Introduction
The world of decentralized finance is rapidly growing and governance tokens have emerged as an important tool for this growth. These tokens are giving users the control over the future direction of blockchain protocols, allowing them to take part in decentralized decision-making. However, while governance tokens play a major role and hold a significant promise, there are still questions about their implementation, specifically about decentralization, voting power, and potential for manipulation.
Thus, in this article, we will walk you through what governance tokens are, how they function, and whether they're truly living up to their goal of decentralizing control in the DeFi landscape.
Understanding Governance Tokens
Governance tokens are a type of cryptocurrencies whose main purpose is to grant their holders the right to vote on decisions within a decentralized project. Thus, this means if you hold a governance token for a DeFi protocol, you will also gain the power to vote on important issues that will impact the entire project's purpose and operations.
For example, you are using a DeFi lending platform where users can borrow and lend their crypto assets. If that platform is planning to introduce a new token in its lending pool, it will not be launched immediately without a unanimous decision, not by the centralized team, but by the governance token holders through a vote. Whereas, the more governance token you own, the greater your influence in the decision-making process.
The Function of Governance Tokens
Governance tokens mostly function through smart contracts. These are self-executing programs on a blockchain that automates actions when pre-determined conditions are met. Example, if there's a proposal being made, for instance, a fee adjustment on the lending platform - token holders have the power to vote on that proposal if they agree on implementing or not. As mentioned, the number of governance tokens a holder owns is what will generally determine the weight of their vote. Thus, the more tokens, the greater the impact.
Furthermore, there are cases that a platform requires a minimum number of tokens before a holder can participate in the voting. Whereas, it works similarly to a shareholder voting in traditional companies. The only difference is that the decision-making takes place on a blockchain. Additionally, some platforms also offer delegation, wherein a token holder can delegate their voting power to another user if they, themselves, can't personally participate in the process due to personal reasons or lack of expertise. This is a part of the broader topic of Asset Management in DeFi.
Advantages of Governance Tokens in DeFi
Aside from providing voting power, governance tokens also offer other several advantages to both DeFi protocols and their communities. Let's take a closer look:
Empowering communities to make decisions
Instead of being controlled by central authorities or executives, governance tokens promote giving power to the community. It enables their holders to take part in significant processes, specifically in decision-making. It allows the people who actually use the platform to have a say in its future. This ensures that all changes are based and a reflection of the needs and interests of their users.
Aligning user incentives with project success
Governance tokens also helps in aligning the interest of users in connection with the success of a project. And since they are now stakeholders, if the platform thrives, the value of their token will increase as well. This will then create a sense of ownership which further encourages token holders to make decisions that promote long term growth instead of just short-term gains.
Decentralization
Lastly, governance tokens also help DeFi platforms to achieve decentralization by distributing the decision-making power across a diverse group of stakeholders which aligns with the main goal of DeFi in completely removing the centralized control from traditional financial systems. Thus, if one team member leaves or the company dissolves, it won't affect the entire protocol and it will continue functioning because the decision power lies with the rest of the community.
Drawbacks of Governance Tokens in DeFi
Despite all its promising potential, governance tokens also introduce several challenges that DeFi projects and their communities must address as well. Here are the following, including how DeFi platforms must prepare for evolving regulatory compliance.
Power imbalance
The goal of governance tokens is to create a decentralized decision making process. While that's true and what's actually happening, in most cases, projects are being dominated by large holders of tokens referred to as whales. These are often early investors or venture capitalists. Thus, these whales can unbalance the influence over key decisions, beating the purpose of a decentralized idea. Thus, if there's a proposal that benefits long-term users, it might be blocked by the whales if it threatens their profits.
Low voter participation
As mentioned earlier, many token holders fail to participate in governance decisions. These are usually because some holders do not fully understand the proposals or they either lack the time to engage with the decision-making. As a result, decisions are typically made by a small, active group of voters. This can impact the outcomes and may lead to less representative decisions.
Complexity of decision-making
While this is a great opportunity, most especially to token holders, understanding all the aspects that's involved such as the blockchain technology, can be complex and overwhelming. Some holders can be experts but many are not which can lead to poor decisions, manipulation, and exploits. To better understand these complexities, you may want to read about How DeFi is Changing Traditional Financial Systems.
Conclusion
Governance tokens really play a major role in terms of decentralizing the decision-making process in DeFi, making users more involved. While this poses both advantages and challenges, the DeFi space will continue to evolve and these governance tokens will likely become more well-established and sophisticated which will further drive the future of decentralized finance.
