Airdrops: From User Growth to Governance

In this edition, we explore the role of airdrops in web3 user growth and decentralization.

With airdrop season upon us, it‚Äôs time to explore the journey from user growth to decentralization in our feature, ‚ÄúUnpacking Airdrops: From User Growth to Governance.‚ÄĚ

Before we dive in, here's a rundown of the latest in web3 governance.

The First-Ever Multichain Governance System

Wormhole, Tally, and ScopeLift have announced MultiGov, the first multichain governance system designed for DAOs operating across Solana, Ethereum, and EVM-compatible Layer 2s.

Gnosis 3.0

Gnosis has progressed from a prediction market (Gnosis 1.0) to an integral part of Ethereum's infrastructure (Gnosis 2.0) and is now advancing to Gnosis 3.0. This phase focuses on a network of projects linked by the GNO token, signaling a shift towards open financial rails, facilitating wider access to decentralized financial tools.

Zero-knowledge proofs of identity using electronic passports

The proposal explores the use of zero-knowledge proofs of identity utilizing electronic passports, addressing the challenge of verifying users' identities online without compromising privacy. This system leverages the NFC chips embedded in passports, issued by over 172 countries, containing secure information like name, nationality, and date of birth. 

Unpacking Airdrops: User Growth to Governance

We are currently in the midst of an airdrop season, witnessing several high-profile projects distribute valuable rewards, with many others poised to follow suit. The total valuation of the top 50 airdrops is around 26.6$ billion.

Airdrops, a concept unique to the cryptocurrency sector, play a crucial role in bootstrapping communities, stress-testing protocols, enhancing liquidity, distributing power among community members, offering tax advantages, and much more. Indeed, airdrops represent a significant step towards progressive decentralization. This process involves transitioning control from a centralized core team to a broader community. This community includes power users, ecosystem dApps, small token holders who contributed during the testnet phase and subsequent stages, large investors, and inevitably, sybil accounts that engage in pump-and-dump schemes almost undetected. 

It's becoming increasingly common for a substantial portion of rewards to be allocated to the core team. This practice potentially undermines the incentive for community involvement and leads to a level of centralization that could make the system resistant to takeover, with the core team maintaining considerable influence.

Why Airdrops in the First Place?

The broader reasons for conducting airdrops encompass marketing, sparking activity on both the supply and demand sides, decentralizing ownership to enhance community participation, and ensuring regulatory compliance.

Marketing

Airdrops serve as an incentive for community engagement with a protocol or project, a task that is otherwise challenging to initiate. Announcing or hinting at a potential airdrop can attract a significant number of users, boosting the protocol’s popularity and, in return, stress-testing its capabilities. If we compare airdrops to the Cost of Customer Acquisition used in traditional marketing strategies, airdrops are 4-7 times more cost-effective, thereby raising questions about the efficiency of conventional methods.

Network Effect

The initial adoption spurred by the excitement around airdrops triggers a network effect that expands the project's reach. This effect encourages developers, decentralized applications, and other DAOs to engage in building on the platform, thus generating a network effect among developers. Concurrently, retail and power users contribute to a network effect on the demand side, enhancing the protocol’s overall ecosystem.

Ecosystem Growth

Airdrops are often directed towards projects that were pioneers in leveraging the protocol, thus enhancing its utility from an early stage. Retroactive airdrops to these dApps further bolster ecosystem growth. For example, the RetroPGF grants framework of Optimism can be viewed as a retroactive airdrop to builders who contributed to ecosystem development.

Targeting Power Users

By distributing tokens to liquidity providers in lending protocols, decentralized exchanges, and smart contract creators who explore new use cases, airdrops can promote long-term growth. This distribution strategy benefits the protocol by attracting users who contribute both immediate and enduring advantages.

