DeFi is a fast paced industry with developments every moment ranging from billions in cash flow to attractive returns but there is one thing that makes DeFi truly decentralized—the power of governance. The act of governance traces back to ancient Greece and ancient Rome, as a method to elect worthy leaders. It allows people to participate and communicate. It is also a distinguishing factor for wide scale adoption. This is undoubtedly true for DeFi as well. In this article, we explore the role of governance in DeFi, governance tokens, their discourse in the history of the DeFi ecosystem, and how they make DeFi special.
With smart contracts, peer to peer (P2P) lending, and strong incentive mechanisms at the crux, the DeFi industry stands at a staggering market cap of $136B at the time of writing. Something that makes DeFi truly unique is the power of governance, specifically governance tokens.
They are blockchain tokens that allow users voting rights in the decision makings in the development of the project. These ERC-20 tokens are usually staked for making proposals or voting. They keep decision making from being centralized. Furthermore, it allows pivoting to smart contracts without tempering.
They play an important role in building communities of the various blockchain projects. Governance tokens also help founders understand the community’s opinion on various issues like gas fees, treasury management etc. by allowing them to vote. This in turn helps them achieve product-market fit faster. Moreover, this makes it easier to identify what is essential and minimizes time spent in decision making.
These tokens are usually distributed as rewards for using a specific protocol. It is important to understand that these tokens don’t overpower or allow control over the ledgers. At the same time - without these tokens, these projects would just be smart contracts without any control. They can only be used for changing certain parameters.
History of Governance
Back in 2016, the first original governance model was introduced by the DAO, but Compound was the first DeFi protocol to launch their governance token ($COMP) in June 2020. It also introduced “Yield Farming”, a popular phenomenon in the DeFi ecosystem at the moment.
Two ways of governance exist in the blockchain ecosystem, off-chain and on-chain. While off-chain models interact and guide the protocol through conferences, online forums, emails, etc. some discrepancies in the power balance are witnessed in them. On-chain governance on the other hand are transparent as they lie on the blockchain itself i.e. governance proposals exist on the smart contracts. This model has been inclusive of all users and allows stakeholders to participate for the collective good of the community.
Where does Governance take place in DeFi?
The governance for a platform starts with a discussion on any potential changes or prevalent issues by stakeholders. This usually happens on the governance forums, discord or telegram. After gaining traction, any user can attempt to put forward changes to the system through an “Improvement Proposal” for an on-chain vote. Users must own a governance token to participate in the voting. On-chain governance is often criticized to be plutocratic as voting power is directly proportional to the number of tokens here.
For a proposal to be accepted, a minimum percentage of votes are required. This is called a Quorum. A key challenge in DeFi governance is participation, but new projects try to build better models to mitigate the same.
Once a proposal is passed, it is implemented. Usually, these changes are based on the software as the code changes after approval. This process is called implementation.
Benefits of Governance Tokens
DeFi is fast paced and code modules become obsolete or need some pivoting quite often. This can be due to issues with security or simple design overhaul. Governance tokens help the community add, remove, or change existing structure of the protocols by voting.
Governance tokens also ensure that future technologies can be adopted by the existing frameworks and have the flexibility to evolve over the course of time. Furthermore, it allows the community to change the code, in case it is needed in terms of scalability or any other monumental change. It also allows community growth by incentivising adoption and participation.
Shortcomings of Governance Tokens
Governance tokens also have certain shortcomings. For example, there have been crashes in the past due to trading of governance tokens. Take the case of Sushi Swap, where the token holders started trading the tokens for small profits and made it highly volatile. During this event, the lead developer sold his tokens due to which the price dropped more than 50%. This is also known as a rugpull.
Other issues include vulnerability to 51% attack, lack of participation in voting and vote delegation. Lack of accountability is also noticed as the community blames an invisible group that is unknown. Another issue in any governance protocol is a whale accumulating a substantial amount of tokens. This would allow them to temper protocols by creating proposals for personal gains.
What are Fair Launches?
The term “Fair Launches” put forward an interesting concept, with the growing popularity of governance tokens. It says that there shouldn’t be any private distributions, and protocol creators should not own any tokens initially. This makes the process fair as all tokens need to be earned in the same way by all the stakeholders.
Some popular examples include Mint Club and Yearn Finance. Mint Club explicitly states that there is no token sale or free allocation of the $MINT token. The community earns 100% of the tokens, not the team. Hence, a rug pull is difficult as there is no free allocation of the initial token supply.
Similarly, yearn finance is another protocol in which no tokens were reserved for the founding team. The only way to earn tokens was through participating as a liquidity provider to designated liquidity pools which is the most important aspect to fair Launches.
Conclusion
Governance tokens play a vital role in making DeFi truly decentralized. It empowers communities and inculcates a sense of belonging. It also promotes participation and growth of any protocol, rather than just looking at it as an investment. It is worth noting that the power of voting has great benefits if used judiciously for the overall welfare.
While there are ways certain users can exploit a protocol like rug pulls or 51% attack, communities are actively working to reduce such instances.
These protocols help communities foster and are necessary for the overall growth of the DeFi ecosystem. They decentralize management by allowing stakeholders to participate fairly.
Author is a decentralized finance (DeFi) intern at Polygon, with a keen interest in blockchain, and business modeling. They are a student at Aligarh Muslim University - majoring in Electrical Engineering. Also, a sitcom junkie who often passionately argues about music, particularly TheWeeknd and can be reached out on Twitter @ArsalanSartaj