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What is a governance token? Explain the features and mechanisms using case studies!

Official | 2022.12.12

Text by ゆーすけ

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There are many people who are worried that “There are governance tokens in projects used in DAOs (decentralized independent organizations) and DeFi (decentralized finance), but I want to know how they work, their characteristics, and case studies.” .

In this article, we will explain the mechanism of the governance token from the beginning, with examples of its use. We will also introduce tax and legal issues related to governance tokens.

1. What is a governance token?

A governance token is a rights token that is necessary when participating in the “decision making” of a decentralized project such as DAO or DeFi. The decentralized type is a method that allows an unspecified number of people to decide (decide) the management and future direction of the project, and the project operator entrusts it to those who hold governance tokens.

Governance tokens are similar to how stocks work (holding stocks allows you to attend general meetings of shareholders and participate in decision-making), and you It determines how easy it is for you to agree with your opinion.

It can also be distributed to people using the project or purchased on exchanges, and holders can earn profits if the price rises.

On the other hand, governance tokens are not tradable due to the intention of the management side (there is no transfer restriction for private companies), so they are more diversified than stocks and are easy to earn profits. Due to the magnitude of user incentives, there is also the advantage that the project management side can easily raise funds through governance tokens.

However, it has been pointed out that sometimes large holders own most of the governance tokens, and the rights are biased and diversification is not effective.

In addition, projects that issue governance tokens often issue another token that rotates the economic zone of the project.

2. Features of Governance Token

Governance tokens have the following three characteristics.

  • Benefit from project
  • It is easy to be influenced by large investors
  • Issuance limits often apply

I will explain them one by one.

(1) Benefits can be received depending on the project

Depending on the project, holding a governance token may not only benefit from price increases, but may also receive benefits such as a partial refund of transaction fees.

A typical example is “Curve”, one of the DeFi projects, where you can acquire “vcCRV” by locking CRV, a governance token, for a certain period of time, and if you own veCRV, you can receive the following benefits.

  • Participate in DAO decision-making
  • Providing liquidity to Curve will give you up to a 2.5x boost
  • Entitled to receive 50% of transaction fees

Curve is a DeFi project that has a lot of incentives, but the benefits of owning a governance token are great.

Perhaps due to the size of the incentive, Curve is developing into a competition where companies enter to receive Curve’s benefits one after another and compete for CRV.

(2) It is easy for large investors to influence authority

Governance tokens can be used as rights that allow holders to participate in project decision-making, and decentralization is guaranteed because the management side does not participate.

However, in many cases, the strength of authority fluctuates according to the amount of governance tokens held, and companies and institutional investors with financial strength are in an advantageous situation.

There is also a survey that 90% of the decision-making voting rights were concentrated in a specific person, and there is also an aspect that it does not function as a governance token at all.

Reference: Unmanned finance, namely “decentralization” 丨 Nihon Keizai Shimbun

(3) There are many cases where there is an upper limit of issuance

Governance tokens are often projects with an issuance limit.

Since the number of governance tokens to be issued is fixed, the price tends to rise as the demand increases.

In addition, since governance tokens receive benefits, it is possible to suppress the selling pressure of holders, so there is a high possibility that the price will rise more than ordinary tokens.

3. Use case of governance token

Examples of projects that utilize governance tokens include the following.

Project nametoken nameIssue limit
MakerDAOMSEK1,005,577 sheets
UniswapHIM1,000,000,000 sheets
AaveGHOST16,000,000 sheets
CompoundCOMP10,000,000 sheets
CurveCRV3,303,030,299 sheets

In this article, we will explain the use cases of the governance tokens of the representative projects “MakerDAO”, “Uniswap” and “Aave”.

(1)MakerDAO

MakerDAO is a DeFi project that publishes the stablecoin “Dai”.

In addition to Dai, MakerDAO also issues a governance token, MKR, with a limit of 1,005,577 issued.

Holding MKR allows you to participate in decision-making, such as Dai policy-making and roadmap development.

I explained that there are cases where governance token holders are biased and authority is centralized as a result, but MakerDAO has dissolved the issuing foundation to prevent that.

Therefore, it can be said that the project is more distributed than the conventional project.

(2)Uniswap

Uniswap is a DEX project that allows users to trade virtual currencies directly between users.

The governance token “Uni” has a maximum issuance limit of 1,000,000,000 tokens, and is supplied after a four-year lockup period, so token inflation is unlikely to occur.

In addition to purchasing Uni on exchanges, Uni can be obtained as compensation for supplying UniSwap liquidity, and you can gain voting rights such as increasing the pool that can be mined and granting support to other projects.

(3)Aave

Aave is a DeFi project that provides virtual currency lending and flash loan (immediate borrowing and repayment) services.

The governance token “AAVE” has an upper limit of 16,000,000 issuance, and there are incentives to participate in the governance of AAVE and receive a fee discount when depositing AAVE as collateral when lending funds to AAVE.

4. Points to note regarding governance tokens

A point to keep in mind with governance tokens is the lack of decentralization due to the bias of token holders.

Since the original role of governance tokens will be lost, some projects will lose their value.

Also, if the project management side issues governance tokens in Japan, it should be noted that the market capitalization will be taxed even if the governance tokens owned by the company are not cashed. is.

It can be said that the reason why we often see operations moving overseas is that the project cannot be promoted unless a certain amount of funds is accumulated as a governance token.

In addition, it is expected that DAO will increase in the future as a way to use governance tokens, but at present, the legal development has not caught up, so there is a possibility that there will be concerns about this point as well.

5. Although there are points to note, there are high expectations for future utilization methods

Governance tokens are rights tokens that participate in decision-making used in decentralized projects.

Since the holder participates in the operation of the project, it will be a deterrent to avoid opaque management due to centralization. In addition to the right to participate in decision-making and profits from price increases, holders may also receive incentives, among other benefits.

On the other hand, some projects have biased governance token holders and lack decentralization, so it is necessary to scrutinize how internal controls are carried out.

However, governance tokens are already used in many projects such as DEX and DAO that operate based on “decentralization”, and the more similar projects are created, the more governance tokens will be used. prize.

I look forward to future utilization methods and incentives for each project.

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