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TLDR below. This is not financial advice.
Governance tokens emerged thanks to the birth of famous DeFi projects such as MakerDAO, Compound, Aave, Uniswap, etc., which have seen growth in marketcap skyrocket since DeFi Summer 2020.
In today's article, we will discuss what governance tokens are, how they impact the DeFi space, and why they are valuable.
What Is A Governance Token?
A governance token is a type of token that grants voting rights to their owners in a particular protocol.
There are currently two ways to calculate the power of voting for governance tokens: token-weighted voting (almost protocols) and time-weighted voting (e.g. Curve).
Voting power is weighted according to the number of tokens, which means that the more governance tokens a holer holds, the more decision-making weight they have on an issue. While time-weighted voting rights give more rights to those who lock the governance token for longer.
In off-chain governance, network participants communicate outside of the network. These mechanisms can be used to grant token holders informal voting rights. Votes can signal the community to download the code change, but votes do not automatically trigger the change. If a minority disagrees, they can choose not to download the code update. This will result in two separate networks (hard fork).
With on-chain governance, code changes are done automatically once voting is complete. Similar to off-chain governance, a minority can choose a minority group can choose to create a hard fork with the new changes.
The main difference between the two governments is in the way in which participants choose to participate. The on-chain governance allows the code change to occur by majority vote, while the off-chain governance requires participants to download the code change.
As an open-source network, each scenario presents an opportunity for the minority to create a network that works for them.
For example, we have seen many forked platforms like Sushiswap from Uniswap, Swerve from Curve or Mirror from Synthetix. Basically, these fork platforms either compete directly with the original platform (Swerve) or go in a new direction compared to the original platform (SushiSwap, Mirror).
Governance tokens allow holders to vote for changes in the network to which they belong. Usually, the number of tokens a person holds is proportional to the power of votes they have.
Governance Token Impact On DeFi
For many in the crypto space, governance tokens are a key function of the DeFi protocol that enables decentralised voting. This approach is consistent with the financial decentralisation that the system hopes to achieve.
The principles of DeFi focus on financial democracy:
The ability for all users to participate; and
Have a voice in a monetary system that works in favor of the majority.
Looking back in history, we have seen a change in governance in protocols like MakerDAO and Synthetix. In March 2020 MakerDAO completed its transition to complete community governance. In the course of 2020 Synthetix launched several DAOs, with each DAO managing separate parts of the protocol created by the main developers.
This could be an indication of where DeFi is headed.
Where Does A Governance Token's Value Come From?
Governance tokens have skyrocketed in value since DeFi Summer 2020. As of today, the four largest TVL DeFi governance tokens ($AAVE, $CRV, $COMP, and $MKR) have a combined market cap of about $6.56 billion. So where does all this value come from?
Short Answer: Governance Token Incentives.
More specifically, the protocols use two main incentives to increase the value of governance tokens: Liquidity Mining Lending, and Staking. You can easily see one of the incentives or both being used in DeFi protocols alongside other specific incentives to increase the use case for governance tokens, thereby increasing their value.
For example, Compound is considered a pioneer in the governance space because it rewards users with $COMP, incentivises them to lend and borrow to earn more tokens, and effectively reduce the probability of default. In this way, $COMP creates its own demand.
The interest in governance tokens is driven by the hope that developers will develop valuable products, creating use cases for such tokens. Besides, DeFi is becoming more widespread and everyone wants to participate and possibly make money, potentially influencing how these projects are operated.
What Are The Risks Of Governance Tokens?
In theory, governance tokens give token holders voting power to influence the direction of a DeFi project. For example, community members can make new suggestions for changing project-specific properties. Furthermore, governance token holders can vote on each proposal.
The ultimate goal is to create a self-governing decentralised community in which all stakeholders can discuss and vote on how to manage the protocol or project.
For example, Compound believes that “by placing $COMP directly in the hands of users and applications, a growing ecosystem will be able to upgrade the protocol and will be incentivised to jointly manage the protocol in the future with good governance”.
However, governance tokens come with certain risks. This article discusses three potential challenges:
Risks of governance token trading
Risk of proportional distribution
Risks of management communication
Risks of Governance Token Trading
Governance tokens serve the purpose of giving token holders power over key project decisions. Anyone who holds them can participate in voting. For example, Compound allows $COMP holders to debate, propose, and vote on all protocol changes.
However, there is a big problem with the ability to trade them. Basically, governance tokens should not receive any value as that would make them transaction objects. Unfortunately, most projects cannot control this.
Let take a look at the so-called Sushiswap exit scam. Many investors have been actively trading $SUSHI governance token. However, the creators of Sushiswap decided to sell a significant portion of their tokens. This sell-off caused the price to drop by 90%.
In this case, you have just lost 90% of your token value while actively participating in project management.
In this example, most investors who own the Sushiswap governance token see it as an incentive to earn more when they can trade. This monetary aspect was the main reason for the massive crash, as most liquidity providers don't consider $SUSHI a governance token. Therefore, they have no problem selling it at a low price as any additional profit is a bonus.
Risk of Proportional Distribution
For projects that have tokens through yield farming, there is a risk that whales can gain many voting rights through purchasing governance tokens. The benefit here is that being the frontrunner allows you to farm a lot due to the low level of competition for that group. As a whale, you can add a lot of liquidity to win the main stake in the project. The same applies to team members, who often receive a large portion of the stake in the project for their contributions.
Why is this a problem? It leaves the whale or team members with disproportionate control over the project. In theory, whales could launch and approve new proposals in their favour.
This problem becomes more fraught as centralised exchanges engage in DeFi by offering DeFi products to their users in a managed manner. As a result, they can use their substantial stake to influence the direction of the project or even slowly destroy competing products as liquid exchanges are direct competitors to centralised exchanges.
Risks of Management Communication
For example, a project asks you to vote on proposals using your token. However, there are some problems with this approach.
Too many suggestions.
Suggestions are too technical or irrelevant to the average user.
People vote by watching prominent figures tell them what to do.
So, some proposals are too technical or are not suitable for the average user, and become too time consuming for the development team.
On top of that, many people do not have in-depth technical knowledge of blockchain technology. For that reason, they rely on celebrities or node operators to make recommendations because they believe these people are community experts. This approach can quickly become dangerous as most people heed the call of these prominent figures who can quickly gain a lot of power.
In short, the governance token is a step forward in the decentralisation of voting rights led by DeFi. With Governance tokens, if they only have governance functions, have no intrinsic value in themselves, but they are related to the incentives of each different protocol, so they carry other values. Their value can be seen in three main incentives: Liquidity Mining, Lending, and Staking, along with a combination of protocol-specific incentives. That is why we often see relatively valuations like PE and PS. However, governance tokens still have certain risks which affect the main purpose for which they are formed.
Ps: Order the textbook "Economics and Math of Token Engineering and DeFi" today!