Understanding Common Token Models in DeFi: Fee-based, Governance-based, and Re-collateralization-based

Written by: dYdX Team Compiled by: Leo Young

DeFi Tokens are undoubtedly the best-performing assets in the cryptocurrency market recently, primarily due to one factor: value accumulation.

Most DeFi token models tie the rewards received by holders to network usage and growth. In fact, many successful models are similar to traditional securities. Holders value their assets based on the fees earned within the network and governance capabilities. DeFi tokens also incorporate incentive design schemes to ensure that the interests of the network align with those of long-term holders.

Staking is a common model. Although DeFi tokens have passed the initial value capture tests, many models still need improvement. In the future, the best value capture models for decentralized financial networks will be found through more experimental insights.

Using token incentives to grow decentralized networks is not a novel idea. Fred Ehrsam explained early on in his blog about decentralized business models how to use tokens to solve the chicken-and-egg problem faced by networks and markets. The issue with this approach is the inability to distinguish between long-term investors or users committed to network development and speculators. This problem was particularly evident during the 2017 ICO bubble, where tokens were sold to speculators who quickly profited and sold off, completely disregarding actual network development.

At this point, the industry began designing token model experiments to attract long-term participants. Especially, DeFi became a breeding ground for such experiments. The general utility of areas like staking and lending requires users to join the network, which serves as a large sample for testing these token incentives. Experimental results indicate the emergence of three unique token models, with functional overlap being quite common.

1. Fee-based tokens (cash flow)

2. Governance tokens (voting rights)

3. Final collateral tokens (system re-collateralization)

Many of the most successful tokens gradually merge two functions. Many tokens start as governance tokens and later seek to add some form of fee capture functionality, which can be implemented as long as holders vote for permission. This also indicates that many such tokens have management roles. Essentially, we want network participants to drive more value capture.

Token Classification

Current DeFi tokens in the market

Fee-based Tokens

Tokens generated on DeFi protocols that serve as fees verified through cryptography are called fee-based tokens. Fees are specifically used to access and use DeFi protocols—similar to transaction fees charged by traditional financial service providers. These fees are directly sent to the Ethereum addresses holding the base fee tokens or to a comprehensive wallet. So far, fees are distributed in the base network tokens stablecoins or ETH.

In some examples, token holders vote to decide how to use the accumulated fees. For instance, in the Kyber Network, token holders can use their funds to repurchase KNC on the open market and then burn it from the total supply. The " buy and burn " strategy is commonly used to increase the value of deflationary DeFi tokens.

Fee-based tokens represent a significant advancement in DeFi token models, as they can be valued based on cash flow. Compared to assets like Bitcoin and Monero, which use intangible parameters to value a fixed supply, this model makes it easier for investors to assess value. Tokens can now be valued based on future cash flows, allowing for comparisons among similar projects to determine value discrepancies.

Governance Tokens

Tokens that grant holders the voting power to decide the fundamental smart contract functions of a project are called governance tokens. The foundation supporting the value of governance tokens is that fully decentralized protocols should not be controlled by any single entity. Token holders collectively manage a set of contracts and decide on future protocol changes.

So far, governance DeFi tokens have been used to vote on proposals, determining which assets to support, the collateral levels for certain assets, and how to use protocol fees. For example, Compound has had many new proposals recently to determine the borrowing values of certain assets.

Governance will gradually shift towards deciding how smart contracts should be upgraded. This can be accomplished through programming: once voting is confirmed, smart contracts can adjust without human intervention. To achieve this, developers need to embed proposals into the final code. Thus, once voting is completed, the smart contract will automatically integrate the proposals.

Final Collateral Tokens

Tokens that serve to maintain price anchoring support for DeFi protocols are called final collateral tokens. For protocols that aim to create synthetic assets, there may be situations where there is insufficient external collateral to achieve the anchoring of composite assets. In such cases, the base network tokens can be used as liquidity resources to buy and sell any anchored assets that need to be restored. Tokens are used to support the protocol, and in exchange, collateral token holders typically receive a share of network transaction fees.

The two most notable examples are MKR and MTA. MKR is the first token model supporting final collateral functions. If, for any reason, the system needs to cancel collateral, MKR will be sold on the open market to support Dai supply. In MTA, if any stablecoin in a basket of assets deviates from its pegged value, MTA is sold to ensure that stablecoin holders do not incur losses.

Staking and Inflation

Many DeFi models deploy two elements: staking and inflation.

Staking allows holders to support the protocol's long-term interests. By staking, holders lock up assets for future use, effectively reducing circulation and lowering market selling pressure. More importantly, users can often stake to gain the right to provide services to other network holders. As a reward for providing services and enhancing the network's value, stakers typically receive inflation rewards.

Inflation financing models have been validated and have proven very successful in initiating liquidity in the early stages of protocols. For example, Synthetix uses inflation to incentivize stakers to create synthetic assets, which are then placed on Uniswap, generating liquidity in the secondary market. Until the sETH pool became one of the best liquidity pools for trading ETH on Uniswap, this approach sparked a frenzy.

Staking also brings unique effects to market structure, and whether this is beneficial is debatable. Generally speaking, staking rewards, especially high staking rewards, put pressure on liquidity, making it difficult for buyers and sellers, thus not significantly impacting prices.

