This is our research on the use of sustainable token economic models in lending agreements. It is divided into two parts, and this article is the first part.
The Hover team spent a lot of time researching existing lending protocol structures. Our research reveals multiple challenges these protocols face as they scale and grow.
This series will discuss what these challenges are, why they matter, and how Hover addresses them in our new tokenomic design.
Historically, lending protocols have typically used their tokens for two main functions: governance and issuance. With a clear token utility, one might think that the performance and token utility of the protocol would be passed on to the token value. However, this does not necessarily hold true, especially when looking at the value such platforms bring to their ecosystems.
Instead, token activity becomes correlated with total value locked (TVL) and not with other factors. For example, AAVE experienced a 90% retracement after reaching its peak price in mid-2021. While this trend is highly correlated with overall market performance, token valuations also decline shortly after peak prices as total value locked falls.
AAVE Total Value Locked (TVL) and Token Price (DefiLlama)
The performance of the Venus protocol was even worse, with a 97% retracement from its peak. While such pricing factors are complex, and drastic price drops are seen as the norm in the DeFi space, that doesn't mean this token drop is good or necessary.
Taking the Venus protocol as an example, to reach just 50% of its all-time high price, its market cap would need to be $2.3 billion at the time of writing. Considering the all-time high for DeFi Total Value Locked (TVL) at $174 billion, and the ever-increasing circulating supply of Venus, the chances of $XVS reaching that target again are very slim.
When considering the price-to-total value-locked (TVL) ratio of Venus, we can see a trend emerge that is almost identical to AAVE: the total value locked determines the value of the token.
$XVS TVL and Token Price (DefiLlama)
This analysis is not specific to AAVE or Venus, but to highlight a systemic challenge within the DeFi lending space: lending protocols rely on total value locked (TVL) to maintain token prices. This has led the entire DeFi space to focus on driving growth in Total Value Locked (TVL).
What is the easiest tool to increase the total value locked? It is to issue certificates.
What's the easiest way to push a token's price down? …sell issued tokens.
Disadvantages of distribution
The fundamental reason for the performance of lending protocol tokens and platforms is that they use issuance to attract total value locked (TVL) and boost token prices. As market participants take advantage of the issued tokens and sell the tokens, the price of the token will fall back.
What are the first steps protocol managers or core contributors consider taking to deal with this transition? They increase issuance to increase Total Value Locked (TVL). Due to the increased circulating supply, it becomes exponentially more difficult to reapproach the previous token price when a new round of issuance begins.
We speculate that a decrease in token value reduces the total value locked (TVL) as market participants look for alternative protocols with better token pricing or market rates. This overall model is a vicious cycle where the market is flooded with devalued tokens to drive platform liquidity. However, in such a process, rational market participants will sell their earned incentives, causing the value to fall again.
Lending protocols have taken a short-term approach to platform growth, driven by weak token utility and unsustainable liquidity solutions.
governance deficiencies
Aside from issuance, another oft-cited value driver for lending protocols is governance. While this is good for narrative purposes, the reality is that price-oriented short-term traders tend not to vote or take advantage of governance mechanisms very often. Let’s take MakerDAO, one of the largest DAOs in DeFi, as an example.
MakerDAO (MKR) has a maximum supply of 1,005,577 MKR, with 977,631 MKR in circulation. According to Etherscan, there are more than 93,000 MKR holders on Ethereum. MakerDAO governance proposals used an average of 100,000 MKR to vote on, meaning ~10% of the total supply was used for governance.
Even considering circulating supply, this utilization is relatively low. One might think this is because the community has reached the required quorum, but broadly speaking the community is not participating in governance.
The number of participants is well below 100, and each proposal has a different voting weight. Assuming 50% of MKR holders on Etherscan are smart contracts, escrow, etc. and therefore unable to vote, that still means 0.2% of holders participate in governance activities representing 10% of the total supply.
This suggests that, at least for MakerDAO, governance is not a community-driven value proposition, but rather a secondary use case for a large number of holders.
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