Decentralized finance (DeFi), has grown into a range of applications that brought financial tools on the blockchain. These platforms, mainly developed on the Ethereum blockchain, now allow borrowers, lenders and investors to execute financial transactions without the need for a trusted intermediary. Besides utility and security tokens, a new token type has emerged to power the governance of these decentralised ecosystems. These are Governance tokens, and they give holders the right to influence the direction of decentralized finance projects.
Governance in DeFI
In general, governance defines a framework of rules and procedures that regulates the conduct of all participants of a network. DeFi aims at developing an alternative financial system that is completely decentralized, fully automated, censorship-resistant and free of counterparty risk. Differently from the traditional banking system, DeFi applications are based on open-source principles and aim at offering permissionless access to their services. This means that anyone should be able to use these platforms, and to read, audit and contribute to the code. No permission is required from a central authority to join the platform, and no single entity should be able to control the decision-making power for the project.
To achieve this goal, a decentralised infrastructure and the decentralisation of powers assume utmost importance. DeFi protocols are attempting to have as many stakeholders as possible sharing control of the protocol, and governance tokens are being used to achieve this governance decentralisation.
What is a Governance Token?
Governance tokens are tokens created to allow their holders to help shape the future of a protocol. Governance token holders can influence decisions concerning the project, they can submit a new proposal or vote on an existing one, or even decide on possible changes to the governance system itself. Proposals can regard the determination of certain system parameters, form consensus on important community goals and targets, as well as voting on code contributions and funds allocation. Nevertheless, governance tokens are becoming increasingly popular in the crypto ecosystems for giving users a direct stake in managing DeFi platforms.
In most cases, organizations who let users control the development of their systems are called decentralized autonomous organizations (DAOs).
DAOs are governing bodies that oversee the allocation of projects resources and should ensure the long term success of the project. Token holders vote on issues and proposals controlling these DAOs. It is in the token holders’ best interest to want the protocol to run efficiently, and to implement features that draw users to the platform or increase demand for the token. Popular distribution models make it so governance tokens can be earned by people who participate in the protocol. MakerDAO and Compound are two primary examples of DeFi protocol making use of this type of token-incentivized governance.
Token voting is the first step toward open and transparent on-chain governance, but flawed design makes it susceptible to large voters controlling the protocols, or core development team not abiding to the DAO’s vote. Moreover, questions remain over the legal classification of DeFi tokens. A securities classification depends on the facts and circumstances of each token, as a token could fall under some, but not all criteria for defining a security.
Our expert legal team has ample experience in the determination and classification of tokens under several legal regimes, and can guide you in the best possible way should your token have semblances of securities or financial instruments.
