The last lesson in Shrimpy Academy’s DeFi series covers perhaps the most important one of them all: governance tokens and models.
Decentralized finance revived the need for a fundamental feature of blockchain technology, decentralization. The only way to achieve complete decentralization is not only to rely exclusively on smart contracts but to delegate voting powers to the community as well. As long as the decision-making process is relayed to community members and executed by a developer team, it is safe to say that the project is decentralized.
Governance models are not necessarily a DeFi thing. The original governance model dates back to 2016 when the Decentralized Autonomous Organization (DAO) held an ICO and gathered a total of $120 million in ETH. After only two days, the DAO embedded itself as the largest crowdfunding project in history.
$120 million solely for the right to vote might seem strange, but today’s governance models both have increased complexity and are worth a lot more.
Governance tokens are cryptocurrencies that represent voting power on a blockchain project. They represent the main utility token of DeFi protocols since they distribute powers and rights to users via tokens.
With these tokens, one can create and vote on governance proposals. Community members can spend tokens to directly influence the direction and characteristics of a protocol. It is possible to:
Although most DeFi tokens in the market are governance tokens, that does not mean that voting is their only defining feature. Holders of governance tokens can also stake, take out loans, and earn money by yield farming. Nevertheless, their sole and primary purpose is power distribution.
No one feels left behind or without a voice in an ecosystem like DeFi. Developers do not have to make hard choices, and they can interact with the community and find out what is wrong with the project, why a specific feature should be changed, and how the team should handle funds and partnerships.
Governance also enables users to actively bring change to smart contracts. If an anonymous group attacks the project’s ledger, steals funds, or performs any other malicious activity, neither users nor developers are forced to fork to a different network (which was the case with the DAO).
Ultimately, governance tokens matter because they are harbingers of 100% decentralization. Governance tokens are not premined, and the decision-making process is limited only to those who are quite literally invested in a platform. We can think of it as shareholders who reap the benefits of a businesses’ success. The company can only succeed if those involved are financially incentivized to push the entire project forward.
Is there a difference between governance tokens and utility tokens? If so, which one is better and why?
We have previously covered governance tokens, so let us quickly dive into utility tokens. The additional context will help us analyze whether one crypto category is better than the other or not.
To explain it briefly, utility tokens are digital assets that have some form of utility. This utility is, most of the time, restricted to the native blockchain network or crypto platform. A great example of a utility token is BNB. The asset is used for various purposes on Binance, including paying for fees, voting on new token listings, and paying tickets as ‘entrance fees’ for features like the Binance Launchpad.
The fundamental difference is that utility tokens feature no governance power. Binance users can indeed vote on token listings, but beyond that, nothing else can be changed. Users cannot use BNB to decide on other more critical features or to cast their vote and decide to change how Binance looks or works.
Governance tokens are an upgraded version of utility tokens. Because of that, they may as well be the better option. As previously mentioned, governance tokens can also be used for other processes, like staking and creating loans, so there is really no reason why one should prefer utility tokens over governance tokens.
It is more than clear that governance tokens are advantageous. But what are their disadvantages, and how do they affect crypto protocols? Let us quickly summarize the good, the bad, and the ugly.
Governance tokens represent the foundation block of all things decentralized. They are the central point of most DeFi projects nowadays, and without them, developers would not have the right to boast how decentralized and better their platform is compared to CEXs.
Like the Agora in ancient Greece, governance models are the main spot for political thought and discussion. Forums are always filled with new entrants and ideas that seek to better the project and increase its value. After all, what is the purpose of investing in a governance token if you wish to destroy or harm the platform?
But governance tokens are not without their faults. Malicious actors can still perform activities akin to 51% attacks by merely accumulating tokens. With enough financial power, a whale can disrupt the whole project and single-handedly create and approve decisions.
However, it is worth noting that it takes a long time to reach such a stage. Until then, users have the power to implement features that can prevent similar events and stop whales in their tracks.
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