Understanding the Value Source of Governance Tokens in One Article
Like stocks, governance tokens are certificates of future profit distribution rights.This article is sourced from Index Coop and edited by Tudou Research.
Highlights of the article:
The role of governance tokens in value exchange within commercial organizations
"Governance rights" are important rights of producers in modern commercial organizations
The incentive effect of governance tokens on producers and their supervisory role in decentralized organizations
Users participate in organizational governance through governance tokens
I. Introduction | The Rebirth of Crypto: DeFi Governance Tokens
What comes to mind when you think of cryptocurrencies? Is it the unfiltered remarks of Elon Musk, who wiped out hundreds of billions in market value with a single tweet, or the dogecoin represented by a cute yet sarcastic Shiba Inu, or perhaps the sovereign digital currencies that central banks around the world are gearing up to launch?
Undoubtedly, 2021 was a year filled with memes in the cryptocurrency market. It was also a key year for the underlying blockchain technology of cryptocurrencies to move from the code repositories of a few teams to mainstream application scenarios.
However, just as everyone was confusedly trying to connect central bank digital currencies, dogecoin, bitcoin, and Shiba Inu, a type of asset that may have the most potential in the next decade was quietly rising. Beyond the protagonist Bitcoin, the spotlight is also on the governance tokens issued by star DeFi projects. The well-known UNI, SUSHI, and AAVE all belong to governance tokens.
However, governance tokens of blockchain projects have long been criticized and labeled as "air tokens," as if a few people could issue a coin by typing a few pages of code on a notebook and then make countless profits. After the ICO fiasco in 2017, the voice of governance tokens fell silent for a long time, with risk-averse investors becoming increasingly conservative, and the market capitalization of mainstream coins gravitating from project platform tokens to value-storing coins like Bitcoin.
This stagnant situation was revitalized in the summer of 2020. During the months of June, July, and August of that year, several star projects in the decentralized finance (DeFi) ecosystem made breakthroughs in customer acquisition, operations, technology, and financing. Blockchain platforms first truly implemented application scenarios and achieved user growth.
To explain it in the terms of internet companies, it completed the most difficult and crucial evolution from 0 to 1 on the road from 0 to 100. The emergence of decentralized brokers UniSwap and SushiSwap, as well as the lending platform Compound, marked a historic milestone in cryptocurrency history, second only to the issuance of Bitcoin.
Since then, the crypto economy has shed the label of "air tokens," and community-led blockchain platforms have demonstrated validated business models, including value exchange with users, continuous cash flow generation, and user network effects. Users utilize the services of a platform and pay fees to that platform; when users feel that the platform's services meet their needs, they will stay and use it repeatedly, even expanding the marketing chain through referrals. On DeFi platforms, we have already seen business models that are no different from traditional companies under the fiat currency system.
For example, users can buy or exchange crypto assets on SushiSwap, and for each transaction, they must pay a 0.05% fee to Sushi, similar to how brokers charge transaction commissions when buying and selling stocks on a brokerage app or exchanging currency at a bank. When we obtain a small loan on the crypto lending platform Aave, we need to pay a 0.3% fee to Aave. Users who have used Ant Group's Huabei to borrow money will also be familiar with this type of fee structure.
II. Demand Side and Supply Side: The Model of Commercial Organizations
We say that any profit-making organization, whether a company or a DAO (Decentralized Autonomous Organization) in the crypto ecosystem, has value exchange as the cornerstone of its sustainable development. Here, "value exchange" exists in two dimensions, with the organization itself as the intermediary.
On the demand side, value exchange is implemented in the form of a business model, reflecting the value exchange between the products/services provided by the commercial organization and the users. Products bring good experiences to users and meet their needs, and users reciprocate by paying fees to the merchants. Users lack products but have surplus money. Merchants lack money but have surplus products. Ideally, such exchanges enhance the marginal welfare of both parties.
From the consumer's perspective, we can easily limit our focus to the demand side, that is, the link between users and merchants, while neglecting the supply side. We can break down the value chain and treat the commercial organization as an entity, distinguishing it from consumers and producers. Here, the concept of "producers" refers to individuals or entities that provide production factors for the organization, including employees who provide technology and management skills, developers who provide creativity, and financial institutions and investors who provide capital.
On the supply side, there is also value exchange occurring between the commercial organization and the producers. Producers provide production factors to receive returns (wages, equity, or investment returns), and the commercial organization provides returns to producers in exchange for the products generated from the resources provided by the producers.
III. How a World Without Governance Tokens Operates
Under the rules of the traditional business world, demand-side value exchange uses fiat currency as a medium, with users paying merchants in fiat currency to obtain products. Fiat currency, as a value medium issued by central banks and backed by government credit, has had its consensus continuously reinforced and solidified over the millennia since the advent of paper money.
