Governance token far-reaching impact on DeFi protocols

DeFi goes on to play a crucial role in the evolution of the financial sector for many reasons. For one, it is an open and permissionless system that is available to everyone. Secondly, arguably more interesting is interoperability that helps DeFi companies scale products by leveraging other innovations in the industry.

When combined, powerful financial products are possible which has led to the commitment of many developers in developing the DeFi ecosystem. 

DeFi craze and experimental nature of governance tokens:

DeFi is now one of the fastest-growing sectors in the blockchain. Now with over 100+ DeFi projects, a net worth of over $7 Billion value locked in DeFi smart contracts. Source: DeFiPulse.

In the center of the DeFi ecosystem lies governance token. A governance token is an experimental approach in the DeFi ecosystem that lately has gained popularity. DeFi projects handout governance tokens to incentivize a variety of actors (liquidity providers, lenders, borrowers, etc) in the protocol.

As of this writing, the market cap of Ethereum’s top 10 DeFi governance token projects had risen to over $4 billion. But, it is true that many folks in the crypto space still don’t understand these tokens – what they do and how they drive intrinsic value.

So what are these governance tokens, and why are they gaining value?

Governance tokens in the DeFi platform serve as a capital that offers some control over the distribution of economic resources across a group of people (not to mix with platform economic models). In other words, whoever has this capital, has the power to decide which inputs to use to create things or useful work or provide services. 

For example, roads (and transport infrastructure) are capital for inhabitants of a city as it pins down the success of city growth. This insight helps to define the capital intrinsic value which is directly proportional to the value of the resources it governs. In this case, economic activity (flow of resources) from one place to another in the city.

If capital is the power to organize economic resources (or change the rules) and when that power takes the form of a token, it can trade, priced, and modeled by the market. As the value of these resources grows, so does the value (or importance) of the token which governs them.

Governance tokens have a far-reaching impact on the DeFi landscape:

Governance tokens play a key role in defining the economic model of the platform. The crypto-economic model defines ‘the rules’ of the system – what is the unit of work, how do users pay, how actors get compensated, the token supply model, etc., while the governance token defines who has the power to change those rules. 

As the resources (TVL) in DeFi protocols grow, so does the influence of the governance token, making it more valuable. So, its influence must be distributed among the community so that no single person controls this tremendous power.

A case from the real world: Recently in May, when Mr. Zuckerberg said Facebook would not remove or flag Mr. Trump’s posts that seemed to encourage violence against those protesting police racism, it sparked outrage among several Facebook employees and civil rights activists. 

Despite the huge protests, Mr. Zuckerberg decided not to take down the post. Not going into if the decision was wise or otherwise, it was one person’s decision affecting the larger community (or ecosystem). On the contrary, if Facebook was a community-owned platform, community votes will be put on the count to decide what action to be taken on the post.

Therefore, if the decision has an impact on the larger community, it is best to have community opinion into consideration.

It is the main reason why DeFi protocols create a wider distribution of their governance token, giving its community an increasing amount of power to make the protocol decisions. This way DeFi protocols ensure that unbiased quality information feeds in the decision-making process.

For instance, in Compound, a lending/borrowing platform, the community can propose the following changes:

1. adding new assets to the platform, 
2. remove an asset,
3. changing an asset’s interest rate.

Similarly, in the DeFi asset management (yield aggregator) platforms that optimize yield for users such as yearn.finance and APY.Finance, the community can control the following economic resources: 

1. proposing and voting on risk scores for strategies. 
2. determining risk tolerance levels.
3. adding new yield strategies.
4. allowing changes to the strategies.
5. incentive structure. 

This way the platform also keeps itself up-to-date with the users (community) latest interest and adapts to the strategies proactively as the marketplace evolves, thereby ensuring the platform continued usage.