Two models emerge for how value might accrue in crypto-land: 1) DAOs will successfully ship products and services that produce cash flow and accrue value to the token. 2) DAOs will act as a sort of infrastructure plane on which dapps are built, which generate cash and accrue equity value.
“You show me the incentives, I’ll show you the outcome”
— Charlie Munger
The theme of yesterday’s and today’s newsletters is capital allocation.
Yesterday, we talked about cash-flowing protocols and when it makes sense for protocols to return capital to token holders.
Today, we’re going to discuss value accrual. Specifically, how murky regulatory waters have caused weird incentive structures and unusual approaches to governance in crypto.
Equity vs Tokens
It’s not uncommon in crypto for a project to have both equity and a token.
For instance, FTX has equity but it also has FTT. Same with Binance and BNB.
Uniswap has the UNI token, but there's also Uniswap Labs, which has equity. The labs model is very common for both DeFi projects (Compound, 0x, etc…) and L1s (Ava Labs, Solana, etc…)
Bored Apes have NFTs (BAYC, MAYC), Ape Coin and Yuga Labs equity. Hmm.
Lots of different options here. The question is, where does value accrue, to the token or to the equity of the project?
In companies, equity helps align incentives. It is the glue that connects competing sets of KPIs between marketing, sales, etc… and helps people get on the same page.
In other words, it gets everyone rowing the boat in the same direction.
But if a project has both equity and a token, how does everyone know which direction to row in?
Good Project, Bad Tokenomics
Two models emerge for how value might accrue in crypto-land:
DAOs will successfully ship products and services that produce cash flow and accrue value to the token.
DAOs will act as a sort of infrastructure plane on which dapps are built, which generate cash and accrue equity value.
Let’s take the example of Uniswap Labs, which has the option of turning on the fee switch and diverting real cash into the DAO's treasury, which (theoretically) token holders would have a claim to.
(I made that sound very simple, but it’s not. It’s both technically challenging to do on v3, and it’s unclear how this would impact Uniswap’s ability to be competitive. Listen to this podcast episode for more details.)
The decision to turn on the fee switch would drive cash flow toward the Uniswap protocol, and thus, value is slowly added to the UNI token.
The problem with this model is that UNI starts to look an awful lot like a security, which is a problem.
The Howey Test states that an asset is a security if there is:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
I am not a securities lawyer. And if you have ever interacted with a lawyer, you might be familiar with the unique type of agony that is trying to get a straight answer from one.
My understanding today is that projects are getting different advice from different legal firms about how to avoid their tokens fitting the above definitions.
But, when you start to look at Uniswap's current set up through the lens of the Howey Test, some things kind of start falling into place.
For instance, a court can’t make a case for a “common enterprise” if Uniswap Labs is separate from Uniswap the DAO. It’s also harder to make the case for profits to be derived from the efforts of others.
The Goal of DeFi
I want to be clear: This is not meant to be an indictment of the current state of DeFi.
It’s an acknowledgement that DeFi protocols are in a challenging predicament, in large part due to the current state of regulation.
Having interacted with the Uniswaps and Compounds of the world, I believe their goal is to ship great products that will radically change the world of finance.
That being said, we do not currently have a regulatory structure in place that supports this new model.
For that reason, teams like Uniswap have to suffer through tremendous friction and bend over backwards to be compliant.
And the situation makes incentives tricky for the Uniswaps and Compound Labs of the world, because now they have to decide:
Do they focus on improving the base protocol and accruing value to the token?
Or, do they focus on shipping products built on that protocol and accruing value to the equity?
Also, if Uniswap or Compound Labs is TOO effective at accruing value and profits to the token, the government could argue they did an illegal security sale and send them to prison.
Pretty clear incentives if you ask me.
So now what we have is a structure where there are two incentive mechanisms (project equity and tokens), a scenario which is inherently more complex than having just one (equity alone or token alone).
This is why it is critical that crypto as an industry fundraise, raise our voices in DC and push for a model that accommodates innovation.
Once investors and builders feel comfortable operating without regulatory overhang, the sky's the limit for what this space can do.