What are governance tokens? Are they speculation or a necessary existence? Discussing the importance of governance tokens.

DeFi projects need to rely on network effects as a moat, and tokens and liquidity mining are key innovations that drive bidirectional market liquidity.

(This article is authorized to be reprinted from ChainNews, the original title is "The Way of DeFi | Hasu: Tokens are the Key to Guiding DeFi Network Effects", original article here)

Governance tokens (although I prefer to call them equity tokens) typically give holders a share of the fees generated by the project and some voting power in governance.

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Take SUSHI as an example (the native token of Sushiswap exchange), when staking in the Sushibar contract, stakers receive a fee of 0.05% of all trading volume, and they also get "Sushipowah," representing voting power in Sushiswap's off-chain governance system.

Tokens like SUSHI have been one of the most hotly debated topics in recent years, dividing most crypto enthusiasts and researchers into two camps. The first camp believes that tokens are a burden that needs to be minimized (they often question why XYZ project needs a token?). In the past, I was also part of the first camp, but now I find myself gradually joining the second camp, viewing tokens as a necessity and an essential incentive mechanism.

Let me explain how I changed my mind.

I'll start with the theories of the first camp, which can be summarized with three main arguments:

Governance itself is an attack vector because it allows bad actors to change the rules of the protocol and in the worst case even steal user deposits. This goes against the original purpose of using smart contracts.

The goal of crypto projects is to replace rent-seeking companies and institutions with open and fair protocols. Extracting rent from users is a regressive behavior that violates this core value.

Since protocols are open-source, anyone can fork, so equilibrium rent always tends to zero. It's just a matter of time until we converge to this equilibrium, and then the value of governance tokens will also collapse to zero. That's why anyone selling these governance tokens today must be a scammer.

Governance and Security

To put it plainly, I find the first argument to be very correct. The majority of the value in crypto networks and applications comes from being hard to change. This allows users to trust that applications will do what they say they will, and developers can build without platform risk.

Adding governance to a system that doesn't need governance changes this dynamic entirely. When we allow humans to change a system top-down, we lose the above guarantees. And because some changes can be very detrimental to users, we need to pay these governors to bribe them into preferring honest behavior over malicious behavior. In other words, the security model of the application transitions from a cryptographic model to an economic model (guaranteed by economic incentives), and this is terrible.

This argument traces back to Bitcoin itself. Critics argue that we pay miners so much to protect the network, but the only ones who can attack the network are the miners themselves! Do we really want to pay protection money to the mob?

If we could save money, we would gladly get rid of miners. But unfortunately, we need "human input" to order Bitcoin transactions and blocks, so we need to pay human workers enough to incentivize their good behavior.

Need human input -> Need incentives -> Need costs

This argument applies to many systems in DeFi. Without human input, Compound and Maker cannot function, and without fees, they cannot operate. This is because the risks of changes are not isolated, and someone needs to control the addition of collateral because some bad collateral could potentially break the entire system.

For Uniswap or Sushiswap, the situation is different, where each pool is a separate entity. If a pool dries up due to one token going to zero, the risk doesn't spread to other asset pools. Therefore, Uniswap or Sushiswap do not need governance to manage which pools can exist.

However, this doesn't mean that Uniswap and Sushiswap shouldn't have tokens. In fact, I will now explicitly state that they should have tokens. Token maximalism should not be used solely because developers feel the need to provide additional functionality for their tokens, but in conjunction with governance minimalism. Even if a project has a native token, governance minimalism is still key.

Rentier Ethics

Occasionally, people remind us that all our wealth is a result of the capitalist system. This system combines societal incentives with individual incentives, allowing people to be self-serving and benefit society by serving each other.

I believe calling those who serve others in exchange for some compensation "unethical" is illogical. I think DeFi is the fastest-growing innovative market I've seen, and it's no wonder. Smart people have the motivation to work there because they can get rich in the process.

If we have a moral responsibility in this space, it should not be to minimize the rents we seek, thereby escaping capitalism. Instead, we should ensure that the social standards we set for this space align with how humans want to behave and channel that energy into a better world for everyone. Market mechanisms (competition, open-source code, etc.) will ensure that over time, rents do not exceed necessary levels.

Guiding Questions

Critics of tokens argue that because protocols can fork, equilibrium rents will go to zero. I think this is increasingly becoming a pipe dream, for two reasons.

