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In short, the governance token is a step forward in the decentralisation of voting rights led by DeFi. With Governance tokens, if they only have governance functions, have no intrinsic value in themselves, but they are related to the incentives of each different protocol, so they carry other values. Their value can be seen in three main incentives: Liquidity Mining, Lending, and Staking, along with a combination of protocol-specific incentives. That is why we often see relatively valuations like PE and PS. However, governance tokens still have certain risks which affect the main purpose for which they are formed.
Governance tokens emerged thanks to the birth of famous DeFi projects such as MakerDAO, Compound, Aave, Uniswap, etc., which have seen growth in marketcap skyrocket since DeFi Summer 2020.
In today's article, we will discuss what governance tokens are, how they impact the DeFi space, and why they are valuable.
What Is A Governance Token?
A governance token is a type of token that grants voting rights to their owners in a particular protocol.
There are currently two ways to calculate the power of voting for governance tokens: token-weighted voting (almost protocols) and time-weighted voting (e.g. Curve).
Voting power is weighted according to the number of tokens, which means that the more governance tokens a holer holds, the more decision-making weight they have on an issue. While time-weighted voting rights give more rights to those who lock the governance token for longer.
In off-chain governance, network participants communicate outside of the network. These mechanisms can be used to grant token holders informal voting rights. Votes can signal the community to download the code change, but votes do not automatically trigger the change. If a minority disagrees, they can choose not to download the code update. This will result in two separate networks (hard fork).
With on-chain governance, code changes are done automatically once voting is complete. Similar to off-chain governance, a minority can choose a minority group can choose to create a hard fork with the new changes.
The main difference between the two governances is in the way in which participants choose to participate. The on-chain governance allows the code change to occur by majority vote, while the off-chain governance requires participants to download the code change.
As an open-source network, each scenario presents an opportunity for the minority to create a network that works for them.
For example, we have seen many forked platforms like Sushiswap from Uniswap, Swerve from Curve or Mirror from Synthetix. Basically, these fork platforms either compete directly with the original platform (Swerve) or go in a new direction compared to the original platform (SushiSwap, Mirror).
Governance tokens allow holders to vote for changes in the network to which they belong. Usually, the number of tokens a person holds is proportional to the power of votes they have.
Governance Token Impact On DeFi
For many in the crypto space, governance tokens are a key function of the DeFi protocol that enables decentralised voting. This approach is consistent with the financial decentralisation that the system hopes to achieve.
The principles of DeFi focus on financial democracy:
- The ability for all users to participate; and
- Have a voice in a monetary system that works in favor of the majority.
Looking back in history, we have seen a change in governance in protocols like MakerDAO and Synthetix. In March 2020 MakerDAO completed its transition to complete community governance. In the course of 2020 Synthetix launched several DAOs, with each DAO managing separate parts of the protocol created by the main developers.
This could be an indication of where DeFi is headed.