Governance token: has dYdX finally found the right formula?

Since the emergence of decentralised finance (DeFi), the main players in the ecosystem have been grappling with a question that no one has yet managed to resolve:

👉 How do you remunerate the holders of a token without taking the (huge) risk of being requalified as a financial security with all the regulatory consequences that implies?

Today, the position of financial regulators, notably the SEC 🇺🇸, is clear: tokens that receive "passive" income must be considered as "securities", i.e. shares that give entitlement to dividends.

"The regulator may consider any governance token that provides a return to be a financial security," confirms lawyer Kristopher Kastens, a partner at Kramer Levin.

At least, as some would say, things are clear.

Result: the vast majority of players in the ecosystem, whether Aave or Uniswap, dare not remunerate token holders, even though the pie is enough to make one salivate: in 2022 alone, the decentralised exchange application Uniswap recorded $620 billion in volume.

While those who contribute liquidity to Uniswap receive a 0.3% fee on these volumes, token holders, who also contribute to Uniswap's development, receive nothing 😅. An injustice denounced by many: "investors in governance tokens provide considerable funding, but have virtually no benefit in return", judges a good connoisseur.

Some projects, such as the GMX application, have begun to remunerate holders of their governance token (we talked about it here), "but everyone expects GMX to be attacked head-on by regulators", he adds.

So all would be lost? 😞

Not at all!

One of the latest entrants to the market, dYdX, thinks it has found THE solution for remunerating holders of its token without it being reclassified as a classic financial security💡.

This "solution"?

Develop its own blockchain and remunerate token holders for their staking activity.

The dYdX solution: having your own blockchain

As some of you may know, dYdX is currently migrating from StarkEx (an Ethereum layer 2 developed by Israeli start-up Starkware) to the Cosmos ecosystem, which is banking on interoperability.

The main consequence of this change is that dYdX will no longer be a simple application designed on Ethereum, but a blockchain in its own right, offering a new life to its governance token, the DYDX.

Evolving on its own blockchain should allow dYdX "to be more scalable and decentralised", but will also "allow us to regain control of tokenomics via staking", explains Charles d'Haussy, CEO of the dYdX Foundation.

In plain English, all holders of DYDX tokens who stake their assets in the new blockchain will participate in securing the protocol, and will thus receive all the revenue generated in proportion to their stake.

Like other players in the ecosystem, dYdX recorded a trading volume of $466 billion last year, which could make some money for token holders! 🙌

"These rewards can't be seen as passive income, it's a kind of salary paid as compensation for securing the blockchain," bellows a source close to the project. "It has nothing to do with a dividend", she continues.

Stakers will mainly be rewarded in USDC stablecoins, via the exchange fees, but also in DYDX tokens.

Interestingly, there is no floor to staker, even small budgets are accepted. Stakers will share the costs generated from using the platform, which amounted to $137.8 million over the whole of 2022 according to a report by the dydX Foundation.

Charles d'Haussy assures that this migration to Cosmos is not a reaction to regulation since the change had been planned almost two years ago. Nevertheless, "it reinforces the decision that was taken by the DAO" by allowing the threat of DYDX being reclassified as a security to be removed.

Investors seem to have approved of the strategy, with the token appreciating sharply in recent days.

A source of inspiration?

Holders of UNI, Uniswap's governance token 🦄, can't say the same. The market's most popular decentralised exchange platform has been divided since September 2020 over the issue of remuneration for holders of the token.

Aside from the argument put forward that charging fees on exchanges would make Uniswap less competitive, many members of the Exchange community reject the allocation of remuneration to UNI holders on regulatory grounds 🔍.

We can understand them: some of them are large US venture capital funds and fear sanctions from the US Securities and Exchange Commission (SEC).

The solution that has been chosen is to charge fees for the sole benefit of the Uniswap Labs start-up (which is behind the development of the app).

In the face of criticism, Uniswap Labs CEO Hayden Adams has defended himself by saying that these fees will only apply if you use the Uniswap Labs user interface (which is the case for most users).

But the problem remains the same for investors: the UNI token keeps seeing its value fall, for lack of any financial incentive to hold it over the long term.... 🙃

What does the future hold for major DeFi applications?

Other major DeFi players have been testing alternative strategies in recent years with varying degrees of success. This is particularly the case with Aave, which allows users to earn a return on their native token as long as they store it within its Safety Module.

In return for topping up this guarantee, holders receive a proportional return paid out in AAVE tokens.

But once again, this reward does not come from the activity generated by Aave. It is taken directly from the DAO's own limited treasury.

"I suppose UNI and AAVE holders would like to have a UNI or AAVE blockchain to offer a redistribution of the revenue generated," explains Charles d'Haussy. "Time will tell how the sector evolves, but people are watching closely what is happening on the dYdX side", he notes.

For projects like Aave or Uniswap, the opportunity to take inspiration from dYdX and launch their own blockchains is not obvious. They rely on the great composability of Ethereum and its ecosystem. They therefore have an incentive to stay where the assets traded and lent for cash are.

The dYdX project does not have this constraint, as it only offers trading in derivatives (which are virtual)... Clearly, it can attract liquidity from any ecosystem.

"These debates highlight the risk of a project launching a token if it has no concrete use for its holders beyond profit sharing," points out Paul Frambot, cofounder of Morpho.

The project born in 2021 has deployed its token on blockchain without making it publicly tradable for the time being. The holders of the token are investors, users as well as contributors.

"Most of the tokens available today don't really have any value, most of the time they rely on a system where investors allow the project team to make money by selling them. That's really not virtuous," he insists.

What's going to happen now? 🤔

The dYdX project will undoubtedly be one to watch over the coming months, as will the Cosmos ecosystem, which is betting that any application has the opportunity to become its own blockchain governed by its own rules. However, there remains the regulatory risk, which has still not been officially decided, even with the new formula...

"Projects can always try to move away from the status of financial security, no one can be sure of success until there is a specific regulatory framework," concludes lawyer Kristopher Kastens. There's no better way to put it.