Decentralization

Airdrops facilitate the transfer of governance power back to the community by ensuring that the distribution mechanism broadens participation. This approach helps to establish a diverse voter base that can guide the protocol’s direction and make it resistant to governance-related vulnerabilities. Over time, airdrops have increasingly favored larger allocations to DAOs, protocol delegates, core team members, and institutions to improve governance, bring expertise into decision-making, and enhance resistance to potential capture by external entities.

Regulatory Compliance

Decentralization also plays a critical role in ensuring that tokens are not classified as securities, thereby offering tax benefits to token holders. If a protocol is sufficiently decentralized and meets the criteria of the Howey Test, its tokens cannot be considered securities, aligning with regulatory compliance standards.

Airdrop Strategies

Auroracoin is often referenced as the pioneer of the airdrop concept in the cryptocurrency realm. However, the design and distribution strategies of airdrops have evolved significantly over time, aiming to enhance efficiency, user retention, and the development of safer governance frameworks.

One-off Drops

The retrospective airdrop by Uniswap, which was a one-time distribution, showcased the potential popularity of airdrops within the industry, inspiring numerous similar initiatives. Despite the initial success and attention garnered by the Uniswap airdrop, only 7% of its recipients still hold their tokens, highlighting challenges in long-term user retention.

Transaction Analysis and Broad Filtering Criteria

Protocols have broadened the scope of activities required for a user to qualify for an airdrop. Eligibility conditions are increasingly tailored to the protocol's nature; for instance, Layer 2 protocols might require users to engage with blockchain ecosystem apps, transact a minimum value, or incur specific gas fees. These strategies not only boost protocol usage and create a positive feedback loop but also raise barriers for sybil attackers.

Multiple Drops

To enhance user engagement and retention, the strategy of implementing multiple airdrops has gained popularity. According to a report by Sixdegree Labs, churn rates tend to increase over time but stabilize in the long run. Recurring airdrops targeting active community members, such as those participating in governance or consistently engaging on-chain, represent a more focused approach to retaining users who are committed to the protocol.

Drops to DAOs

Distributing airdrops to DAOs and teams that supported the protocol's early development can help diversify token ownership and boost voter engagement. For example, Arbitrum allocated 1.3% of its airdrop to other protocols and teams, bringing in expertise for critical decision-making areas like risk assessment, audits, and protocol upgrades, which general users may lack.

Point System

The introduction of a points system by platforms such as EtherFi, EigenLayer, and Kelp has become a prevalent airdrop strategy. This system facilitates transparent communication between protocols and users about the potential for airdrops and provides real-time visibility into eligibility criteria and performance metrics. Although reminiscent of loyalty programs in traditional web spaces, the non-transferable nature of points in these systems enhances their effectiveness compared to other strategies.

Drop to NFT Holders

Airdropping to holders of specific NFTs, such as those owning Pudgy Penguins or Madlabs NFT, represents a new trend in the airdrop meta. Projects utilize this strategy to generate excitement around their token launches. The long-term effectiveness of such airdrops remains to be seen and will likely be assessed over time.

Airdrops, User Retention, and Sybil Attacks

Airdrops attract an unprecedented number of users to a protocol, offering a level of engagement that other marketing methods cannot match. The allure of "free money" is significant, with approximately $30 billion spent on airdrops. However, the effectiveness of airdrops is primarily gauged by user retention rates, a critical metric that often presents a challenging picture.

According to a recent study titled¬†‚ÄúAirdrops: Giving Money Away Is Harder Than It Seems,‚Ä̬†which examined four airdrops,¬†it was found¬†that up to 95% of tokens are sold on exchanges immediately following the airdrop. This behavior essentially contradicts the intended purpose of airdrops.¬†Additionally,¬†the average churn rate¬†stands at 80%¬†after four months, even for leading protocols. While airdrops¬†do¬†create a network effect, the associated customer acquisition costs are so substantial that they cannot be¬†overlooked,¬†despite the various advantages¬†that airdrops¬†may offer.

