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“Trust is one of the greatest economic forces on earth.”

- Charlie Munger

The Beanie Baby Investment Case for Governance Tokens

When I started paying attention to crypto way back in 2021, the meaning of “governance token” was self-explanatory: Owning a governance token simply gave you a say in governance.

Projects like Uniswap worded their documents carefully, making it clear that their tokens came with voting rights and nothing else.

For the most part, token holders were in agreement. 

Social consensus at the time viewed tokens primarily as a mechanism to manage decentralized software — token holders were therefore expected to always have the best interests of the protocol in mind.

When a16z delegates its voting rights to outside groups, for example, they instruct those groups to cast their votes solely in the best interest of the protocol.

Importantly, the protocol’s best interest was understood to be whatever made it secure and efficient, not what made its token valuable.

This is a large part of what made protocols different from companies: Whereas shareholders are interested in maximizing the price of a stock, token holders were expected to be interested only in maximizing the usefulness of a protocol.

Two and a bit years on, protocols are looking more and more like companies and tokens are looking more and more like stocks.

Most projects have stopped pretending that the tokens they offer are anything other than pseudo-equity. It’s unexceptional now to see plans to earn revenue and return it to token holders explicitly spelled out in the documentation for a new protocol.

These are only unenforceable promises, of course — and according to Coinbase, they might not even be that. 

Coinbase is winning their ongoing case against the SEC that tokens are not securities mostly by arguing that there is no relationship between the holders and issuer of a token — token holders have no formal claim on assets, cash flows or anything else.

“It’s the difference between buying Beanie Babies Inc. and buying Beanie Babies,” a Coinbase lawyer argued in court.

Matt Levine thinks that’s no way to run a financial system: “The problem for crypto is that, to have a big attractive financial market in the long term, you need to have obligations. You need to have some system for ensuring that investors get what they pay for, that entrepreneurs have duties to the investors who give them money, that people deal honestly.”

But do obligations have to be legally enforceable to have value?

Coinbase makes a convincing case for why the lack of legal obligation means that governance tokens are not securities — but that doesn’t mean they can’t be equity (or crypto’s version thereof).

If nothing else, governance includes the ability to govern yourself a payout.

Unlike equities, this is not a legally binding right.

In most cases, the governance vote would be off-chain and then have to be implemented by a founding team or a multisig, which will have no legal obligation to do what token holders tell them to do. 

To get an equity-like payout from a governance token then, you will just have to trust them.

This is ironic, seeing as crypto is meant to be removing trust from both money and finance. 

But it's not unreasonable.

Most blockchains use proof-of-stake mechanisms to reach consensus, but the rest of the crypto ecosystem — everything that’s not written in code — runs on social consensus.

I’d argue that this has worked pretty well so far. Sometimes even too well.

Most projects are highly responsive to social media sentiment, as evidenced by some recent incidents of airdrop allocations being adjusted in response to widespread complaining — complaining done mostly by airdrop farmers who have no intention of sticking around any longer than it takes to sell their allocation.

If projects are responsive to the concerns of mercenary airdrop farmers, surely we can count on them to be responsive to the concerns of long-term token holders?

Trusting times

Trusting social consensus to enforce unwritten norms may seem naive, but this is not just a crypto phenomenon — traditional finance runs on trust, too.

Consider that companies like Rolex and Red Bull have operated for decades on handshake deals with major suppliers — they consider operating on trust to be safer than operating on legal agreement.

Investors implicitly consider it safer, too.

Apple shares don’t have value because of legal guarantees: Apple’s management could easily destroy the shares’ value without breaking any laws — by giving iPhones away for free, for example. Or buying Tesla.

The damage would be done long before shareholders could vote the rogue executives out.

Instead, Apple shares have value because investors trust management to do the right thing.

This is why Charlie Munger viewed trust as such a great economic force.

Munger, of course, famously hated crypto (“I wish it had never been invented”), so he probably wouldn’t appreciate being invoked in this newsletter.

But is there any reason to believe that the trust that’s worked so well in traditional finance won’t work equally well in crypto finance?

It’s not just TradFi types that are skeptical.

Vitalik, for example, once wrote that buying governance tokens as an investment is “pathological.”

Maybe so.

But I’d argue that it’s a pathology that crypto shares with traditional finance and, well, almost any endeavor in life that involves people.

Trust is what makes most things work — even in trustless crypto.

(And, anyway, how could you not trust that face at the top???)

― Byron Gilliam

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