Growing in popularity in the crypto financial economy, the way governance tokens are distributed as rewards ensures that the platform community is consolidated.
Decentralized finance was one of the fastest growing sectors in the crypto space in 2020. According to the data from The Block, The number of deposits in DeFi protocols increased from US$19.72B in January 2021 to US$240B in January 2022.
As of yet, DeFi is not completely decentralized and governance tokens are a common part of DeFi projects, enabling them to gain a higher level of decentralization. Many governance tokens enable investors to influence the protocol’s decisions.
Governance tokens function as regular ERC-20 tokens issued on a suitable blockchain, invariably deployed on Ethereum, with the token main difference from others being that the issuing platform has created purpose-built applications for their use.
Governance tokens come with certain rights regarding the project they are attached to, which often include the ability to vote on the project’s developments & directions.
For example, individual games like Aavegotchi issue their own non-fungible tokens enabling holders to vote on future developments in the game, meaning they have the power to shape the virtual world from within the ecosystem they use.
Decentralized Autonomous Organizations are increasingly keen to use these governance tokens to gather interested stakeholders around their innovative projects, enabling them to take a direct part in the future of the organization itself.
A governance token usually comes with 1 vote but project owners can choose different vote attribution systems based on their values and needs. They’re also able to create voting attribution models for their governance tokens that will favor an individual’s real commitment and engagement to a project over the wealthy collectors, who otherwise can centralize their voting with their large tokens portfolios.
Tokens can be staked to the platform and the user can vote on certain parameters within it, influencing the project’s future direction.
One of the central pillars of the DeFi ecosystem is the way in which projects go about distributing their native token. In this setup, the token is ‘earned’ by participation in the project. There are a few ways an investor can acquire a platform governance token.
Governance tokens can be bought directly on crypto exchanges and traded just like any other fungible ERC-20 crypto token but their purchase implies becoming the owner of rights regarding governance tokens also has a direct relationship with the governance token’s native project.
The most common ways to earn governance tokens are through staking tokens into the platform’s liquidity pools or by participating in the incentives of the platform.
Staking a token is when a user delegates a certain amount of token owned to a platform. This can be in the form of adding their native token into a liquidity pool or as part of a liquidity pair (or LP).
Liquidity pair tokens can be created on Decentralized Exchange platforms (DEX) like Uniswap and Balancer where you can stake equal amounts of two currencies like ETH and the governance token to the DEX and you receive Liquidity Pair tokens in exchange. Which you then stake back to the governance tokens’ the platform to earn more.
You can also stake earned tokens back onto the project once claimed.
Currently, not all Defi governance tokens have a defined rewards structure and there are also many different types of structures.
Examples of reward structures are types of stock buyback (where the token provider buys back some of his token) such as MakerDAO. Interest earned on the MakerDAO stablecoin ($DAI) is used to purchase the MakerDAO governance token ($MKR) and an amount of $MKR is burned, diminishing the overall supply of the $MKR to increase its value.
Curve, on the other hand, offers voting on which liquidity pool gets the most return to users who have staked.
Some platforms have incentivized the growth of their ecosystem by giving away or ‘airdropping’ a certain proportion of their native token to early supporters, foundation members, or for example during events or meet-ups on discord or in a metaverse like Decentraland or signing up early to their website.
Where governance decisions are made through programmable interfaces on the blockchain, with the on-chain governance model much of the process is automated for instance with votes being processed through validator nodes in the blockchain.
Off-chain governance uses already existing compliance and regulatory mechanisms separately from a blockchain and incorporates the results on-chain. For instance, certain compliance actions might be manually processed. It can make scaling an issue and also coordinating certain voting can be more complex with off-chain instances.
Unlike traditional centralized governing bodies and organizational structures, a project using a Governance token has a much more adaptable structure.
Governance tokens are still in their infancy, with project owners still searching for new methods of distribution and monetization of their tokens. So far, some projects have failed, have been corrupted, or have ended up being scams.
Nevertheless, the number of use cases for these governance tokens continues to grow. There’s no doubt that in the coming years, we will discover new impactful and mind-blowing usages for governance tokens.