Governance tokens are the key to a decentralized future in DeFi.
They give you a say in how protocols are run and how rewards are distributed. This is a major shift away from the traditional financial system, where power is concentrated in the hands of a few.
In this blog post, we will explore the world of governance tokens in DeFi.
We will explain what they are, how they work, and why they are important.
Also, we will discuss some of the risks associated with governance tokens and how to mitigate them.
Table of contents
- What are Governance Tokens in DeFi?
- How Do Governance Tokens Work?
- How Voting Works?
- How these Tokens can be used?
- Why Governance Tokens are important in DeFi?
- How Governance Tokens Can Provide Passive Income for You?
- How You Can Get Governance Tokens?
- Some Popular Governance Tokens in DeFi
- What are the Risks associated with Governance Tokens?
- How To Mitigate the Risks of Governance Tokens?
- What is the Difference between a Token and a Governance Token?
What are Governance Tokens in DeFi?
Governance tokens in DeFi are cryptocurrencies that give you voting rights on a blockchain project.
They are used to decentralize the decision-making process and give you a say in how the project is run.
You may have noticed that all these growing DeFi platforms offer their own tokens, which are known as Governance Tokens.
These tokens are different than typical cryptocurrencies. Their general purpose is to provide the token-holders voting rights with regard to an underlying DeFi protocol.
The top three DeFi platforms by TVL have seen their governance tokens experience a massive increase in price since the start of 2021.
These tokens are all part of a larger ecosystem, called decentralized autonomous organizations(DAOs).
DAOs are completely decentralized crypto platforms, and governance tokens are central to the system.
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How Do Governance Tokens Work?
Governance tokens typically work by using a system called “on-chain” voting. This means that votes are recorded on the blockchain, which makes them transparent and immutable. To vote, you simply need to connect your wallet to the project’s governance interface.
People who hold these tokens gain the right to vote on how the project will be developed and how it will work.
For example, voting on which new features will be added., how many new tokens to mint, whether to raise or lower transaction fees, how to allocate a budget etc.
Oftentimes, if you are a token holder, you get additional perks, along with voting power, for holding tokens. For example, a share of the platform transaction fees.
Although most decentralized finance (DeFi) tokens are governance tokens, voting is not their only defining feature. People possessing these governance tokens can use them to take out loans, stake them, and earn money through yield farming. Given all this, their primary function is still to distribute power.
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How Voting Works?
Typically, one governance token gives a person one vote. In that case, the voting power is proportional to the number of governance tokens they are holding.
However, sometimes other factors decide how much voting power a person can have. For example, how long you have been holding this token? This is called time-weighted voting.
In most cases, the voting is done through smart contracts. If that is the case, the voting results are applied automatically. If there are no smart contracts, the development team, or someone hired to do the maintenance, can also implement the changes.
However, the whole point of DAOs is to operate autonomously and with as little human intervention as possible.
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How these Tokens can be used?
These types of tokens can be used in a variety of ways.
a. Protocol parameters, such as interest rates and fees.
b. New features and products
c. Upgrades and changes to the protocol.
d. Distributions of rewards and funding.
Why Governance Tokens are important in DeFi?
These are an important part of the DeFi ecosystem because they help to ensure that projects are run in a fair and decentralized manner.
They also incentivize you to participate in the community and help to make the protocol better.
A benefit of these tokens for organizations is that the voting process becomes more efficient. That, in turn, can make the whole organization more efficient and profitable.
How Governance Tokens Can Provide Passive Income for You?
In some instances, when you stake these tokens, you get additional perks like access to more services or a share of the protocol’s profits.
If the latter is the case, holding this token is like holding a share of a revenue stream.
For example, Illuvium, a blockchain claims it will share 100% of the game’s revenue between people who stake ILV their governance token.
Even if governance tokens do not have much value at the beginning, early on you usually speculate that you will increase in value as the project becomes more successful.
A way to increase the value of a token is if the protocol decides to buy back tokens.
In other words, reduces the supply of the tokens on the market, thus increasing their price.
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How You Can Get Governance Tokens?
The way these tokens are distributed depends on the protocol and there are many ways to do so.
One such way is airdrop. Oftentimes, protocols will reward early users with free tokens. For example, Uniswap’s airdrop.
There is also liquidity mining where you supply initial liquidity to DeFi dApps and receive rewards for doing so. For example, Compound’s liquidity mining.
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Some Popular Governance Tokens in DeFi
A DeFi project like Compound may allow you to do things like yield farming and lend using tokens that are native to another protocol.
However, it has its own token (COMNP) as well. This token governs how the Compound DeFi Protocol progresses.
Token holders vote on initiatives, and the value of their tokens generally rises when the DeFi protocol n gains more users or increases its TVL.
And if the price is any indication, governance tokens have become very popular since 2021.
