HashKey: Deficiency in DeFi Token Governance and Liquidity Incentive Mechanism
Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom)Editor's Note: This article comes from
Chain News ChainNews (ID: chainnewscom)
, Written by: Lin Bullen, working for HashKey Capital Research, published with permission.
This article takes the Compound project as an example to study DeFi governance tokens and liquidity incentives. At present, most of the newly issued DeFi governance tokens do not play a strong role in their ecology, and the project party has not given a good empowerment to the value of DeFi governance tokens. Although liquidity incentives can bring about a surge in the price of DeFi governance tokens in the short term, there are irrationalities in the way and mechanism of token distribution. In the long run, a more complete incentive mechanism is needed to ensure the liquidity of the DeFi ecosystem .
Open finance (Decentralized Finance, hereinafter referred to as DeFi), also known as decentralized finance, refers to various financial field applications for digital currency and digital assets established in an open decentralized network. Based on blockchain technology, the decentralized value network is used to skillfully combine financial services, smart contracts, digital currency and digital assets to maximize efficiency and trust.
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DeFi Market Update
According to DeFi MarketCap data, the current total market value of DeFi project tokens has grown to nearly 7.5 billion US dollars. Although the concept of DeFi has been well known to the public in 2018, it has not fully emerged until today and has become one of the hottest sectors in the cryptocurrency market in recent months. On the whole, there are three main reasons for the recent outbreak of DeFi:
The cryptocurrency market is picking up. The global epidemic situation is gradually calming down. At the same time, after the market fell sharply on March 12, users' investment sentiment is gradually optimistic, and the demand for financial management on lending platforms has increased.
DeFi products are becoming more and more abundant. At present, the products of DeFi projects in the market are becoming more mature and perfect. In addition to the traditional DEX (decentralized exchange), there are also AMM (automatic market maker)-based trading platforms such as Uniswap, Balancer, etc., and derivatives trading platform Synthetix. The functions of the fund lending platform are also more diversified to meet The needs of different users.
This article will mainly discuss the first point above, and introduce the most popular DeFi project Compound as an example, and explain the governance mechanism and liquidity incentives of its project tokens. At the same time, it sorts out the functions and development status of DeFi governance tokens in the market, and finally makes a summary of liquidity incentives.
Compound project introduction
As the pioneer of liquidity mining, the Compound project triggered a market frenzy with the issuance of its governance token COMP. The governance mechanisms and liquidity incentives of other similar projects such as Balancer and AAVE are highly similar to those of the Compound project. In addition, the Compound project currently has a relatively high market value in the DeFi field. Therefore, research on the governance mechanism and liquidity incentives of the Compound project has good reference significance, so that we can better analyze the value capture of DeFi projects.
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Compound Introduction
Compound is a DeFi protocol based on Ethereum. Its main business is similar to the "mortgage lending" of banks. Users can mortgage their assets in the agreement to obtain annualized income, while the lender of the assets needs to pay the corresponding interest . Users borrowing and lending funds through Compound will be accompanied by the growth of Compound's liquidity pool, increasing the liquidity of the ecosystem.
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COMP Distribution Rules
Compound announced at the beginning of this year that it would introduce the governance token COMP, and disclosed the distribution method of 42.3% of the tokens: "borrowing is mining". About 4.23 million COMP out of a total of 10 million COMP will be distributed to users who borrow and borrow on the Compound platform, and it is completely free. The specific distribution rules are as follows:
COMP will be allocated to each lending market (ETH, USDC, DAI, etc.), in proportion to the interest generated in the market, and the allocation ratio will change at any time (the governance proposal was revised to market-based on June 23, 2020) The amount of Chinese capital is allocated as a proportion);
In each market, 50% of the COMP will be allocated to the asset provider, and 50% of the COMP will be allocated to the borrower. Users can obtain the corresponding COMP according to the proportion of their assets in the market;
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COMP Governance Mechanism
According to Compound, users of all protocols and applications developed based on Compound will continuously and automatically obtain governance rights. COMP governance tokens can be used for Compound community governance, and holders can propose changes to the Compound protocol or vote on proposals.
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The figure above shows the entire process of proposal decision-making in the Compound ecosystem: First, any holder who owns 1% of COMP tokens in the entire network can apply for a proposal for the entire protocol. The proposal will include increasing asset support, adjusting the pledge rate, and adjusting the market Interest rate model, modification of some variable parameters in the agreement, etc. Then the proposal will enter a three-day voting window, and any user holding COMP governance tokens can participate (1 COMP represents 1 vote). If the proposal obtains 400,000 votes, the proposal will enter a 2-day waiting lock-up period, and then the proposal will be implemented through the entire network.