Staking suppresses liquidity for two reasons:

1. Staking rewards increase borrowing costs.

2. Incentives encourage holders to stake, keeping assets off exchanges.

High borrowing costs make it harder for market makers to obtain the supply needed for a two-sided market. The fees earned from providing liquidity do not compensate for the staking rewards that holders forgo, especially during periods of high early inflation rates. Similarly, high borrowing costs curtail short selling, as the expected income from short selling must offset depreciation and staking rewards. Given the current price trends of DeFi projects, short selling is unlikely to have an impact on the market. The high staking rewards also somewhat reduce holders' motivation to keep assets on exchanges.

Low liquidity leads to high volatility. For many high-potential DeFi tokens, this creates upward price momentum. Tokens that truly capture value in DeFi almost always have a bullish structure because sellers are scarce. This results in strong upward momentum for DeFi tokens. A prime example is SNX.

Value Capture

The most novel feature brought by DeFi token models to the cryptocurrency asset space is that tokens generate intrinsic value.

Before DeFi tokens, very few tokens could be quantitatively valued. First-generation crypto assets generally could not be valued. Assets were priced based on market structure and narratives, with participants primarily responding to these factors. The fundamental lack of intrinsic value is the root cause of the high speculation and volatility in the crypto asset market. It was widely found that these assets could only appreciate through steadfast holders, after which exchanges issued platform tokens similar to stocks, using the proceeds to buy back and burn tokens, effectively mimicking a stock dividend mechanism. One flaw of platform tokens is the lack of transparency in the buyback and burn process. Holders are unclear whether buybacks are subject to front running or whether buybacks actually occur. Currently, platform tokens only leave behind the expectation of appreciation.

With DeFi tokens, protocol fees are directly distributed to token holders, allowing for at least basic valuation methods such as Discounted Cash Flow (DCF) to analyze network value. Valuation can be conducted by predicting future network growth and then extrapolating current value. Additionally, the uniqueness of DeFi platforms is that they often require a cold start supply side to fully meet demand. To achieve this, many token models combine staking and inflation rewards (as mentioned above). This incentivizes holders to keep tokens off the market, creating a damping effect on sales, thereby leading to greater value capture.

The value capture of purely governance-based DeFi tokens is slightly different. According to fundamental principles, the value of governance tokens is equivalent to the marginal cost of a forked network. The difference with DeFi networks is that forking the code does not simultaneously take away all liquidity, which is the moat of DeFi. Given this, the market may assign a premium to governance rights, as seen with the fully community-operated project Yearn Finance. Yearn performed better than the other two most important governance tokens, COMP and BAL, after its autonomous launch.

Source: coingecko.com

Liquidity Mining Cold Start

Another area of true innovation in DeFi is liquidity mining. As discussed in our recent series of articles on dYdX Trader Insights, liquidity mining is an innovative way for DeFi protocols to establish a user base and cold start liquidity. Liquidity mining has similarities to Bitcoin mining, where protocols reward those providing work or liquidity providers in DeFi, enhancing the value of the network's supply side. This incentive creates initial network effects.

Even though liquidity mining is a brand-new model, it has already proven successful based on early launch scales. After Compound launched COMP liquidity mining, there was a massive increase in deposits, with trading depth increasing by 400%. Similarly, after Balancer announced BAL mining, active users surged. In recent weeks, the focus of the cryptocurrency asset market has been on Yearn Finance users and the massive increase in the total value locked in YFI token issuance. Within a week, the total value locked in Yearn contracts increased from less than ten million dollars to three hundred million dollars.

Although liquidity mining has clearly become an effective way for cold start growth, many behaviors are self-reinforcing, meaning existing DeFi capital switches back and forth between optimal yield opportunities while also leveraging DeFi protocols. This makes liquidity mining unsustainable, but it is important to acknowledge two realities. First, users lock up funds in these protocols to earn yields. Without liquidity mining opportunities, it is unlikely that protocols would achieve such large locked amounts. Furthermore, due to the low profit fees generated by the protocols, intrinsic value is naturally affected.

Secondly, since many liquidity mining opportunities are denominated in stablecoins, users use leverage and certain rewards to pay interest. Essentially, this is a profitable trade, but it also comes with many associated risks. The problem is that when market volatility is high, DeFi can be very fragile, and leverage can collapse quickly. Unfortunately, liquidity mining may increase systemic leverage. Therefore, it is crucial to recognize and mitigate risks before allocating funds to liquidity mining.

Conclusion

The DeFi token model represents a significant advancement in the cryptocurrency asset ecosystem for several reasons. First, DeFi tokens capture intrinsic value by earning on-chain fees through protocols. This makes it easier for investors to adjust based on token value rather than pricing tokens based on market structure and sentiment. Second, DeFi tokens serve as incentive mechanisms, allowing users to participate in a way that reinforces protocol network effects. DeFi tokens are primarily used to incentivize liquidity, allowing early participants to earn substantial rewards. The liquidity incentive models of many newly launched projects have a significant impact on network effects.

Fortunately, we are still at the tipping point of DeFi token experimentation. Fee-based, governance, and re-collateralization models are three important token models used in the early stages. We believe that the DeFi stage will see more innovations. As DeFi networks grow, new token use cases will emerge, allowing the network effects created today to continue.