But, Arthur, clearly there are a bunch of governance tokens that were successfully airdropped to CFMM liquidity providers on Ethereum, and, clearly, they led to liquidity being provided, and, clearly, people are ascribing some value to them, so what gives?
A few of things are going on.
First, there is simply confusion. If enough people believe that a dex governance token has some value from the mere fact that it sits next to a useful smart-contract, then that can be enough to sustain its value, at least for a while. This gets diluted away as more and more smart-contracts are launched with some tokens sitting next to them. The more generous take on this is that people value having an original Picassos in their living room far more than they value having an indistinguishable copy and who’s to say they are wrong?
Second, some people might cynically believe that these dex governance tokens aren’t really worth anything but figure they can sell them to people who fall in the first category, or even to other people like them who figure they can do so later when there are even more people in the first category. This is basically a gambling game of hot potato, with players knowing full well they are playing hot potato.
Now, you can very well subsidize liquidity provision by catering to (1) and (2) but it seems a bit icky doesn’t it?
Third, there is speculation that some governance tokens will eventually capture cash flows associated with the use of the underlying smart-contract. For example, the UNI token could at one point in the future be programmed to capture 0.05% of the transaction flow through Uniswap.
The third reason is by far the most plausible one for ascribing value to these and it doesn’t share the ickiness of 1 and 2. It’s not, however, without its own problems. Let me put it as dialogue because there are a series of arguments and counter-arguments to consider.
— “The token is valuable because it captures part of the economic value provided by the smart-contract in the form of fees.”
— “It’s easy to replicate the contract, it’s open-source! A version of it without the fee is more appealing.”
— “Not so! The original will have much greater liquidity making it much more appealing even with the fee.”
— “The competitor can automatically route orders to the cheapest pool available, negating the network effects from liquidity.”
— “Yes, but doing so will involve extra complexity and extra gas fees. It might also not work at all on a layer 2 chain where CFMM might move.”
— “You still have the option of raising cold, hard, cash, using that to bootstrap liquidity, and undercut the fee.”
— “It’s not just about the liquidity, it’s integration in wallets, user experience, brand reputation. There’s an entire set of intangibles that are hard to replicate and 0.05% if a very small amount to pay for the convenience. Dropbox is a successful company offering commodity technology in a tidy package.”
— “Fees in traditional finance on centralized exchanges are microscopic in comparison. The financial industry squeezes pennies out of every trade. Choosing which cloud drive provider to pick is very low stakes in comparison. People care about the absolute cost not just the percentage take. Besides, comparison with companies is overrated. Companies place moats to prevent losing network effects from interoperability, moats that can’t really exist in an open environment.”
Now suppose that you’re convinced by the argument that
- A successful enough dex can be sufficiently well protected from the competition to sustain fee extraction.
- The right to receive those fees can be tokenized
- Those tokens can be used to bootstrap the success of the dex in the first place
First of all, this does not mean that the governance token can magically cancel out impermanent loss. The only thing it does here is, at best, shift some of the fees received by late liquidity providers to early liquidity providers. There is a reasonable case that impermanent loss is greater in the early days. When there’s little liquidity, much of the volume is arbitrage, not people wanting to use the contract out of convenience. Nonetheless, it doesn’t eliminate impermanent loss in the long run, at best it lets you get over an initial hump.
Ok, but let’s admit we buy the argument that tokens can capture part of the economic activity in the long run. Then this really becomes an argument for “nationalizing” the functionality at the protocol level and burning 0.05% in tez and using on-chain DAOs to bootstrap those contracts.