DeFi has seen tremendous growth in the last 12 months. All metrics (value lock volume, users, trading volume, valuation, etc.) have risen dramatically. But while some of these metrics are easy to track, others are more ambiguous. One challenging metric is valuation.
In traditional stocks, valuation is tied to equity itself or direct partial ownership of the company. This interest equates to effective control of the company and confers certain benefits on the equity holder, such as a pro rata share of profits (dividends).
So what is a governance token?
In a decentralized protocol, the code is the law, so the actual control depends on what is represented in the code. In this sense, each DeFi application will have a different ownership profile, as each protocol will write a different set of rules to define what ownership means. Some protocols are coded to have no concept of external ownership, they will operate only according to their initial internal rules and will never change! However, most of the teams creating these protocols recognize the need for upgrades and changes and therefore encode them using the concept of ownership so that the chosen parameters can be adjusted and changed.
In short, governance tokens are ERC-20 tokens associated with specific projects where a quorum of token holders is required to adjust or change the selected parameters. Therefore, these tokens “govern” the agreement.
However, it is important to note that.
1) Governance tokens do not lead to unilateral control. Governance tokens can only affect the selected parameters that have been initially encoded into the project.
2) Each project has a different definition of ownership and governance, and will decide for itself which parameters can be changed and how the changes are approved.
Obviously there are many nuances here. In this article, we will take a quick look at what makes governance tokens valuable, and some reasons to use them with caution.
I. Reasons Governance Tokens May Be Valuable
Why is it valuable to have control and influence over decentralized protocols? In short, governance tokens convey certain privileges, including
Cash flow distribution rights: protocols may charge fees to their users. After these fees are collected, the governance vote may decide to distribute a portion of the fees to token holders, similar to a stock dividend.
The right to change the agreement: As mentioned earlier, tokens grant their owners the right to vote on the future of the agreement. For example, most programs allow token holders to vote on smart contract code changes and fund management.
Code changes represent the direct business logic of the application. In some cases, these decisions can be very important, similar to a board of directors voting on the strategic direction of a company. Control and influence over these decisions is important, and some parties are willing to pay a significant price for it.
Funds management usually focuses on the percentage of tokens typically allocated to “community activities,” a budget that is used to fund beneficial projects and feature development. Influence over these decisions is another extension of the control over the future direction of the agreement.
Right to future token distribution: Some projects make it possible to mint new tokens to the users of the protocol, usually through liquidity mining. The idea is to distribute governance proportionally to the users of the protocol, leading to deeper levels of retention and participation. Governance tokens are often used to set these parameters.
The following are some examples of existing DeFi projects on these dimensions.
Finally, governance tokens are the closest thing to ownership in a decentralized project and often have some degree of influence on the future direction of these projects. Most projects also charge users a fee, and for this reason, a portion of the value may eventually accrue to the token holder.
II. Reasons to be cautious when investing in governance tokens
While governance tokens can provide compelling returns, please note some key challenges and risks.
Utility of the token cap table: The total supply of tokens typically includes a large allocation to founders/team members and investors, thereby granting control to a relatively small segment of the population. As a result, the protocol is actually richer than a democracy. As a result, some projects have avoided team and investor allocations altogether, opting instead for a “fair launch,” where governance tokens are distributed entirely to platform users. In practice, however, this can still lead to an over-concentration of positions as whales take outsized positions in the secondary market.
The St Louis Fed’s DeFi paper notes, “In many cases, most governance tokens are held by a small group of individuals …… Even if the issuance is considered relatively “fair “, actual allocations typically remain highly concentrated.”
Upcoming investor and team vesting process: Most team and investor tokens typically do not flow immediately, but remain locked in on a prescribed vesting schedule. The cumulative effect is that most token supply is illiquid when the contemporary coin first launches and begins trading. The reduced float can cause the “fully diluted value” of the project to inflate to seemingly excessive numbers.
The potential challenge is compounded by the fact that typically a portion of the team and investor tokens will be immediately liquid upon issuance, resulting in a supply shock that can affect the impact on governance voting and potentially market prices. When participating in governance tokens, be aware of the total supply of tokens as well as any unlocked nodes.
Regulatory Issues: The U.S. Securities and Exchange Commission (SEC) has issued guidance that the more decentralized a project is, the less likely the underlying token will be considered a security. It is unclear how decentralization will be defined in practice, but the SEC has indicated that BTC and ETH have previously reached this. Nonetheless, the threat of being considered a security still looms over projects with governance tokens, as it is unclear how the SEC will view some of these projects in the future.
iii. concluding remarks
Looking at it obliquely, governance tokens are similar to traditional interests: they can control the future of the agreement and can dictate cash flows and/or receive dividends. The main differences, however, are that governance tokens are limited in scope (only a small set of parameters can be voted on), are usually provided free of charge to the users of the protocol, and are not strictly fair in a legal sense.
It is also helpful to be aware of the potential downsides. Each project will implement governance tokens differently, issuing a unique token cap table that may contain onerous vesting schedules, thus making initial liquidity low, and will be independently assessed for compliance by regulators.
There is reason to be excited about the new paradigm introduced by governance tokens, but it is also early in their evolutionary history. These are new concepts with plenty of room for design and will continue to evolve, so be sure to do your own research and proceed accordingly.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/how-does-coinbase-view-governance-tokens/
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