Weekly Gauge #33 : Governance-oriented tokenomics

Origins of a positive inflation flywheel

In order to anticipate with the most accuracy the triggers and catalysts of the next trends in a financial market, it is important to know precisely the fundamental principles of the said market. This week, we will therefore take a look at the history of DeFi in order to give meaning to what we are building today.

In the aftermath of a historic stock market crash in March 2020, the crypto ecosystem in the broadest sense of the word experienced inordinate growth. This boom period was initiated by an influx of real liquidity from traditional markets -for the technological innovation that the ecosystem represents as much as for its capital efficiency-, but was quickly diluted by a consensus of exacerbated inflationary policies of these new actors of the global economy.

Although the Bitcoin network and the first experiments on Ethereum had already been in production for a few years, we can agree that their ambitions, when they were not oriented towards illegal activities, essentially served as a technological proof of concept and a technical base for future developers.  

Thus, the first tokenomics and iterations on incentive frameworks were born, clearly inspired by, if not replicated from, traditional methods such as quantitative easing. Introduced by Compound and Synthetix, the farming of rewards based on an astronomical rate of token inflation, in exchange for providing depth of liquidity for their financial products, brought in its wake a gigantic wave of projects replicating inflationary schemes -sometimes openly ponzified- which fatally led to the bursting of a speculative bubble when traditional institutions such as central banks finally cut off the floodgates, and highlighted the economic instability of many players.

Nevertheless, some companies that we will qualify today as Blue Chips, were able to take advantage of this period of euphoria in order to gather financial resources but also brilliant minds, which will manage to formulate the stakes of the development of decentralized finance, in particular by insisting on the concept of "DeFi Native" innovation that are not replicable with the tools of traditional finance.

When it came to taking responsibility for the economic failures of many projects, the issue of governance became increasingly important in the development of crypto projects, and the concept of DAO gained considerable momentum. However, the low participation rate of governance token holders in the basic DAO models reproduced from traditional shareholding demonstrated once again the need for "DeFi Native" mechanisms.

Among those projects aware of the impact of their tokenomics on their lifespan, the first to propose a truly effective alternative will be Curve Finance, through its Vote Escrowed CRV (veCRV) model. To date, this mechanism has enabled more than 50% of the CRV supply to be taken out of circulation, effectively countering the inflationary policy of the CRV token, and has also enabled the protocol to achieve record participation rates of around 90% of eligible holders.

Fast forward 2 years during which the governance-oriented tokenomics introduced by Curve has continued to expand its influence and dominance over other decentralized exchanges, many projects have been designed to take advantage of this flywheel while others have adapted to offer their users access to this sustainable source of revenue. This is how the governance wars began.

To better understand the different layers of governance wars we invite you to refer to Weekly Gauge #31 which details the roles of the different players in this DeFi stack. 

Following this constant drive to improve capital efficiency and adoption of these financial services, we can now witness a transition of incentives and capital to layer 2 networks, which we analyzed in Weekly Gauge #32 

To support our argument that the next up-cycle in the valuation of companies offering decentralized financial products and services will be driven by innovation in governance and value distribution mechanisms, we can compare the recent performance of projects in this niche with the rest of the market : 

Finally, it seems coherent for an economy that has its origins in the individual's desire for independence and control over his or her finances, that the issue of governance is a key element in the development of DeFi. Moreover, technological capabilities seem to allow the creation of value at many levels of the process which makes it an ideal field for profit maximalists.