Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom), published with permission.
Editor's Note: This article comes from
Chain News ChainNews (ID: chainnewscom)
Chain News ChainNews (ID: chainnewscom)
Written by: Mohamed Fouda, partner at cryptocurrency investment firm Volt Capital, member of the TokenDaily research team
COMP, LEND, etc. are governance tokens. The process of distributing these tokens to DeFi liquidity providers (LPs) is known as Yield Farming, and various recent protocols offering Yield Farming have attracted unprecedented liquidity. The most typical example of this is the phenomenal surge in the value of YFI.
YFI is a governance token released by the DeFi protocol yearn.finance on July 17. Its project party declared that the token "has no value", but the price of the governance token soared to more than $1,000 within 72 hours. Weekly rose above $4400.
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YFI token price chart since launch
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the great power of voting
DeFi governance tokens present a unique opportunity to influence the direction of open protocols that would otherwise be nearly impossible to control. These tokens empower token holders to vote to change the parameters of the underlying protocol. Governance token holders can essentially change smart contracts or roll out newer versions of the protocol if they have enough voting power. The powers assigned to holders of these governance tokens are very similar to those assigned to shareholders.
Governance tokens have several advantages over traditional stocks/shares. In a traditional startup/corporate, shares allow owners to vote in favor of the CEO or other C-level executives, while governance tokens remove the need for proxy voting.
Specifically, when there are enough votes, funds and large investors can propose changes publicly and quickly, put the change plan to a vote, pass the scale expansion plan in their favor, and impose their will. In other words, systems utilizing governance tokens are actually creating a version of traditional/centralized finance (CeFi), only masquerading as DeFi. We at Volt Capital call it ReFi, or decentralized finance.
As the development of DeFi protocols is still in its infancy, we do not expect to see this happen for a while. However, once these agreements grow to the size of Chase, Bank of America BoA, or Wells Fargo, the incentives change.
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Pros and Cons of Governance Tokens
Governance token distribution is fairer than equity distribution
token distribution
These decentralized protocols cannot be regulated
The above arguments largely overestimate the error-correcting capabilities of the protocol. Let's figure it out one by one:
token distribution
DeFi protocol founders and developers are trying to distribute tokens widely, and distributing tokens to liquidity providers is a way to try to achieve this goal, but the actual situation often fails to meet expectations. Take the yield farming phenomenon as an example, where funds and wealthy investors (aka whales) utilize recursive liquidity provisioning to maximize their yield/share from governance tokens. Ultimately, these tokens are concentrated in the hands of a few investment institutions/farmers.
In addition, investors in these DeFi projects currently control a disproportionately large number of votes. For example, over 13% of Compound’s voting power is controlled by the top 10 addresses. Certainly this ownership structure is better than JP Morgan or Bank of America today, but by how much? The figure below shows that the difference is actually very small:
Shareholding distribution of traditional financial institutions, source: CNN Money
fork
Regulatory resistance
A common misconception in the cryptocurrency space is that DeFi can operate at scale without regulation. This idea might be possible if you create a smart contract that burns the control keys so that there is no practical way to edit or change the contract. However, the existence of governance tokens makes this task impossible. Certain projects have had small-scale success to date, but on a large-scale operational basis, having a governance token could lead to increased regulation by creating accountability for product usage.
Major governance token holders could end up being legally held accountable for illegal use of protocols over which they financially control, such as money laundering. If the majority owners of these tokens are brought to justice, a small percentage of token holders will inevitably follow changes to the protocol, limiting the use of the “DeFi” protocol to “unintended” users.
fork
It is widely believed that users can easily fork the protocol if they think it has gone bad. But forking is very difficult in practice. The protocol relies heavily on momentum, and forking away from the existing governance structure means the protocol reverses momentum against the will of its leadership. A certain degree of brand stickiness will reduce the impact of forks, Ethereum Classic or Bitcoin Cash are typical examples. Forked protocols are generally considered less trustworthy by the vast majority of users.
There are two other factors that make forking nearly impossible.