First, without rents, there's nothing worth forking: If you can't reward your early users, it's hard to compete with existing networks. These rewards need to come from somewhere.

Supporters of the first camp often say, "Bitcoin was achieved without rents," yes, Bitcoin emerged without rents, but it didn't emerge without tokens, and in many ways serves the same purpose. Bitcoin wasn't useful early on, but people knew that if it became useful later, each Bitcoin would be worth a lot. So they bought and traded Bitcoin, increasing its liquidity and public image in the process.

If you got in early with Bitcoin, you would have made substantial returns as Bitcoin skyrocketed. So, the real incentive was to be an early participant. However, if you compare this to Uniswap, the largest DEX on Ethereum, you'll find that there isn't the same incentive. Early liquidity providers or traders with Uniswap encounter a worse situation: bad UX, illiquid markets, and no organic traders.

This doesn't mean early adopters are impossible, but they must immediately find a system that is useful to them, a significant limitation for early networks. Imagine if BTC couldn't appreciate, and the only motivation for owning it was for immediate transactions, it likely wouldn't exist today because those use cases weren't realized to a meaningful extent.

This is why it's crucial to have a way for networks and two-sided markets to extract funds from later users to reward early adopters.

This is why I believe the mechanisms pioneered by Synthetix and Compound are so important. These projects found a way to transfer the utility of future adopters to early adopters, bridging the gap during the challenging early adoption stages.

Attracting and Retaining Developers

We've delved into how capitalism operates precisely because it relies on people's self-interest, needing to be able to serve each other.

This is what tokens (specifically pre-mines) can provide: they allow projects to raise funds and hire developers, designers, community managers, etc., most of whom are not working for free.

Now, people usually present two counterarguments, depending on which community they come from.

Bitcoin enthusiasts might say, "Bitcoin didn't have a pre-mine, look at where it is today."

Bitcoin aimed to solve one of the most fundamental problems in the world, hard money. This way, it could attract volunteers who work for it for ideological reasons (also, most Bitcoin contributors today are funded by someone). Not every project can do this, nor should they. There are thousands of smaller problems that need solving, and solving all of these problems can equally change the world.

Ethereum enthusiasts might say, "Uniswap was founded with funding from the Ethereum Foundation."

Indeed, but the funds from the Ethereum Foundation are equivalent to a pre-mine, and assuming Uniswap didn't later raise risk capital to hire and retain more talent, then Uniswap wouldn't be where it is today.

Since Bitcoin's inception, no project has been able to guide itself without rewarding early contributors and not just be a copycat (thus excluding Litecoin). Even Monero, often seen as another fair launch currency, has been accused of having pre-mined. Perhaps we shouldn't condemn this, but we must acknowledge that few are willing to dedicate their lives to a highly speculative venture without any economic incentives.

Network Effects and Moats

At this point, we have established that protocols that tokenize late adopter utility to reward early adopters are likely to outperform those that have no tokens and rely entirely on organic growth. The final question is, if a project has grown large, can someone fork out the fees and tokens to socialize its utility?

First, remember that protocols reliant on human input will never eliminate costs because this is a necessary condition to incentivize miners/governors. These will still generate significant network effects, a new fork must overcome.

For example, the network effects of Maker and Synthetix exist in the form of their synthetic tokens. Any fork would start from zero collateral locked and zero synths in circulation.

Without direct economic incentives, it would be very challenging to get market participants to stop what they're doing and transition to a new system together. A new system, even if slightly cheaper to use, would have a weaker brand, weaker liquidity, no developers, no community, inability to integrate with other projects, etc. Overall, once a project reaches a certain scale, it can essentially resist forks, it's just a matter of reaching that point.

Conclusion

Crypto projects have a disadvantage compared to traditional companies in that everything is open-source, making it harder to monetize innovation. That's why all highly successful crypto projects will rely on network effects, using the superior properties of public blockchains (trustless neutrality, permissionless access, etc.) as their moat.

However, new networks are challenging to guide. Overall, tokens and liquidity mining are an outstanding innovation in guiding two-sided market liquidity, and the crypto market urgently needs to overcome the network effects of existing networks.

Don't just ask "Why does xyz need a token?", we also need to ask "How does xyz support a token?"

Because if a project can support a token, its chances of success significantly increase.