The collective market cap for the governance tokens of some of the top DeFi platforms (like Curve Finance, UniSwap, Compound, and Yearn Finance) has grown to over $25 billion.
Polychain Capital, Andreeson Horowitz, and Geoffrey Hayes are the three largest holders of Compound COMP governance tokens.
It is a decentralized crypto asset exchange (DEX). However, Balancer also created its own governance token (BAL) that it issues to liquidity providers.
The owners of the coin can vote on platform initiatives as well as exchange the token with others.
As the overall platform grows, the token increases in value.
It is another DEX, that launched its own governance token (CRV) in 2020 as well. Instead of doing some kind of public offering, Curve issued CRV to current liquidity providers on the platform.
Traditional financial institutions are also starting to notice the value of owing governance tokens.
Maker Governance Token (MKR)
It is used in MakerDAO,which is one of the biggest DeFi platforms on the market.
If you are the holder of the Maker governance token you can vote on issues such as budgets and the platform’s economic rules.
Voting on this platform is weighted by the amount of tokens that vote for a proposal.
It is a decentralized exchange (DEX) and its governance token is UNI.
It gives its holders the ownership of governance rights to the protocol. For example, a recent vote was on whether the UNI proposal submission threshold should be reduced to 2.5 million. Another one was who should Uniswap v3 be deployed to Polygon.
Governance tokens are also used in many metaverse blockchain games, as they often function like decentralized organizations.
One of the most popular ones is aptly named Decentraland. If you are holding MANA you can vote on things like what types of wearables and names are allowed in the game.
tHE BLOCKCHAIN GAME ILLUVIUM HAS A TOKEN THAT HAS THREE MAIN FUNCTIONS.
Holding ILV allows you to shape the game’s future. However, you can also earn rewards for staking your tokens and earn a passive income.
What are the Risks associated with Governance Tokens?
a. Rug pulls
A rug pull is a type of scam where the developers of a project abandon the project and take all of the investor’s money. This is a particular risk with new governance tokens, as they have not yet had time to establish a track record.
b. Whale manipulation
Whales are holders of governance tokens. They can use their voting power to influence the direction of a project in their own favor.
This is a risk for all governance tokens, but it is especially pronounced for tokens with a small number of holders.
c. Smart Contract vulnerabilities
Smart contracts are the code that powers DeFi protocols. If there is a vulnerability in a smart contract, it could be exploited to steal users’ funds or manipulate the governance process.
This is a risk for all DeFi protocols. But it is especially pronounced for new protocols that have not yet been thoroughly audited.
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How To Mitigate the Risks of Governance Tokens?
These are a few things you can do to mitigate the risks of investing in governance tokens.
a. Only Invest in tokens from established Projects
When investing in a governance token, it is important to choose a project with a good track record and a strong community.
b.Diversify Your Portfolio
Do not pull all of your eggs in one basket. Diversify your portfolio by investing in a variety of different governance tokens.
c. Do You Research
Before investing in any governance token, it is important to do your research and understand the risks involved.
Read the project’s white paper and join the community to learn more about it.
Only started in January of 2020, Curve Finance has now seen its total TVL grow to over $3 billion from essentially nothing in little over three years.
Curve is a stablecoin exchange, which may be one reason why crypto asset owners have flocked to the platform. Because of the stability of the assets, stakers may expect to earn a more steady yield.
Curve issued CRV to current liquidity providers on the platform.
What is the Difference between a Token and a Governance Token?
Utility tokens allow access to the primary or special features of a user application. Holding them can also attract special incentivization depending on the protocol.
Governance tokens bear the value of the government or community they represent. Their value is an expression of the quality of the project they govern.
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These governance tokens can be a risky investment. But they also have the potential to generate high returns.
Without these tokens, decentralized organizations and other types of blockchain projects could not achieve their democratic vision.
That’s what makes them valuable for such a model. Furthermore, they not only give their holders voting rights but also have a potential for passive income, which is a bonus.
It is important to do your research before investing in any governance token and to understand the risks involved.
Do share your thoughts on governance tokens and decentralized organizations?
These tokens convey certain privileges, including rights to cash flow. Protocols may charge a fee to their users . These fees are collected, and a governance vote can decide to distribute a portion of fees to token holders, akin to to dividends in equities.
People possessing these tokens can use them to take out loans, stake them, and earn money. Even through yield farming, you can make money. These tokens’s primary function is still to distribute power.
These tokens allow a community to have a direct impact on the strategic management of a crypto project. To ensure only honest members of the community participate in the process., governance tokens provide voting powers to their holders.
Most of the time you are required to invest in the project and as a reward for your loyalty, you get a say in how it develops.
In that sense, holding governance tokens is similar to owning shares in a company. This decentralized approach gives power to the community and keeps it unified.