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DeFi governance tokens and the new hype cycle

Posted by
Ilya Abugov

The forming unsustainable bubble in DeFi may have negative effects on the industry.

Despite being a young industry, crypto has already seen a number of hype cycles. The rise and fall of asset prices during the ICO, and then the brief but exciting period of IEO days, brought a lot of attention to blockchain-based projects. Now it appears the DeFi sector wants its turn.

Compound’s successful start of distribution of the COMP token appears to have initiated a trend, and we may start to see more and more of these tokens distributed to the public.

While decentralized governance has been one of the core goals of the crypto industry. The rapid rise of these tokens and their exuberant valuation demands a closer look at the underlying risks.

DeFi represents the first real tangible success of decentralized applications. If the sector creates an unsustainable bubble, its implosion may have significant negative effects on the industry as a whole.

Waves protocol founder and CEO Sasha Ivanov recently warned against a potential “ICO bubble” occurring with DeFi projects. Ivanov calls DeFi the future but is concerned by the growing hype around the industry.

Knowing the history of DeFi

Decentralized governance is not a new concept. Projects like Dash, Decred, and Tezos have built on-chain governance into their network functionality. The networks have been managed with various degrees of decentralization and treasury oversight.

For example, Decred has even been able to vote on which PR firm to hire through the Politeia system. However, all of these are layer one protocols. For a dapp, and especially, a DeFi dapp to venture into decentralized governance, one would need to look at MakerDAO.

However, in the case of MakerDAO, MKR, which is often referred to as the governance token, is actually more than that. It is a “recapitalization source”, which can be minted and burned. In fact, during the protocol’s difficult period in March, the MKR tokens were auctioned off to help cover the debt.

In both sets of examples, the governance systems serve three purposes: setting a course for decentralized project management, attracting attention to the project, and incentivizing good behavior.

COMP and its effect on Compound

The distribution of the COMP token has created a lot of excitement in the DeFi space. The perception of scarcity has driven the value of the asset and has propelled Compound into the top 30 on CoinMakretCap.

Moreover, since Compound distributes COMP to those who supply and borrow on the dapp, transaction volumes have skyrocketed in June.

Given the number of active wallets, it looks like the number of users has also increased significantly.

Much of this effect may be due to the nature of the distribution strategy and the interlinked nature of Ethereum DeFi.

Since a user gets COMP tokens for both supplying and borrowing, in order to best “farm” the governance token, it is beneficial to borrow, convert the token on another dapp, and then send back to Compound this time as a liquidity supply.

Consequently, this not only stimulates volumes on Compound but on the supplementary applications as well.

So what’s the problem?

The gathering rain cloud over the accelerating DeFi parade is full of uncomfortable facts. Of the three big goals of decentralized governance discussed above, Compound has achieved generating buzz. In that regard, everything has been perfect, especially timing.

With global economies under stress and the looming presidential election in the US, it looks like it may be at least 5-6 months before regulators, especially the SEC find the bandwidth to look into this new asset.

Given the Howey Test framework, an asset may become classified as a security if: “it represents an investment in a common enterprise with the expectation of profit solely through the efforts of others.” While COMP is not supported by any direct revenue stream (such as a dividend), and its predecessor MKR, has so far remained out of the gaze of the regulators, rampant speculation and exuberant valuation may attract the attention of SEC, much in the same way as the ICO boom of 2017-2018.

Still, Compound attracted attention, but what about the rest of the aspects of decentralization? Compound has historically been a top-heavy project, with major whales generating most of the activity on the dapp.

The skyrocketing volumes have only slightly diluted that effect. Over the last 30 days, the top 30 addresses (by generated volume) have accounted for over 70% of borrowing volume and over 53% of supply volume.

Given that there have been over 10,000 addresses involved in supply operations and over 3000 addresses involved in borrowing operations, the centralization is staggering.

Moreover, these numbers refer to addresses. Not users, given that some users prefer operating multiple addresses, actually centralization may be even more pronounced.

Finally, it is unclear why the distribution of a token that is not algorithmically tied (it does not serve a function in the operation of the protocol) to the system will incentivize good behavior.

For earlier examples, like Decred, the token’s value is ultimately supposed to be linked to the economic value of the network. With respect to the COMP token, the nature of its valuation, even theoretical, at the moment, remains unclear.

The new attack vector

In 2019, Micah Zoltu published a post describing how MKR whales could theoretically attack MakerDAO to make a profit. With the introduction of the COMP token, the dapp potentially adds another attack surface.

On the other hand, it is also conceivable to see the projects TVL become a benchmark for deriving valuation. Similar to the concept of “cost-of-attack” on Ethereum or Bitcoin. The market could see a derivation of a similar idea for DeFi projects.

The DeFi party continues

Still, despite potential pitfalls ahead, right now the DeFi sector is full of optimism. In the spring, UMA launched its voting token, and now, on the heels of Compound’s success. Balancer, a DEX project, has also released its governance token.

Given the crypto market’s propensity for hype cycles, it is natural to expect more projects to start launching their own governance tokens. So far, this experiment has shown the ability to drive awareness and volume. At this point, that seems to be all that matters in the industry.

However, if the trend does take hold, similar to what was seen in the ICO space. The market is likely to start questioning the specific nature of the utility of the new tokens and their valuation. As such, this should only be seen as a first step and it would not be surprising to see the tokens and the distribution methodologies change over time.

We will continue watching this space. Make sure you bookmark DappRadar and sign up to our newsletter below to get updates direct to your inbox.

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