After 2000, the internet ecosystem flourished, and many aspects of human life and production were moved online, leading to changes in the currency that represents the consensus layer of value exchange in economic life, in line with the digital trend. Online mobile payments driven by e-commerce and social platforms are digital fiat currency cash, with their value and liquidity guaranteed by the banking system and centralized authentication.
The invention of Bitcoin gave rise to a batch of internet-native currencies that go beyond digital fiat currencies, collectively referred to as cryptocurrencies. Among them, Bitcoin and Ether (the currency of the Ethereum blockchain) are widely accepted. The high consensus and strong security of these two cryptocurrencies allow people to have reliable value consensus tokens outside the fiat settlement system.
Bitcoin, Ether, and the vast stablecoin ecosystem derived from them provide a strong consensus medium for value exchange, serving as an alternative to fiat currency, thus connecting the demand side.
However, on the other end, the value exchange medium relied upon by the supply side is not just currency. The stories happening on this side are much richer. The demand side involves the interaction between consumers and commercial organizations, while the supply side involves the interaction between commercial organizations and producers who provide production factors (employees, managers, investors, regulators).
What producers require, in addition to simple monetary compensation, is a more important right: governance rights, including personnel appointment rights, existing capital dividend rights, future cash flow distribution rights, and decision-making rights on major organizational matters, even down to the voice in product strategy and functionality.
In traditional business, this mechanism is supported by a comprehensive set of internal and external corporate governance measures.
Let’s make a sweeping generalization and categorize production factors into labor, management, and capital.
Internally, stakeholders include labor factor providers (employees) and management factor providers (managers). Employee benefits are constrained by labor laws and internal company reward and punishment systems, and large companies also provide equity incentives for long-term employees. The decision-making process for major corporate matters is completed by a board of directors appointed by shareholders and executed by managers.
Beyond the black-and-white system, internal governance also relies on ethics and social culture. The corporate culture of different companies influences whether the decision-making process is more centralized or more decentralized, and it also affects whether the distribution of benefits is fair and reasonable.
The board of directors, representing the interests of capital providers appointed by shareholders, serves as the connection point between internal and external stakeholders. In the external supply-side value exchange, investors exercise governance rights through equity backed by securities laws and gain rights to future profits of the company. Besides being supervised by shareholders, companies are also regulated by government agencies.
IV. Governance Tokens 101: Rewarding Producers
The native commercial organizations in the crypto economy are built on a decentralized architecture, rather than traditional equity ownership. Moreover, these decentralized communities mostly do not employ formal employees but rely on community enthusiasts to contribute voluntarily. In nearly a decade of rough development, the crypto community has not been properly integrated into government regulatory systems.
Thus, in the supply-side value exchange chain of the commercial organizations we defined, the governance rights and distribution rights of producers are inherently unprotected.
Platforms created by a few anonymous programmers and crypto culture believers cannot gain trust and consensus. The supply side lacks a value exchange medium, making it particularly necessary to introduce a governance mechanism native to the digital commercial world to protect the rights of producers. Governance tokens emerged as a solution. Decentralized commercial organizations issue crypto governance tokens to provide producers with monetary rewards and governance rights, rewarding them for their contributions in providing production factors.
Governance tokens are also a broad category of cryptocurrencies, utilizing digital encryption technology to ensure that traders can verify the accuracy of each transaction on the blockchain without the need for intermediaries.
Their most basic role is as a monetary equivalent. Decentralized commercial entities can reward contributors (equivalent to company employees) in the form of governance tokens. For example, the decentralized exchange SushiSwap issues $Sushi tokens to the programmers who maintain its platform. As of June 2021, each unit of Sushi could be exchanged for about $9.
V. The Source of Governance Token Value
Of course, wage substitutes are just the most basic function of governance tokens. The grander value of governance tokens lies in their replacement and transformation of the large, effective, and intricate corporate governance systems developed over centuries.
Governance tokens grant holders voting rights. Governance token holders can influence organizational decisions through direct voting or by electing representatives to vote, replacing the equity structure in traditional corporate frameworks. Token holders enjoy rights similar to shareholders, controlling the distribution of existing capital and future cash flows, and having decision-making power over organizational strategy and execution. On a micro level, various improvement proposals in the daily operations and product development of decentralized commercial organizations can be proposed and voted on by governance token holders.
Governance tokens provide a channel for decentralized communities to obtain external financing and governance mechanisms.
