The role of governance in the booming decentralized finance industry is a nascent one, and there are ongoing conversations from key figures in the industry around its purpose and what governance may look like in the future.
Sam Bankman-Fried of FTX recently shared that his firm’s involvement in DeFi will be “motivated by short-term profits and is not seeking to have a long-term impact in protocols via governance.” In doing so, he argued that he’s simply using DeFi protocols for their intended purposes.
This is not necessarily the case. Some mining programs are designed this way, and Bankman-Fried is playing by the rules. If the project doesn’t want this kind of involvement, then the project should design its program accordingly.
Decentralized governance is one of DeFi’s key missions
DeFi hopes to create an open financial system that can be accessible by anyone in the world. Governance tokens are usually designed to fulfill two purposes. First, projects use them to decentralize decision making. The more people involved — as the logic goes — the less likely an attack or abuse by a single party can occur.
To achieve the first goal, the tokens are usually also designed to incentivize holders to participate and make beneficial decisions for the DeFi protocol. This way, governance tokens can also be likened to the traditional shareholding system in corporations, which is essential to the success of capitalism by incentivizing shareholders to lend capital and govern a company out of pure self-interest.
Because one goal is to decentralize token holders, the concentration of governance tokens held by a few holders is said to be a problem. However, in the early stages of a project, it can be essential.
The centralization of decision making allows projects to move faster and pivot. For MakerDAO, for example, it was easier to vote on introducing new collateral assets when its Dai stablecoin moved too far from its peg.
But in the long run, when there is wide community participation in a project’s progress, it’s better to have decentralized token distribution because whales could leverage 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 governance, we can observe that big MKR holders vote against other stakeholders. What’s more, even non-governance tokens benefit from more holders, as those are incentivized to work for the benefit of the project just to have the token price increase in return. For governance tokens, this mechanism works even more so, as token holders can directly influence important product decisions on top of just writing blog posts and schilling on Twitter.
Many projects are aware of this and have taken a progressive decentralization approach. Having a limited supply of governance tokens is good because it’s more predictable for holders to have an idea of their voting power over time, and it makes it harder to be exploited by potential bad actors.
Putting the yield in yield farming
Yield farming, or liquidity mining, is a new way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols as a concept — and has exploded in 2020 amid the DeFi boom.
Many governance tokens are issued as the yield in these yield farming schemes. Decentralized exchanges benefit from yield farming by capturing liquidity and even increasing the project’s treasury to use it toward a growth strategy. Users, on the other hand, earn yield in the form of the governance token.
The question is: How can this be sustainable? If users sell governance tokens, how can projects hold the liquidity and establish a broad base of governance token holders?
Looking at Uniswap, we find that the liquidity was drained to a certain extent with the end of the issuance of its governance token. However, this was less than expected and far from being potentially harmful. An example is the distribution of Uniswap’s UNI governance tokens to holders, which looks sufficiently decentralized to be ready for long-term governance.
Uniswap didn’t have governance before the release of its UNI token a couple of months ago. At that time, changes to the protocol were decided by the Uniswap team alone.
Governance may mean more autonomy, but is it the best bet?
With many examples of founders selling their governance tokens and abandoning projects, there is a growing concern that governance tokens are yet another investment pipedream, which leaves project founders rich and users with empty pockets. As always, there are exceptions. After a long DeFi summer, however, we have seen 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 participating, understanding the risk and taking all of this into account when doing your investment calculations are a good way to start. It’s 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 does work, as we have seen a lot of successful open-source software, and we believe a project can be successful by involving collective wisdom.
In DeFi, governance tokens may arguably be the best form to leverage collective wisdom and achieve decentralized governance. There is still much for people to explore, and there are projects in which governance is actually based on reputation, which is also a promising approach.
The views, thoughts and opinions expressed here are the author’s alone 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 spent years working at Kyber Network and Deloitte Consulting. He studied computer science at the University of Chicago and accounting information systems at Michigan State University.