The role of management In the booming decentralized financial sector is an emerging industry, and there are ongoing conversations from key industry figures about its purpose and what governance might look like in the future.
FTX’s Sam Bankman-Fried recently shared that his company’s involvement with DeFi “will be motivated by short-term gains and not pursue long-term impact in protocols through governance.” In addition, he argued that he is simply using DeFi protocols for the intended purposes.
This is not necessarily the case. Some mining programs are designed this way, and Bankman-Fried follows the rules. If the project doesn’t want this kind of involvement, the project should design its program accordingly.
Decentralized governance is one of DeFi’s main missions
DeFi hopes to create an open financial system that is accessible to everyone in the world. Governance tokens are usually designed to accomplish two purposes. First, projects use them to decentralize decision-making. The more people involved – as the logic goes – the less likely that an attack or abuse by a single party could occur.
To accomplish the first goal, the tokens are also usually designed to incentivize holders to participate and make favorable decisions for the DeFi protocol. In this way, governance tokens can also be compared to the traditional corporate shareholder system, which is essential to the success of capitalism by encouraging shareholders to borrow capital and run a company out of pure self-interest.
Because it is a goal to decentralize token holders, the concentration of governance tokens from a few holders is said to be a problem. However, it can be essential in the early stages of a project.
Centralization of decision-making allows projects to run and run faster. For example, it was easier for MakerDAO to vote for introduction of new collateral assets when his Dai stablecoin moved too far from his pin.
But in the long run, when there is broad community participation in the progress of a project, it is better to have a decentralized distribution of tokens as whales can use the governance in a way that benefits themselves, but not all stakeholders. In an extreme case we would call it an attack, but even in MakerDAO’s board we can observe that large MKR holders vote against other stakeholders. In addition, even non-governance tokens benefit from more holders, as they are incentivized to work on behalf of the project just to regain the symbolic price hike. For governance tokens, this mechanism works even more, as token holders can directly influence important product decisions, in addition to writing blog posts and schilling on Twitter.
Many projects are aware of this and have followed a gradual decentralization approach. Having a limited supply of governance tokens is good because it is more predictable for holders to have an idea of their voting rights over time, and it makes it more difficult to be exploited by potential bad actors.
Bringing the yield into yield farming
Yield agricultureor liquidity mining, is a new way of earning rewards from cryptocurrency holdings using unlicensed liquidity protocols as a concept – and it exploded in 2020 during the DeFi boom.
Many governance tokens are issued as revenue in these revenue farming schemes. Decentralized exchanges are taking advantage of yield farming by capturing liquidity and even increasing the project’s treasury to use it for a growth strategy. Users, on the other hand, earn revenue in the form of the governance token.
The question is: How can this be sustainable? When users sell governance tokens, how can projects maintain liquidity and establish a broad base of governance token holders?
If we look at Uniswap, we see that liquidity has decreased to some extent with the end of its governance token issuance. However, this was less than expected and far from potentially harmful. An example is the distribution of Uniswap’s UNI governance tokens to holders, which appears decentralized enough to be ready for long-term governance.
Uniswap had no governance before the releasing its UNI token a few months ago. At that point, changes to the protocol were decided only by the Uniswap team.
Governance may mean more autonomy, but is it the best choice?
With many examples of founders selling their governance tokens and leaving projects, there is a growing concern that governance tokens are once again an investment pipedream, leaving project founders rich and users empty pockets. As always, there are exceptions. However, after a long DeFi summer, we have seen some decent projects and blueprints of how to successfully launch decentralized governance. Uniswap is one example, but even its delicious antagonist SushiSwap seems to have found its niche.
Therefore, as with most things, doing your research before you participate, understanding risk and taking it into account when conducting your investment calculations is a good way to start. It is similar to the reasons why some institutions understand that there are high risks of being hacked, so they use risk-adjusted returns for their investment decisions.
Ultimately, decentralized governance works, as we’ve seen a lot of successful open-source software, and we believe a project can be successful by involving collective wisdom.
In DeFi, governance tokens are arguably the best form to harness collective wisdom and achieve decentralized governance. There is still a lot to discover for people, and there are projects where governance is actually based on reputation, which is also a promising approach.
The views, thoughts and opinions expressed here are solely of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Lucas Huang is currently head of growth at TokenLon. Before joining TokenLon, he worked for years at Kyber Network and Deloitte Consulting. He majored in computer science at the University of Chicago and accounting information systems at Michigan State University.