Traditionally, decision-making in companies was done using a board of directors. A group of authority figures gather in a room and make decisions that are heavily influenced by a select few shareholders. Average Joe’s have no say in this process. In decentralized finance (DeFi) this is entirely different. Instead, decision-making is delegated to the community. It is a more democratic process where anyone can join in. You don’t need a reputation or specific skillset. The technology is truly revolutionary. In this article, we will be discussing what DeFi governance tokens are and much more. So without further ado, let’s get right in.
In this article:
- What are decentralized finance governance tokens?
- How do they work?
- Governance in DeFi
What are decentralized finance governance tokens?
Decentralized finance governance tokens provide the right to govern cryptocurrencies. Token holders propose changes and the community vote on them. Ultimately, decision-making is given to the community and the voting power is directly proportional to the number of tokens you hold. The users shape the development and operations of the project. This is all done in a transparent and permissionless way.
How do they work?
One common feature that all decentralized autonomous organizations (DAOs) have is that they utilize governance tokens. Community members are actively rewarded with these tokens for being loyal and active in the community. In turn, token holders vote on proposals to ensure more secure development of the protocol. A token holder with 500 tokens will have double the voting power as someone with 250. Not to mention, blockchain technology means that all decision-making is completely transparent. Unlike traditional finance, you can view who voted on what, making DAOs a perfect fit. The implementation of these proposals is done automatically via smart contracts.
Governance in DeFi
So now you’re wondering. How are governance tokens used in DeFi? But first, let’s define DeFi. In essence, this technology is based on traditional blockchain architecture which is used to bypass the traditional banking system. The aim is to create an alternative system for trading, lending etc. The middle man is removed and the trust is placed in the smart contract. Governance tokens help to achieve this goal by allowing management of the protocol to be truly decentralized. Voting power is spread across the whole community all in an open and permissionless way.
Equality – as there is no authoritative control it provides a more fair and equal opportunity for the individual. All you need to vote and submit proposals is a token. Apart from that, there is no barrier to entry. The user simply interacts with the protocol. Not to mention this system cannot be cheated. The transparent nature means that all users can view the details of all proposals submitted.
More robust development – Another advantage of governance tokens is the ability to build more active and robust development processes. Ultimately, development is determined by the community. They can shape the User interface, change trading fees or even revise funding for the development. There is no longer a huge misalignment between the interest of organizations and communities.
Community – the governance model facilitates strong collaboration. Each member is incentivized to work together and improve the project. Discussion around future discussions is encouraged. At the end of the day, if development and collaboration increase it is likely the price of the asset will as well.
Unfair power dynamics – by far the biggest problem is related to token distribution. If a single person holds a large proportion of the token supply then they can swing decisions in their favour. This can often be at the detriment of the wider community. In order for a protocol to be more fair the tokens need to be evenly distributed.
Accountablity – even if tokens are fairly distributed there is no guarantee that good proposals will get passed. Often times proposals get passed which hinder the development of the project. But who is held accountable? Usually no one. If the majority of the token holders are anonymous then who takes the blame?
Governance tokens are certainly an interesting experiment that provides many benefits to DeFi. The key advantage is equality. Each token holder has a say in the proposals. As development goals are determined by each member this encourages collaboration and community. At the end of the day, people want the project to succeed as they have invested both time and money into it. With that being said, this system isn’t perfect. As voting power is proportional to the number of tokens held it can be manipulated by top holders. This often comes at the cost of the community. Not to mention, individuals are not held responsible as they are often anonymous. Overall, this is certainly an interesting alternative to the more centralized approach used by traditional finance, but only time will tell if it’s better.
Want to earn passive income with DeFi? check out my article A beginners guide to Earning Passive Income with DeFi.