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DeFi Governance Tokens Face Three Challenges

  • Before investing, check who owns the majority of tokens, how they are managed.
  • However, concentration might be also helpful in the early stages of a project.
  • When yield farmers run into a problem it may cause a deficit in a particular governance token.
DeFi Governance Tokens Face Three Challenges 101
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DeFi hasn’t always been particularly decentralized, with many of the major platforms and projects beginning with core teams who controlled their initial development.

It seems that this has somewhat changed in recent months, with the rapid ascent of DeFi almost forcing the ecosystem to introduce governance tokens as a means of decentralization.

Governance tokens are popular, but industry players speaking to Cryptonews.com warned they come with a number of problems that will have to be solved over time. These include such problems as the concentration of governance tokens in the hands of a few holders, as well as the potential unsustainability of yield farming using governance tokens.

Fashionable token

The main trend in governance tokens right now is that every major DeFi platform needs to be seen to have one. Over the past few months, we’ve seen Uniswap, Aave, Curve, Compound, and Balancer (among others) have all launched their respective governance tokens, generating market buzz in the process.

NEM Group’s head of trading, Nicholas Pelecanos, told Cryptonews.com that we’ve now reached a point where a governance token is all-but necessary for any aspiring DeFi project.

“Governance tokens have more or less become an essential part of DeFi applications. To be truly decentralized the governance of the application also needs to be decentralized and this is the key utility of a governance token,” he said.

Most governance tokens function like votes, meaning that holders get to place their tokens with proposals for developmental changes.

As Aave’s marketing manager Isa Kivlighan told Cryptonews.com, the vast majority of governance tokens grant voting rights to holders, but little else.

“In Aave, for example, the governance token is the AAVE token, and AAVE token holders are able to vote on governance updates and changes,” she said.

Problem one: concentration

Aside from not providing holders with direct input into which governance changes are proposed in the first place, there is one obvious problem most governance tokens face: concentration.

About 46% of Compound’s COMP tokens were distributed to shareholders, founders and the Compound team. This gives the inner Compound circle much greater weight over governance decisions than users, something which compounds (pun intended) the aforementioned problem that this inner circle will also be the ones making the proposals.

Nicholas Pelecanos suggested that concentration isn’t necessarily a problem, at least not in the earlier stages of a DeFi project’s life.

“Many will argue that this is a bad thing but initially this is actually healthy, you want the founders of a project to be incentivised to help grow the platform and its value,” he said.

Pelecanos noted that, as a project matures, its founders will need to spend their holdings on operational expenses.

“This involves liquidating their holdings, reducing their ownership stake in the project. This is the crypto paradox where founders generally need to spend their tokens to see their value grow,” he said.

This helps projects trend toward decentralization, he added. “We can see this in a lot of the early blockchain projects like NEM.”

Apollo Capital Chief Investment Officer Henrik Andersson also noted that most platforms have mechanisms built in which will see governance tokens being increasingly distributed to users.

“We have lately seen a rise in 'liquidity mining' where governance tokens are distributed to the people providing liquidity to the platforms. In this way, liquidity mining becomes a way of fair distribution of the tokens to the platform users,” he told Cryptonews.com.

Problem two: yield farming

The mention of liquidity mining, yield farming brings us to another problem faced by governance tokens and the platforms using them.

“The yield farming trends we have seen take off in the DeFi space may not be sustainable,” suggested Isa Kivlighan.

Because of yield farming, we may potentially encounter a situation where debtors are unable to repay loans, causing a deficit in a particular governance token. Such a deficit could undermine the stability of a platform, although Kivlighan said AAVE has introduced a system to guard against this possibility.

“At Aave, the AAVE token holders can stake their AAVE in the protocol Safety Module to help secure the protocol,” she said. “In the case of a shortfall event, up to 30% of the stakes can be slashed to cover the deficit. In exchange for securing the protocol, stakers earn Staking Incentives in the form of AAVE.”

Problem three: incentivizing founder exits

Nicholas Pelecanos noted one final problem.

“One of the key issues is with founders selling their tokens and abandoning the project early. This most recently happened with SushiSwap when the anonymous founder left the project taking USD 14m with him after only a few weeks work,” he said.

In the case of SushiSwap, the founder succumbed to pressure and returned to the platform. However, Pelecanos has some closing advice for investors wanting to avoid a similar situation.

“Anyone looking to invest in the space or any blockchain project should take time to look at who owns the majority of tokens and how they are managed. For example, having multisig wallets on the core holdings and value locked in smart contracts helps show the founders willingness to work on the project for an extended period of time,” he said.

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Other insights into governance tokens:

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Learn more:
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Top 4 Risks DeFi Investors Face
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DeFi’s ‘Total Value Locked In’ Metric Is A Crooked Mirror
Why DeFi Isn’t Always As Decentralized As You Might Think
The DeFi Sector Is Breaking The Law - It’s Time to Act

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