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Token Daily Newsletter #43

At What Point Does DeFi Become ReFi?

At the heart of DeFi’s explosive growth lies the DeFi governance token. 

$COMP, $LEND, etc. are all governance tokens. Distributing these tokens to DeFi liquidity providers, a process dubbed Yield Farming, recently attracted unprecedented liquidity to corresponding protocols. The canonical example of this phenomenon is $YFI. $YFI is a token that was announced as a worthless governance token for the DeFi protocol on July 17th, only to skyrocket to over $1000 in less than 72 hours and rally to $4400 less than 2 weeks after the announcement. 


$YFI token price since inception


Voting Power

It’d be convenient to dismiss governance tokens’ rising value as a result of speculative activity and liquidity mining inflated incentives. However, there’s something interesting occurring beneath the surface. Venture funds akin to a16z, which holds a significant amount of MakerDAO and Compound governance tokens, likely aren’t flipping tokens to make a quick buck.

DeFi governance tokens offer a unique opportunity to influence the direction of open protocols that are otherwise nearly impossible to control. These tokens authorize holders to vote to change the parameters of underlying protocols. With enough voting power, governance token owners can essentially change the smart contract or roll out newer versions of the protocol. The power allotted to the holders of these governance tokens is not unlike the power allotted to shareholders.

There are several advantages governance tokens have over traditional stocks/shares. In traditional startups/enterprises, shares allow the owner to vote in a friendly CEO or other C-level executives. Governance tokens eliminate the need for voting by proxy. Specifically, funds and large investors can publicly and quickly propose a change, bring it to a vote, tip the scale in their favor, and force their will if they have enough votes. In other words, systems that leverage governance token risk creating a version of Traditional/Centralized Finance (CeFi) that's simply dressed up as DeFi. As we call it at Volt Capital, “ReFi,” or Re-centralized Finance. 

Since DeFi protocols are still in their larval state, we don’t expect to see this happening in the short term. However, once these protocols are as large as Chase, BoA or Wells Fargo, the incentives will change.

Arguments For and Against Governance Tokens

What are steelman arguments against governance tokens becoming stocks 2.0? Let’s look at the most common ones:

  • Governance token distribution is fairer than equity rounds

  • These decentralized protocols cannot be regulated

  • The protocol can be forked if there are massive points of contention


The arguments above largely overestimate the ability to course correct. Let’s examine each one line by line:

Token distribution

DeFi protocol creators and developers try to distribute their tokens widely. Token distribution to liquidity providers is an effort in that vein. However, the reality of these projects often falls short of expectation. Take, for instance, the yield farming phenomenon. Funds and wealthy investors, aka whales, are maximizing their benefit/share of governance tokens using recursive provisioning of liquidity. This ultimately leads to a concentration of these tokens into the hands of a few players/farmers. Additionally, these DeFi projects have investors who currently control a disproportionately large amount of votes. For instance, more than 13% of the voting power for Compound is controlled by the top 10 addresses. Sure, this ownership structure is better than JP Morgan Chase or Bank of America today, but by how much? As evidenced by the charts below, the difference is marginal:



Ownership distribution of major traditional finance players (Source: CNN Money)


A popular misconception in crypto is that DeFi can operate at scale unregulated. This might be true if you create a smart contract, burn the control keys, and leave no tangible way to edit or change the contract. But the existence of governance tokens renders the task impossible. Some projects have experienced limited success to date, but at scale, owning governance tokens can lead to liability of the use of the product which leads to increased regulation.

Major governance token holders could eventually be held liable for unlawful use, e.g. money laundering, facilitated by financial protocols that they have control over. If the majority owners of these tokens are liable, small owners will essentially follow in enforcing any changes that limit the use of the “DeFi” protocols to “unwanted” users. 

Forking Away

A commonly held belief is that it’s easy to fork the protocol if users feel that the protocol is changing direction. But, forking in practice is very difficult to do. Protocols depend heavily on momentum, and a fork away from a governance-structure-gone-awry means shifting the momentum of the protocol against the will of its leadership. There's a level of brand-stickiness that mitigates the effects of forking. For some examples, look no further than Ethereum Classic or Bitcoin Cash. The forked protocols are commonly looked upon as less trustworthy by the vast majority of users. 

There are two other factors that make forking almost impossible.

First, currently successful DeFi protocols are building moats by investing and supporting other DeFi protocols that will integrate with them and serve their community. This creates a fortress of composability that cannot be easily replicated for forking protocols. 

Second, the major investors and backers of popular DeFi protocols are essentially the same small group of investors. Compare that to the list of top 10 shareholders of JPMorgan and BoA above: you’ll quickly see that the game is not that different. 

Governance tokens can open a door of re-centralization that many of us believed were shut. Ironically, initiatives that aim to distribute control can often lead to even more centralization. 

Thank you Magdalena Gronowska, David Vorick, and Leigh Cuen for helpful feedback on this piece.



Long Reads

⚡️ Bitcoin Investment Thesis: Bitcoin as an aspirational store of value system: Ria Bhutoria discusses the ways Bitcoin acts as a store of value. 

🔹 Final Ethereum 2.0 TestnetEthereum 2.0 Phase 0's final testnet Medalla launched on August 4th with the support of more than 20,000 validator nodes and at least 3 completely functional clients: Prysm, Lighthouse, and Teku. Medalla's announcement sets the stage for Ethereum 2.0's launch in November of this year. 

🔹 DeFi Alliance Accelerator: The Chicago DeFi Alliance recently announced a DeFi-only accelerator. The accelerator is supported by large financial players such as Jump Capital, Cumberland, CMT Digital, and Volt Capital.  

📌  Grin Community Collaboration to Bring Mimblewimble to Nervos: The Nervos Foundation recently announced a donation of 10 BTC to the Grin foundation to boost the development of the Grin's MimbleWimble protocol while leveraging the Nervos Network. This is a relatively new experiment in the crypto industry, and, if successful, will likely open the door for further collaboration opportunities between different projects. 



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Disclosure: Volt Capital and/or its partners may have exposure to some of the cryptocurrencies mentioned in this newsletter.

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