Sybil attacks, executed by sophisticated entities that simulate numerous small users to farm airdrops, pose a significant challenge. It is estimated that these airdrop farmers capture a substantial portion of the airdrops, ranging from 9% to 33% of the total distribution. Although there are methods to combat these sybil attacks, the pressure to increase Total Value Locked and the project parties' minimal efforts to deter airdrop farmers allow this issue to persist. Community reporting, imposing higher costs on farmers, employing artificial intelligence (AI) and machine learning (ML) for sybil detection, and using Proof of Humanity are some of the strategies implemented to identify and eliminate sybil accounts.

Each method comes with its own set of drawbacks; for example, despite the use of AI and ML in the Arbitrum and Celestia airdrops, analyses by X explore indicate that over 40% of the allocation was claimed by sybil groups.

Implications of Airdrops on Governance

While airdrops are not inherently linked to governance, they can serve as an entry point to governance processes and potentially influence the direction of DAOs.

Airdrop Design Mechanisms

Various strategies such as token vesting, issuing non-transferable governance tokens, allocating tokens to DAOs, and increasing core team allocations are implemented to ensure safer governance practices and align with the perceived best interests of DAOs at the time of token distribution design. For instance, Optimism’s approach to retrospectively fund DAOs and protocols actively contributing to ecosystem growth is a prime example of using governance to distribute targeted airdrops to builders and projects. Recently, there has been a trend toward increasing team allocations while reducing community allocations, which has spurred controversy.

Airdrop Farming

Industrial-scale sybil farming, where multiple small accounts are used to disproportionately claim and immediately sell a large portion of tokens, challenges these design decisions. Employing AI and ML frameworks, Proof of Humanity, and setting stricter engagement criteria could potentially save millions of dollars and contribute to the creation of safer DAO environments by mitigating such attacks.

Airdrop Strategies

Protocols deploy various airdrop strategies based on their specific needs. Tactics such as multiple drops and the points system have shown to be more effective compared to others. For example, the first and second Optimism airdrops saw limited user retention, but the third airdrop witnessed a substantial increase in retention rates, suggesting enhanced governance participation. The points system enhances transparency for users, signaling to them that the protocol aims to engage genuine participants rather than airdrop hunters.

Skin in the Game

With most protocols adopting a token-weighted voting system, one approach to increasing voter participation and improving decision-making is to promote a diversified token ownership pattern. This can be achieved by matching allocations for users who, for example, have contributed a certain amount to public goods funding, held tokens from previous airdrops and remained active in governance, or are members of protocol guilds and Ethstakers. Such measures can encourage a broader and more engaged voter base, ultimately leading to better governance outcomes.

Closing Thoughts: Airdrops in User Growth and Governance

The evolution of airdrop strategies has notably enhanced user retention rates over time, particularly through the adoption of recurring drops.

Improved frameworks for mitigating airdrop farming, alongside advancements in governance quality through meta-governance and transparent communication regarding user rewards via points systems, mark significant progress in this domain.

A predominant viewpoint among users is to perceive airdrops as opportunities for attractive returns on investment.¬†Striking a balance that keeps users engaged by providing sufficient¬†returns, while¬†simultaneously¬†supporting protocols in community building and¬†stress-testing, represents an ideal strategy.¬†However, the efficacy of this approach hinges on generating substantial interest and validation from both ends‚ÄĒwithout it, the entire mechanism risks falling short of its objectives.

Moreover, numerous protocols are exploring the incorporation of identity verification processes that respect privacy concerns as part of their airdrop eligibility criteria. Such measures could significantly reduce the prevalence of industrial-scale airdrop farming but pose challenges for project parties and protocols aiming to maximize TVL as the sole goal.

Despite these challenges, the ongoing refinement of airdrop strategies and the exploration of innovative solutions reflect a dynamic and evolving landscape, where the benefits of community engagement and protocol security are increasingly recognized and prioritized.

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