Governance Tokens and Yield Farming in DeFi
Updated: Feb 17
Decentralized finance can be simply be construed as applications in cryptocurrency or blockchain aiming to weed out financial intermediaries with smart contracts governing the mediation.
With the recent attention that bitcoin and all other cryptocurrencies are garnering from the interests and investments from financial institutes, its but only a matter of time that digital assets are part of the offering from traditional financial and banking systems.
Various traditional financial products, like lending, borrowing, and derivatives trading, have been replicated and automated using smart contracts in the Crypto sphere. Although the
blockchain has largely been preferred much like the heydeys of the ICO craze because it provides the interoperability required for various moving parts to interact with one another but other
have also garnered attention.
The major concern is related to the governance criteria of these new smart contract-based protocols that give rise to the concept of governance tokens, generated via Yield Farming approaches. Although most of these Defi projects and governance tokens have drastically lost its value from its peak, but there is an obvious lesson to be learned for the upcoming DeFi2.0 projects like
Yield Farming — What is the Concept?
The entire concept was brought to the focus with the #COMP governance token, primarily. Compound distributed governance token on June 15 which garnered unusual attention and spread like wildfire. The whole concept seemed to be effective and lucrative for the crypto enthusiasts, spreading to other Dapps, quickly fuelling the hype.
Liquidity mining or yield farming can be explained where users provide liquidity by stalking cryptocurrency in a DeFi platform and in return receive rewards for it. The primary focus is generating governance tokens for everyone who participates by providing liquidity and which further allows them to participate in the governance of the DeFi project.
Liquidity providers make fund deposits in a liquidity pool, and this reserve caters marketplace where users can take out or offer loans and exchange tokens for Stable Coins for trading, scalping, etc.
Using these platforms involves a certain commission amount paid to the providers of liquidity in accordance with the share they hold in the liquidity pool. Thereby, earning interests or gaining returns for all the stakeholders.
Apart from the fees, token distribution also adds funds to the liquidity pool. It is the governance token that grants permission to holders for participating in the protocol decisions.
The basic aim of a DeFi application is to generate higher liquidity in the pool. Generally, the invested money should transform into a good investment, as security is offered by the smart-contracts and rewards generated in forms of governance tokens increase in value. However, the yield farming activity intensity distorts the associated crypto asset values, which artificially inflates the demand over a short period of time. As of now, it remains a fragile ecosystem, which involves high risk, high gain for potential investors. From unaudited smart-contracts that can be easily hacked to gullible investors falling prey to scams (as most DeFi project owners remain anonymous). As if things couldn’t get murkier, the asset value is volatile as new protocols appear every time to compete with the promising rewards mechanism.
Nevertheless, yield farming showed a promising future for the decentralized finance ecosystem, drawing new players and financial capital to the field and expanding interests in the industry. As the popularity of decentralized finance is growing, more financial servicing companies are getting involved in the Crypto space bringing fresh ideas and fresh capital.
Yield farming differentiator — Governance Tokens
Decentralized finance is not yet completely decentralized and most of the major projects and platforms are beginning with core teams for controlling the initial phase of development. With the quick action of governance tokens, this is changing progressively as a means of decentralization of the project.
Governance tokens are considered as one of the most essential parts of DeFi apps. This enables projects to get a higher decentralization level. Most of the governance tokens function like votes of shareholders, which enable investors to influence the operational decisions and development roadmap of projects.
Synergy has been found recently in yield farming and governance tokens through the liquidity mining approach. Governance tokens are distributed to the early users, offering liquidity to a specific platform. Hence, liquidity farming is a fair distribution method of the tokens to the users of the platform.
Although governance tokens have a range of benefits that make them popular, still, they have their own set of challenges. The major problem related to governance tokens is the concentration in the limited hands of early investors.
One of the recent reports highlighted that several projects, especially the ones with robust venture capital routes are highly centralized. In projects like Compound and MakerDao, the voting process is controlled by large shareholders primarily because the top 20 addresses have 24% MKR holdings, and 68% COMP holdings of the entire supply.
It’s essential to understand the token ownerships and the management process. For instance, having locked value in smart contracts and multisig wallets on core holdings assist founders’ willingness to work on projects for a longer time period.
The spectacular failure of the governance voting for the decentralized exchange Uniswap Protocol is an eye-opener. The entire voting process occurred around a proposal looking forward to reducing the token numbers required to pass and submit proposals. It ended with rejection, despite the lucrative proposal receiving huge support from nearly 98% of the votes cast. It remained short by 400,000 (approximately 1% shortage out of the 40 million vote threshold required for approval) by the closure of voting. Upon approval, the entire community could have been easily governed by major investors, reducing decentralization effectiveness significantly. The final tally stood at 39,596,759 for, and 696,857 against; which clearly showed the fallacy of a token driven governance model.
On the other hand, lies the success story for DAI. When the holders of Ether deposit their Ethereum in accordance with the protocol of the
, Dai is developed. It allows you to create stable coins using Ether as collateral. DAI can be used as the ERC-20 token on the network of Ethereum for generating yield via DeFi protocols.
By learning from these cases,
aims to incorporate all the benefits of having a DeFi project without its baggage. The project itself is backed from the perspective of giving more rights of governance to the token holders giving equivalent weightage to the liquidity provided rather than investing early as most projects. By having a transparent and audited mechanism the project aims for having a high degree of accountability. The final phase might develop at its own pace but the stakeholders are working hard to launch Phase I soon.