According to the governance overview on Compound’s official website, 15 out of 18 governance proposals were approved in the past two months. After the Compound project executes and distributes COMP tokens, there are 11 governance proposals, with an average of about 940,000 votes cast for each governance proposal. According to Coinmarketcap data, the current total circulation of COMP is about 2.56 million, so overall, the frequency and activity of Compound's ecological governance proposals are acceptable. However, it is worth noting that the total number of participants distributed by COMP to liquidity incentives is only about 150,000, that is, about 85% of the votes in each governance proposal come from the Compound team, so the early governance rights of the project are still in the hands of the team. This situation may be alleviated later with the gradual distribution and unlocking of COMP tokens.
At present, the function of COMP token is only the governance right in the Compound project ecology. For ordinary users, the motivation to hold COMP is not high. As a governance token, COMP has limited value in the lending system of the entire platform. . First of all, due to the setting of the mechanism (the proposal can be passed after obtaining a certain number of votes), most ordinary users holding COMP tokens cannot change the final decision-making power of the proposal, so the governance on the chain is still that the big players have the "right to speak" and formulate rules , which indirectly weakens the degree of decentralization of governance rights on the chain. Second, although Compound has switched from the "administrator governance model" to the "community governance model" in the early stage, it is still in the sandbox experiment stage. If some proposals are deemed unsafe or illegal after passing the vote, the team still has the authority to cancel these proposals, which means that the governance rights of users holding COMP tokens are still very limited.
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Compound Project Liquidity Incentive Mechanism
However, in the long run, the siphon effect brought about by the liquidity incentives of the Compound project cannot last. First of all, if the loan volume continues to expand, the COMP tokens obtained by each lending participant will decrease. Due to the distribution mechanism of COMP, the COMP tokens obtained by each participant are related to the proportion of the loan funds invested in the market. Therefore, the increase in the total loan amount of market funds will reduce the proportion of individuals, and then share less COMP Token. Reduced COMP returns will reduce incentives, causing depositors and borrowers to leave.
Third, the liquidity incentives of COMP tokens have an upper limit. According to the COMP distribution rules above, all COMP tokens will be distributed after 4 years. Because this distribution scheme caused many problems, the team proposed a new governance proposal and modified the COMP distribution mechanism. Currently, COMP tokens are allocated based on the total amount of funds borrowed in each market, rather than the proportion of interest earned. At the same time, the tokens distributed in each block will also be reduced to 0.44 COMP. However, after 4 years, the total amount of COMP tokens will be distributed. When users no longer have liquidity incentives, how to ensure the liquidity of the loan pool will become a hidden danger.
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Analysis of DeFi Token Governance Mechanism
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On-Chain Governance Mechanism
Smart contract security issues. The Balancer project has encountered two hacking attacks this year, indicating that the auditing of smart contracts still needs to be strengthened. Blockchain technology can bring decentralization and transparency to users in terms of governance, but at the same time, the characteristics of smart contracts will also become a breakthrough point for hacker attacks, reducing the security of user funds. Therefore, the security of smart contracts needs to be solved urgently, and auditing contracts will become crucial.
Holders who hold a large number of governance tokens have an absolute advantage in the governance process, and ordinary users are not very motivated to participate in governance. There is no doubt that the interests of large investors will be closely related to the proposal, which will further weaken the interests of ordinary currency holders in the DeFi platform. How to balance the weight relationship between large users and ordinary users in the DeFi ecological governance is still not a perfect solution, and the project party urgently needs to find a fairer and safer governance rule to satisfy the checks and balances of the participants in the DeFi ecosystem .
The performance problem of the public chain. At present, most DeFi projects are built on Ethereum, and the performance of the underlying public chain of Ethereum cannot fully support the continuous expansion of the DeFi ecological operation. For governance, if the governance proposal cannot be confirmed on the chain in time when some emergencies occur, it will directly cause the loss of user interests. At present, many DeFi projects have gradually moved to public chains with better performance, and this will also be a trend in the future. The delay-free interaction during on-chain governance will bring better user experience and solve governance problems more efficiently.
