Realigning Incentives: How to Distribute Governance Tokens Effectively
December 1st, 2021

Convertible Governance Allocations, a powerful corrective tool - Abstract

Token distribution mechanisms have adopted a lot of the structures from within the traditional financial world — including vesting schedules and vesting cliffs — which have resulted in some unintended consequences like adverse price action as tokens vest; and the inability of holders with large economic interests in a protocol to exercise governance control.

This paper presents a model of token distribution that allows token holders who are subject to vesting agreements to exercise the full power of their future governance rights, while also incentivising their long-term interests in the protocol.

In a convertible governance allocation, token holders are issued non-tradeable governance rights immediately, while their ability to trade the fungible governance token vests over time. A complementary mechanism disincentivises early partial redemption by extending the vesting schedule on the portion of tradable governance tokens still-vesting.

Convertible allocations, theoretically, reduce adverse selection (a situation where the distributor of governance tokens is unable to identify the motivations of market participants due to information asymmetry) of governance token holders, incentivise effective governance participation and improve DAO outcomes while reducing governance token sell pressure. They're appropriate for public and private sales as well as airdrops and user behavior reward programs (eg. liquidity mining) where tokens are distributed that have governance rights.

Genuine Governors, Profit Seekers and partial problem solving

DAOs typically struggle to distribute governance tokens to people who actively contribute with long term interests in the success of the protocol.

Existing governance token distribution mechanisms (which were popularised by the Compound liquidity mining program) have been heavily critiqued in recent times (see Alex Kroeger's Mirror article [1]). The programs suffer from an adverse selection problem resulting in two sorts of actors being drawn to a decentralised protocol:

Genuine governors: are interested in the protocol, wish to earn governance rights and contribute.

Short-term profit seekers: are interested in earning governance tokens only for their equivalent cash value. They earn governance tokens, immediately sell them and pocket the profits.

To promote decentralisation, incentivise certain behaviours or fund a DAO's treasury; distributing governance rights is a necessary process. Whether this is accomplished through retrospective airdrops, user incentives, 'governance mining', ICO's or another mechanism; DAOs need a distribution solution that aligns incentives in a way that produces effective outcomes.

To date, proposed solutions have included using vesting cliffs and linear vesting allocations – but these only partially solve the problem.

What is a 'Convertible Allocation’ and how can it solve this?

Holders of the convertible allocation instantly receive a non-tradable token representing their governance rights that allows them to participate in governance decisions as if their allocations had fully vested.

Over time, the tradability of these tokens vests according to a non-linear vesting schedule.

The mechanism also punishes holders who partially redeem their tradable tokens before the vesting period is fully complete, by extending the vesting schedule for their yet-to-be accrued tradability rights. This imposes a 'soft cliff' on the vesting schedule which incentivises holding allocations until they’ve fully vested.

Some clear benefits of the convertible allocation are:

  • Minimisation of governance token sell pressure by preventing immediate tradability of the token
  • Aligns incentives of holder and protocol by providing future interest in the price of the governance token
  • Enables the ability to protect aligned incentives by providing immediate governance rights

A breakdown of how the novel Convertible Allocation mechanism is superior

Traditional vesting mechanisms are crippled by the trade-offs endured by selecting a vesting horizon. While a long vesting period will weed out short-term profit-seekers (long term price exposure threatens their profit maximisation strategies) they also put off genuine governors who wish to have power straight away.

These mechanisms are unfair to genuine governors who should have the ability to influence the protocol with powers equal to their long term economic interests. Hence, vesting cliffs and linear vesting schedules are usually done over too short of a time horizon to effectively limit the participation of rent seekers.

By separating governance and tradability, convertible allocations are flexible enough to enforce longer vesting schedules, therefore self-selecting a greater portion of well-intended governors, easing the adverse selection problem.

The novel convertible allocation mechanism is superior because it will allow greater participation by well-intended governors; while the penalty imposed on early redemptions hugely reduces sell pressure risk. Additionally, the strict alignment of incentives has the power to motivate any rational profit-maximisers to act as an effective governor for the duration of their vesting schedule.

The theoretical outcomes of a convertible allocation include greatly reduced voter apathy, more effective DAO governance, reduced governance token sell pressure and, overall, a far more valuable protocol.

Here are the technical mechanics of a convertible allocation

The following description uses TracerDAO's governance token, TCR as an illustrative example.

Assume that "Jane" has participated in the protocol, or exchanged another asset such that she's entitled to 1000 TCR.

Instead of distributing 1000 TCR to Jane immediately, or on a vesting schedule; Jane is issued 1000 gTCR and a seed of 10 jTCR (1% of her gTCR).

gTCR is a non-tradable representation of TCR. It gives Jane the same governance voting rights as traditional TCR.

jTCR is a non-tradable representation of the accrued tradable rights of TCR. It carries no voting rights, and compounds daily based on a predetermined rate, r.

gTCR and jTCR can be burned together, in a 1:1 ratio to redeem TCR at any time on the dApp.

r is the compounding rate which causes the jTCR balance to become equal to the gTCR balance (assuming no early redemption) after the vesting period of n days. It is calculated using the formula:

For example, with a 180 day vesting schedule the compound rate, r, is approximately 2.6%. The initial 1% jTCR seed is required in order to ensure that jTCR begins accruing.

Each day, the jTCR balance of a wallet is calculated using the formula:

The schedule of accrual, assuming no early burning of jTCR and gTCR occurs within the vesting period, is depicted below:

Convertible Allocation Schedule With No Early Conversion:

If Jane instead decided she wanted to convert some of her jTCR and gTCR into TCR after just 100 days, this would be possible. After 100 days, Jane has accrued 129.16 jTCR.

To prevent her balance from getting harmfully low, she's only allowed to reduce her balance to 1% of her gTCR balance on any early redemptions. Therefore, she's able to burn 119.16 jTCR and 119.16 gTCR in order to redeem 119.16 TCR.

The impact of this early redemption on her vesting schedule is shown in the graph below. Look at how her vesting schedule becomes much longer as a result of her early redemption.

Convertible Allocation Schedule With Early Conversion:

This extended vesting duration penalty creates an active deterrent to redeeming early. Because Jane has a vested interest in the value of the TCR protocol, she'll be inclined to use her voting power and participate in DAO votes in a healthy way that protect her interests.

These conditions have been achieved while actively deterring bad actors or myopic holders from participating in programs to exploit short-term arbitrage opportunities.

What comes next

Convertible allocations are a promising governance distribution mechanism.

The outcomes are strongest when the convertible allocation self-selects the highest conviction governance participants by requiring them to exchange another asset for their convertible allocation as part of a private-sale, ICO or to fund treasury assets.

When the convertible allocation is 'airdropped' or provided to reward user activity, its incentive structure has the power to turn some rent-seeking profit maximisers into genuine governors over the duration of their vesting schedule by providing them with the voting power to influence the value of their future tradable governance rights.

A follow-up to this paper is in the works which will detail the considerations for implementing a convertible allocation.

Written by Pat Jaffe | TracerDAO

Disclaimer: I have not personally come across a mechanism currently used by decentralised organisations similar to the one proposed above. This does not necessarily mean it is novel, however, to the TracerDAO and Mycelium community it is. If you are aware of a similar mechanism in use today, or have feedback, please reach out via Twitter (@isthatPatJaffe) as I would love to discuss.


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