Decentralization is at the core of cryptocurrencies and blockchain technology. While Bitcoin achieved transactional decentralization in 2008, decentralizing smart contracts and project management has taken much longer. Recently, governance tokens have become the preferred way to decentralize control over crypto projects and protocols.
Let’s take a look at what governance tokens are, how they work, and some caveats to keep in mind when investing in them.
Governance tokens are at the heart of the DeFi and DAO ecosystem, enabling communities to participate in decision making.
What Are Governance Tokens?
Governance tokens are ERC-20 tokens that represent ownership in a decentralized protocol. They enable token holders to influence fee structures and reward distributions, as well as how to allocate and spend development funds. While they often provide utility (e.g., income), some only provide the ability to vote on governance matters.
Some examples of governance tokens include:
- Maker: Maker’s MKR was the first governance token in DeFi, enabling holders to vote on-chain on topics ranging from MakerDAO governance processes to collateral types. In addition, interest fees on loans accrue to token holders, providing cash flow.
- Uniswap: Uniswap’s UNI has the largest market cap of any governance tokens. In addition to voting on protocol changes, the governance tokens receive 30 basis points on trading fees as cash flow.
- Curve: Curve’s CRV is a governance token and a reward to incentivize liquidity providers to add stablecoins to liquidity pools.
It’s essential to keep in mind that governance tokens don’t provide unilateral control โ they only influence certain parameters coded into projects and smart contracts. In addition, each project has its own definition of ownership and governance, what parameters might change, and how those changes ultimately come to fruition.
How Governance Tokens Work
Most conventional businesses have an executive team and/or board of directors in control. While shareholders vote for board members every few years, they don’t have a direct say in the day-to-day decisions about the business โ such as new products, how to spend a budget or investments.
Decentralized autonomous organizations, or DAOs, don’t have an executive team or board of directors by definition. Despite the lack of a leadership team, the organization must still make day-to-day decisions and governance tokens enable them to do so. They have become a central part of the DeFi and DAO ecosystem.
Most governance token schemes enable any holder to submit a proposal. If the proposal meets certain basic criteria, it’s put up for a vote across the entire community. Most schemes provide a single vote for each token, meaning that those owning more tokens have more influence. However, there are also other more democratic strategies.
For example, quadratic voting enables individuals to express the degree of their preference rather than the direction of their preference. The goal is to prevent majority rule, by enabling voters to “pay” for additional votes on a given matter to express their support more strongly. Some DAOs are already using the approach in their projects.
Governance Token Pros and Cons
Governance tokens have become a popular tool for DAOs to operate effectively, but that doesn’t mean they don’t have their own set of limitations and challenges to keep in mind. For example, some governance tokens have vesting schedules and cliffs, meaning that existing token holders could see their value diluted in the future.
Pros
- Decentralization: Governance tokens are the only way to effectively manage decentralized projects without trusting them to a forever immutable smart contract.
- Collaboration: Governance tokens enable active users to participate in decisions rather than leaving them to legacy founders or shareholders that may not have the incentive to act in the best interest of the community.
- Community: Governance tokens encourage a more involved community since everyone has a reason and method to participate in a project’s future direction.
- Efficiency: Governance tokens make it clear where projects should go, eliminating any ambiguities.
Cons
- Selfishness: Many voters inherently vote in their own best interest, which may not align with the best interest of the wider community. For instance, the Maker community decided not to reimburse their own community after the flash crash.
- Accountability: Group decisions eliminate any single source of accountability when things go awry. Angry community members may always blame “the majority” while refusing to take accountability when they’re in the said majority.
- Whales: The majority of governance tokens may be held by a small minority of users, meaning they can single-handedly create proposals that benefit them at the expense of others.
- Regulator Risk: The SEC has said that the greater a project’s decentralization, the less likely the underlying tokens would be considered securities. However, there’s always a threat that regulators could take a different view in the future.
The Future of Governance Tokens
Governance tokens have seen a surge in interest following the growth of DeFi over the past couple of years. As a result, governance systems are likely to become increasingly common and more complex, creating new benefits and challenges for the industry. Fortunately, many of these changes are aimed at creating a fairer system.
Some new approaches could include:
- Quadratic Voting: Voters could purchase votes with their governance tokens using a scheme where the price increases with the number of votes. As a result, it’s harder for larger holders to manipulate governance proposals given the increasing cost.
- Holographic Voting: Governance token holders issuing new proposals could stake their tokens to increase the visibility of their proposals. Token holders could then bet on the right outcome to receive rewards.
- Proof of Participation: Projects could limit governance to accounts that are actively participating in the protocol. For instance, a DeFi lending protocol might restrict its governance mechanics to addresses that have a trading history.
- Limited Governance: Projects could constrain governance proposals to certain aspects or parameters of a DeFi protocol. Or, they could introduce time delays between impactful proposals, so the community could evaluate the impact.
Of course, the future of governance tokens will ultimately depend on any regulatory changes. If the SEC alters their stance and considers them securities, they could become much less popular and more heavily regulated. However, the agency has thus far indicated that truly decentralized governance tokens are likely not securities.
The Bottom Line
Governance tokens have become a critical component of DAOs and DeFi ecosystems. While they have become increasingly popular, there are several important caveats to keep in mind before investing in them. Fortunately, new proposals aim to solve these problems by democratizing votes and implementing new technical features.
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