Around the Block #13: On the value and risks of governance tokens

Context

DeFi has seen tremendous maturation implicit the past 12 months. All metrics — worth locked, users, transactions, valuations, etc, — person precipitously risen. But portion immoderate of these metrics are casual to way and digest, others are much nebulous. One sneakily challenging metric is valuation.

In accepted equities, valuation is tied to equity itself — oregon nonstop fractional ownership successful a company. This equity equates to applicable control over a corporation, and confers definite benefits to equity holders specified arsenic a pro-rata stock of profits (dividends).

So what are governance tokens?

In decentralized protocols, the codification is the law, truthful practical control comes down to immoderate the codification says. In this sense, each DeFi exertion volition person a antithetic consciousness of ownership, arsenic each protocol volition person codified a antithetic acceptable of rules that specify what ownership means. Some protocols were coded to person nary conception of outer ownership — they volition simply run according to their archetypal interior rules and ne'er change! However astir teams who make these protocols admit the request to adapt, upgrade, and change, and frankincense codification successful a conception of ownership that enables prime parameters to beryllium adjusted and changed.

Enter “governance tokens.” Simply put, these are ERC-20 tokens tied to a circumstantial project, wherever a quorum of votes from the token-holders are required to set oregon alteration selected parameters. Thus, these tokens “govern” the protocol.

But it’s important to enactment that:

1. Governance tokens bash not effect in unilateral control. Governance tokens tin lone power prime parameters that were coded-in to the task astatine the beginning.
2. Each task volition person a different explanation of ownership and governance, and volition determine for itself what parameters are eligible to beryllium changed, and however changes are approved.

There is intelligibly a batch of nuance here. In this edition, we instrumentality a speedy look astatine what makes governance tokens valuable, but besides immoderate reasons to workout caution.

Why should power and power implicit a decentralized protocol beryllium valuable? In short, governance tokens convey definite privileges, including:

Rights to currency flow: Protocols whitethorn complaint a interest to their users. These fees are collected, and a governance ballot tin determine to administer a information of fees to token holders, akin to dividends with equities.

Rights to protocol changes: As mentioned, tokens assistance their owners the close to ballot connected the protocol’s future. For example, astir projects fto token holders ballot connected some smart contract codification changes and treasury management.

Code changes correspond nonstop concern logic of the application. In immoderate cases, these decisions tin beryllium rather material, akin to a committee of directors voting connected the strategical absorption of a company. Control and power implicit these decisions carries weight, and immoderate parties are consenting to wage handsomely for it.

Treasury absorption mostly concerns the percent of tokens typically allocated to “community efforts” — a benignant of fund to money beneficial projects and diagnostic development. Influence implicit these decisions is different hold of power of the aboriginal absorption of the protocol.

Rights for aboriginal token distribution: Some projects alteration caller tokens to beryllium minted, usually to users of the protocol via yield farming. The thought is for users of the protocol to beryllium fixed a pro-rata stock of governance, starring to deeper retention and engagement. Governance tokens are commonly utilized to acceptable these parameters.

Below are immoderate examples of existing DeFi projects crossed these dimensions:

In the end, governance tokens are the closest happening decentralized projects person to ownership, and mostly transportation immoderate measurement of power implicit the aboriginal absorption of these projects. Most projects besides person immoderate interest imposed connected users, for which a information of this worth whitethorn yet accrue to token holders.

While governance tokens supply compelling benefits, beryllium alert of immoderate cardinal challenges and risks:

Plutocracy of the token headdress table: The full proviso of tokens usually contains important allocations to founders / squad members and investors, granting bulk power to a comparatively tiny subset of people. As a result, the protocol is efficaciously much of a plutocracy than democracy. As a result, immoderate projects person eschewed some squad and capitalist allocations entirely, opting for a “fair launch” wherever governance tokens are wholly distributed to the users of the platform. However successful practice, this whitethorn inactive effect successful concentrated positions arsenic whales summation outsized positions.

The St Louis Fed’s DeFi paper noted that “In galore cases, the bulk of governance tokens are held by a tiny radical of people… adjacent erstwhile a motorboat is perceived arsenic being comparatively “fair,” the existent organisation often remains highly concentrated.”

Upcoming capitalist and squad vesting cliffs: The bulk of squad and capitalist tokens are typically not instantly liquid but stay locked for a prescribed vesting schedule. The cumulative effect is that a bulk of the token proviso is illiquid erstwhile a token archetypal launches and begins trading. This reduced interval tin inflate a project’s Fully Diluted Value to seemingly exorbitant numbers.

Compounding imaginable challenges, usually a information of squad and investors tokens volition go liquid astatine erstwhile (a vesting cliff), resulting successful a daze to proviso which impacts power implicit governance votes, and perchance marketplace price. Be alert of the full token supply, and immoderate lockup cliffs erstwhile participating successful governance tokens.

Regulatory overhang: The SEC has issued guidance that the greater a project’s decentralization, the little apt the underlying tokens would beryllium considered securities. It’s unclear however to specify decentralization successful practice, but the SEC has indicated that BTC and ETH person antecedently met this designation. Nevertheless, the menace of being deemed a information hangs implicit projects with governance tokens, arsenic it’s mostly unclear however the SEC volition presumption immoderate of these projects successful the future.

If you squint, governance tokens carnivore similarities to accepted equity: they connection power implicit a protocol’s future, and tin dictate currency flows and/or person dividends. But determination are cardinal differences successful that governance tokens are restricted successful scope (can lone ballot connected a tiny subset of parameters), are often offered freely to the users of a protocol, and are strictly not equity successful a ineligible sense.

It is besides adjuvant to beryllium alert of the imaginable downsides. Every task volition instrumentality governance tokens differently, transportation a unsocial token headdress array that whitethorn see onerous vesting schedules that enables a debased archetypal float, and volition beryllium independently evaluated by governing bodies for regulatory compliance.

There is crushed to beryllium excited astir the caller paradigm that governance tokens introduce, but it is besides aboriginal successful their evolutionary history. These are caller concepts and the plan abstraction is ample and taxable to evolve, truthful beryllium definite to bash your ain probe and proceed accordingly.