Lots of leading DeFi projects are popular because of their governance tokens – something that hasn’t been the case back in the ICO boom of 2017. Governance tokens, however, come with several risks. This post discusses three potential challenges.
Now, the yield farming hype has made many new governance tokens to control a project’s properties. Yet, these tokens have been abused in different ways, acting as a monetary incentive instead of a true representation of voting power.
In theory, a governance token gives the token holder voting power to influence the DeFi project’s direction. For example, community members can launch new proposals to change specific properties for the project. Moreover, governance token holders can vote on each proposal.
The ultimate purpose is to make a self-governed decentralized community as it enables every stakeholder to discuss and vote on how to manage the protocol or project.
Compound, for instance, believes that “by placing COMP directly into the hands of users and applications, an increasingly large ecosystem will be able to upgrade the protocol, and will be incentivized to collectively steward the protocol into the future with good governance.”
Governance tokens, however, come with several risks. This post discusses three potential challenges:
- The risks of trading governance tokens
- The risks of proportional distribution
- The risks of governance communication
Risks of Trading Governance Tokens
Governance tokens serve the purpose of providing token holders power over critical project decisions. Anyone who owns them can participate in voting. For example, Compound allows COMP token holders to debate, propose, and vote on all protocol changes.
Yet, there’s an important issue with the ability to trade them. Essentially, governance tokens shouldn’t obtain any value as that will make them subject to trading. Unfortunately, most projects have made this mistake.
Let’s take a look at Sushiswap’s so-called exit scam. Lots of investors were actively trading the Sushiswap governance token. However, the founder of Sushiswap decided to sell a big portion of their tokens. This sell-off caused a 90% price fall.
It becomes quite obvious that governance tokens mustn’t be subject to trading. In this case, you’ve just lost 90% of your token’s value by actively participating in the project’s governance. This event is not acceptable.
In this example, most investors who held the Sushiswap governance token saw it as an incentive to earn extra cash as they could trade it. This monetary aspect was the major reason for the big crash, as most liquidity miners didn’t see the coin as a governance token. Therefore, they had no issues with selling it at low prices as any extra profit is a bonus.
There are other incentivization techniques to push owners to participate in the project’s governance.
Risks of Proportional Distribution
For projects that launch a token via yield farming, there’s a risk that whales may gain a lot of voting power through acquiring governance tokens. The catch here is to be a first-mover that enables you to farm a lot due to the low competition for that pool. As a whale, you can add a lot of liquidity to gain a major stake in the project. The same applies to team members that often receive a sizable stake in the project for contributing.
Why is this n issue? It leaves whales or team members with a disproportionate amount of control over the project. In theory, a whale can launch and approve new proposals that benefit them.
This issue becomes more dangerous when centralized exchanges participate in DeFi by providing DeFi products to their users in a custodial way. As a result, they could use their substantial stake to affect the project’s direction or even slowly destroy competing products as liquidity exchanges are a direct competitor for centralized exchanges.
Whether or not this has happened up until now is irrelevant as long as there’s a possibility.
Risks of Governance Communication
Let’s have a look at how Cosmos governance works, for instance. Cosmos needs you to vote for proposals using your tokens. Yet, there are a few problems with this way.
- Too many proposals.
- Proposals are too technical or not relevant to regular users.
- People vote by following prominent figures that tell them what to do.
While some proposals are too technical or not relevant to the regular user, it quickly becomes too time-consuming to stay on top of governance voting.
On top of that, many don’t have in-depth technical knowledge about blockchain technology so they rely on prominent figures or node operators to translate proposals as they believe these people are community experts. This method can quickly become risky as most people listen to the calls of these prominent figures who can quickly gain a lot of power.
Cosmos, for instance, allows governance token holders to delegate their vote. Most often, they select a node operator to allow them to vote in their turn as it is much easier with minimal risks. However, you put your trust in the hands of this validator.
As Mario Laul, a well-known figure in the space of Technology Governance, says, a decentralized network’s governance is strongly influenced by political communication, this needs professionalization. Mario Laul acknowledges that there’s a clear risk that a validator can provide false arguments to win a proposal that favors this person.
Is Decentralized Governance Genuinely Decentralized?
Even though a project relies on decentralized governance, there’s still a developer that needs to update the code or deploy a smart contract based on this governance process. Particularly, decentralized governance relies on centralized actions.
In my opinion, governance tokens shouldn’t have any monetary benefits or incentives attached to them. On top of that, projects should consider professionalizing the communication for proposals and provide human-understandable versions that clearly state advantages and disadvantages.
While governance tokens are an interesting use case, we need better solutions. For example, the Curve Finance founder seized 71% of voting power over his Curve DAO. We want to avoid such events from happening.