The Current State of DeFi Governance Tokens
From the perspective of the functionality of DeFi governance tokens, the earliest DeFi project tokens such as Kyber's KNC and MakerDAO's MKR have relatively complete ecological application functions, such as serving as handling fees, unique destruction mechanisms, governance, etc. , and the diversity of these functions also potentially increases the motivation for users to hold DeFi tokens. In contrast to the new batch of DeFi governance tokens, most of the functions involved are only governance. For example, the governance function of COMP tokens analyzed above still has limitations, so ordinary users have little incentive to hold them. Overall, most of the newly issued DeFi governance tokens are not very functional in their DeFi ecosystem. Of course, it is likely that due to the short issuance time of the tokens, the value of the DeFi governance tokens is still limited by the project team. Without good empowerment, the corresponding relationship between the economic incentive mechanism and tokens in the ecology will take time to dig out.
Generally speaking, the value of DeFi governance tokens should be able to well reflect the business scale of the DeFi project ecology. However, the value capture ability of DeFi governance tokens is weak. With the expansion of governance targets within the ecosystem, DeFi governance tokens cannot capture value well from locked assets. In 2018, the transaction-mining mechanism of the FCoin Exchange once triggered a frenzy in the entire trading market. Although the subsequent failure of FCoin proved that this model is not perfect, the value of the platform currency FT can be seen from governance, sharing of transaction commissions, and destruction mechanisms. Capture in multiple dimensions. At present, the function of most DeFi governance tokens is only voting rights, and their value capture ability is not even as good as the platform currency FT at that time. The price of DeFi governance tokens is not well correlated with its business volume, but presents a short-term speculative phenomenon. This also reflects that the value of DeFi governance tokens has not been fully reflected, and the demand for governance has not increased with the increase in business scale.
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In the case of the growth of the market value of DeFi governance tokens, the liquidity of loan funds is guaranteed, and the deposit interest rate will become very impressive. In most cases, users can even arbitrage on multiple DeFi platforms to further increase their annualized rate of return . This short-term high interest rate phenomenon shows the result of the immaturity of the current DeFi market. With the subsequent growth of the market size and high transparency of information, interest rates will gradually decline, and the arbitrage space will also be compressed.
In a DeFi ecosystem with a complete and well-functioning economic incentive system, the value of DeFi governance tokens will be reflected in the value brought by the game between various users in the ecosystem for their governance needs, but the value base is weak, unlike platform tokens "Repurchase and destruction" has direct economic benefits.
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Liquidity Incentive Analysis
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Reasons for Liquidity Incentives
DeFi governance tokens are inseparable from liquidity incentives, but in essence, the occurrence of liquidity incentives is not brought about by the functions of governance tokens, but for the following two reasons. The first is that this mode of distributing tokens makes users willing to lock up additional funds to provide liquidity for the entire ecosystem. Users can obtain an additional part of airdrops through borrowing, which indirectly increases users' support and loyalty to the project. Second, the price of DeFi governance tokens is more concerned by most users. The rise in the price of DeFi governance tokens has increased liquidity, and the increase in liquidity is good for the fundamentals of DeFi projects to feed back into the continuous rise in token prices. The ultimate goal of obtaining airdrop tokens is to trade them in the secondary market and make a profit, so the continuous rise in the price of DeFi governance tokens plays a vital role in liquidity incentives.
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Drawbacks of Liquidity Incentives
In the early days of the launch of liquidity incentives, the distribution model of DeFi governance tokens did drive the rapid growth of the lending business in the entire DeFi ecosystem, triggering FOMO sentiment in the market and attracting a large number of speculators and arbitrageurs. At present, most users have participated in it, but they ignore the disadvantages brought about by liquidity incentives.
From another perspective, the liquidity incentive model is actually another potential financing method for the project party. The opportunity cost of users injecting funds into the liquidity pool is that they can obtain more interest income on other platforms or off-site, and the project party compensates users for this part of the difference by distributing DeFi governance tokens. At the beginning, the transaction-mining mode of the FCoin exchange was accused of being financing in disguise. Users paid transaction fees, and FCoin achieved "no transaction fees" by returning the user's equivalent platform currency FT. In fact, users Purchased FT with funds. The current liquidity incentives of DeFi governance tokens are essentially the same as FCoin’s transaction-to-mining model, which is not conducive to the long-term ecological development of DeFi projects.
Summarize
The model of liquidity incentives through the distribution of governance tokens is still in the early stages of exploration in the DeFi market, and it will take time to test its long-term feasibility. If the DeFi market wants to become popular in the future, the methods of liquidity incentives need to be more complete and diverse.
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