In the traditional business world, startups exchange founder shares for angel investments from VCs, and in subsequent funding rounds until IPO, they continuously dilute shares to obtain funds. In this process, capital providers, including VC/PE, industrial capital, and sovereign funds, exchange indirect governance rights over the company for their investments.
Often, venture capital funds will join the company's board of directors post-investment to participate in governance, and major personnel appointments and mergers and acquisitions are also decided by shareholders. When the decentralized lending platform Compound seeks external financing, investment institutions exchange funds for the platform's governance token COMP.
As a proof of equity-like rights, you can think of COMP as the stock issued by Compound, where the proportion of COMP held represents the size of voting rights, allowing decisions on operations and strategy, and implicitly including rights to profit distribution. The important anchor for the value of stocks in the secondary market is the rights to the company's future profits, and the rise in stock prices represents investors' continuously improving expectations for the company's future profitability. Like stocks, governance tokens are certificates of future profit distribution rights.
The governance token mechanism makes the supply-side value exchange more flattened. In the traditional wage + equity model, the bargaining power of laborers and capital providers, both of whom are producers, differs. As the frontline of product and service development and operations, grassroots and middle management personnel, although they are the ones providing labor, only receive wage compensation, and most large companies do not distribute stocks to employees. This leads to the alienation of laborers from the products of their labor.
The products of their hard work are disconnected from themselves, and laborers do not directly enjoy the benefits of the products, thus suppressing their agency. Capital providers (including investors, shareholders, and upper management with substantial equity incentives) obtain excess returns through capital rent-seeking.
Laborers contribute labor, capital providers contribute funds, yet for the same unit of cost, the ROI for capital providers is greater than that of laborers. Indeed, the driving role of capital in business development is undeniable. Visionary investors filter out the best entrepreneurial teams for society and promote corporate growth, and they deserve rewards for their capital expenditures. This mechanism has its positive significance. However, the lack of participation and individual sovereignty of laborers in labor returns can lead to the inability to maximize the overall production efficiency of commercial organizations.
Moreover, distributing labor compensation in the form of governance tokens promotes fairness in supply-side value exchange. By enhancing labor contributors' sense of control over the labor process and labor products, they also achieve a greater degree of self-value realization. Compared to equity, the encrypted endorsement and private key characteristics of governance tokens give holders greater control and sense of self-actualization, and the voting rights they contain transform the top-down decision-making process of traditional corporate systems into a new bottom-up decision-making model in decentralized organizations.
We see that the projects that emerged during the "DeFi Summer" of 2020 brought a new methodology for token circulation. The governance tokens of projects not only issue to investors through financing and reward developers and community contributors but also directly reward product users through "airdrops."
In the traditional business field, there is almost no instance of companies incentivizing consumers with equity, and consumers have no institutionalized channels to participate in corporate governance. Xiaomi, in the early stages of developing MIUI, built a user community rich in human touch, where bugs or improvement proposals raised by MIUI users the day before often went live in the development version overnight.
WeChat product manager Zhang Xiaolong once "joked" that every day, a hundred million people teach him how to make products. Upon reflection, truly user-centric products should indeed be guided by user voices. However, in most traditional companies, even in Xiaomi, which has the gene of an internet-native community, consumers lack institutionalized means to participate in corporate governance.
Issuing governance tokens to consumers is a bold attempt. This diversified governance mechanism poses challenges to governance efficiency. However, in practical applications, apart from providing product users with direct opportunities to voice and make decisions during major product iterations, the main role of governance tokens held by consumers is to balance the management.
Decentralized finance remains a virgin territory lacking administrative regulation. The security of protocols, the moral hazard of developers, and the centralization of voting rights among startup teams and VC institutions cannot completely avoid the possibility of wrongdoing. As users of the product, consumers are the primary stakeholders, and they have sufficient reasons to have a voice in platform governance. The existence of governance tokens is a necessary and optimal solution to plug this gap.
VI. Conclusion
When people question the legitimacy of governance tokens, they often ask why traditional companies do not need to "issue tokens," why blockchain-based crypto projects are rushing to issue tokens, and why "cryptocurrencies" created from a few pages of code can have market values in the millions. It must be acknowledged that crypto projects, due to their decentralized nature, inherently lack institutionalized organizational governance structures, which significantly undermines their fairness and legitimacy, leading to disadvantages in financing and numerous management loopholes.
The application of governance tokens not only bridges the governance gap between decentralized projects and traditional companies but also makes supply-side value creation more efficient and value distribution fairer. The circulation of consensus coins like Bitcoin and Ether solves the value credential issue on the demand side, while governance tokens fill the governance vacuum on the supply side.
People need to stop questioning governance tokens. Instead, the more important question is: why hasn't this project issued governance tokens?
