What are Governance Tokens
Decentralized networks have no central entity to manage them. Governance tokens were created to help the community steer the network. Governance tokens represent a percentage of voting power, called “pro-rata voting rights”, over a protocol or network. These tokens typically have code that embeds rules related to how the system can change, like adjusting configurations or adding new components. The ability to adjust a network is essential because DeFi protocols need to stay in sync and react to changing market conditions. It also allows the network to evolve as the ecosystem matures.
Examples of governance tokens include Yearn.finance YFI, Compound Finance COMP, UniSwap UNI, AirSwap AST. Due to their influence over a network, they can accrue value and are traded on exchanges.
Governance tokens rely on incentives to encourage or discourage certain behaviors which maintain network security, solvency and growth. Incentives are powerful tools. Through the use of code to enforce, promote and punish certain behaviors, blockchain-based systems from the base layer to DeFi protocols layer can create stability and promote coordination absent a central authority. Properly designed incentives can reward early supporters and the initial development team. Or they can result in pump and dumps. Designing these incentives requires good Tokenomics.
Tokenomics deals with the management of token economies, including token creation, removal, and applied network incentives. These incentives are best seen at work in treasury management, which deals with the network’s supply of tokens. Tokenomics is not to be confused with CryptoEconomics or the use of economic incentives to provide guarantees about applications in open and adversarial networks. Tokenomics is about coordinating participants, while CryptoEconomics focuses on securing the underlying system.
A token’s policy could be inflationary, deflationary or static. Inflationary policies increase the number of tokens through minting. Deflation reduces tokens through burning tokens. Static policies keep them the same. The policies can be used to encourage different actions. Inflation can be used to bootstrap a network by compensating users for activities to achieve utility, network participants and liquidity. As long as the network’s utility is greater than the inflation rate, it could make sense to increase the supply. This could be measured by many indicators like network activity and the price for the token.
Treasury management is deeply linked to community management since how you incentivize and manage tokens leads to community engagement. An application of this are liquidity mining programs. These provide staking rewards as a positive incentive for users to provide liquidity to a network. Users are credited with a bonus in their token account, based on their stake. They function as a marketing expense to bootstrap networks. Airdrops are another popular form of distribution, the most famous being UniSwap to retain liquidity from being sucked away by competing platforms.
Pioneered by Compound.finance, users were rewarded by engaging in certain behaviors and received tokens which could be used for governance. This model was copied by others and led to the DeFi Summer of 2020. Seeking a return from these tokens led to yield farming, the activity of moving assets between protocols to gain a maximum return.
There are also incentives to discourage negative behavior like slashing funds for certain actions or liquidations for undercollateralized positions. Further incentives include direct rewards where users can be paid for providing liquidity to a pool and earn a fee in proportion to the amount staked.
Not all DeFi protocols or blockchain applications are decentralized. If a protocol’s governance can be centralized if it’s only controlled by the admins. True decentralization implies decentralized infrastructure and governance. Governance token holders exercise their influence via DAOs, short for decentralized autonomous organizations. They can be airdropped to users of a platform to transition to a DAO like Shapeshift did in July 2021. We will cover DAOs in a later section.