a success by many measures, generating $385m million in revenue since its inception. Like Uniswap, dYdX airdropped its trading token to past users (same ticker as its name). Given dYdX’s success as a trading platform, one would expect token holders could have shared in that success as holders of its underlying governance token.  

Figure: dYdX Revenue vs. Token Price

While the platform itself has done well, there has yet to be a mechanism for DYDX holders to capture any fees it makes from users. In fact, all fees flowed to dYdX Trading LLC, a private entity controlled by the team that built out the dYdX protocol. dYdX has been criticized for lack of transparency on how its team uses these fees. Looking at dYdX’s governance document, they provide an overview of the non-profit dYdX foundation but navigating to the dYdX Trading Inc. section redirects to dYdX’s main site. The team is undoubtedly keeping details of the entity accruing fees close to the vest.

While token holders are not entitled to fees, surely they would have a voice in essential governance decisions regarding the protocol. After all, that is why the governance token exists. The dYdX team recently decided to postpone a scheduled unlock, which would have increased the total liquid supply on the market by 15% had it gone through as originally planned. The market supported the decision, and the $DYDX token rallied following the announcement. If one scans dYdX’s past proposals, extending the unlock is not mentioned. This is because the decision to extend the unlock was made unilaterally by the dYdX Foundation and dYdX Trading Inc.

It’s clear that control over dYdX is still centralized to its development team. In their 2022 ecosystem review, the team reiterated their commitment to decentralizing operations. With the release of the next version of the protocol, the development team promises “that dYdX V4 will be open source, fully decentralized, and entirely controlled by the dYdX community”. Perhaps at this point, the $DYDX token will deliver on its promise of governance over the protocol.    

Conclusion

Governance in crypto is fluid, with most newer protocols starting as centralized entities controlled by development teams and their backers. Teams can progressively work towards decentralization through token distribution and establishing organizations aligned with token holder interests. When investing in tokens with governance utility, it’s essential to understand a protocol’s underlying governance structures and how the token fits into these structures. Investors should not assume that the tokens will accrue value just because the underlying protocol does. While the crypto governance models that have begun to arise are more complex and nuanced than traditional corporate structures, they can bring the core promises of blockchain into a world that sorely needs them: transparency, decentralization, and user-owned products.