What Are the Risks of Governance Tokens?

Many of today‘s leading DeFi projects are popular because of their governance tokens – something that hasn’t really been the case back in the ICO boom of 2017.

Now, the yield farming hype has created many new governance tokens to control a projects properties. Yet, these tokens have been abused in various 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 projects direction. For instance, community members can launch new proposals to change particular properties for the project. Further, governance token holders can vote on each proposal.

The ultimate goal is to create a self-governed decentralized community as it allows every stakeholder to discuss and vote on how to manage the protocol or project.

Compound, for example, 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 a certain number of risks. This article 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 holds them can participate in voting. For instance, Compound allows COMP token holders to debate, propose, and vote on all protocol changes.

Yet, there‘s a big 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. Many investors were actively trading the Sushiswap governance token. However, the creator of Sushiswap decided to sell a significant portion of their tokens. This sell-off caused a 90% price drop.

It becomes quite obvious that governance tokens shouldn‘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 owned the Sushiswap governance token saw it as an incentive to earn extra cash as they could trade it. This monetary aspect was the main reason for the big crash, as most liquidity miners didnt 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 holders to participate in the projects governance.

Risks of Proportional Distribution

For projects that launch a token via yield farming, theres a risk that whales can gain a lot of voting power through acquiring governance tokens. The catch here is to be a first-mover that allows 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 who often receive a sizable stake in the project for contributing.

Why is this a problem？ 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 problem becomes more dangerous when centralized exchanges participate in DeFi by providing DeFi products to their users in a custodial way. Therefore, they could use their substantial stake to affect the projects 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 theres a possibility.

Risks of Governance Communication

Lets have a look at how Cosmos governance works, for example. Cosmos requires you to vote for proposals using your tokens. Yet, there are a few problems with this approach.

• 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 people dont have in-depth technical knowledge about blockchain technology. For that reason, they rely on prominent figures or node operators to translate proposals as they believe these people are community experts. This approach can quickly become dangerous as most people listen to the calls of these prominent figures who can quickly gain a lot of power.

Cosmos, for example, allows governance token holders to delegate their vote. Most often, they choose 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 requires 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, theres still a developer who has to update the code or deploy a smart contract based on this governance process. Specifically, decentralized governance relies on centralized actions.

In my opinion, governance tokens shouldnt 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 pros and cons.

While governance tokens are an interesting use case, we need better solutions. For instance, the Curve Finance founder seized 71% of voting power over his Curve DAO. We want to avoid such events from happening.