Governance Token

The primary utility of a governance token is to confer voting rights. Holders can propose, discuss, and vote on changes to the protocol, such as:

• Parameter adjustments (e.g., fee changes, collateral ratios)
• Treasury management and fund allocation
• Protocol upgrades and smart contract modifications
• Adding or removing listed assets Voting power is typically proportional to the number of tokens held or staked, with mechanisms like vote delegation allowing users to assign their voting power to experts.

Governance tokens create economic alignment between users and the protocol's long-term success. They often incorporate value-accrual mechanisms to incentivize participation and stewardship:

• Fee sharing or buybacks: A portion of protocol revenue is used to buy and distribute tokens to stakers or voters.
• Staking rewards: Users lock tokens to earn rewards, securing the governance process.
• Access to premium features: Token ownership may grant exclusive access to services or higher yield opportunities. This design aims to ensure that decision-makers are financially invested in the protocol's health.

Different protocols implement governance through standardized frameworks. Key models include:

• Token-weighted voting: One token equals one vote. Used by Compound (COMP) and Uniswap (UNI).
• Quadratic voting: Voting power increases with the square root of tokens held, reducing whale dominance.
• Conviction voting: Voting power accumulates over time a voter supports a proposal.
• Multisig & Council models: A hybrid where a council of token-elected delegates executes decisions. Frameworks like Compound's Governor and OpenZeppelin's Governance provide modular smart contract bases for these systems.

Prominent DeFi protocols use governance tokens to decentralize control:

• Uniswap (UNI): Governs the largest decentralized exchange, controlling fee switches, treasury, and grants.
• Aave (AAVE): Token holders vote on risk parameters, asset listings, and protocol upgrades for the lending market.
• Maker (MKR): The original DeFi governance token; MKR holders manage the DAI stablecoin system, including collateral types and stability fees.
• Curve (CRV): Employs a vote-locking model (veCRV) where locked tokens grant amplified voting power over liquidity gauge rewards, directly influencing capital allocation.

On-chain governance faces several technical and social challenges:

• Voter apathy: Low participation rates can lead to centralization of power among a few large holders or delegates.
• Whale dominance: Concentrated token ownership can subvert the democratic ideal.
• Proposal complexity: Highly technical decisions can be difficult for average token holders to evaluate, leading to reliance on signaling.
• Security risks: Malicious proposals or governance attacks can exploit smart contract vulnerabilities to drain treasuries.
• Legal uncertainty: Regulatory treatment of governance tokens as potential securities remains unclear in many jurisdictions.

The evolution of governance tokens is tightly linked to Decentralized Autonomous Organizations (DAOs). Trends include:

• Professional delegation: Platforms like Tally and Boardroom facilitate delegation to knowledgeable delegates, creating a representative system.
• SubDAOs: Large protocols delegate specific functions (e.g., grants, risk assessment) to smaller, specialized DAOs.
• Cross-chain governance: Solutions like LayerZero and Axelar enable governance over multi-chain protocol deployments.
• Non-financial governance: Expanding use cases to govern intellectual property, social media algorithms, and real-world assets.

A critical risk where a small minority of token holders control governance outcomes due to widespread voter apathy. This can lead to decisions that don't reflect the broader community's interests or allow a well-coordinated minority to pass proposals.

• Low turnout makes governance susceptible to capture.
• Vote delegation to representatives (e.g., "delegates") centralizes power.
• Example: Many DAOs see <5% of circulating tokens used in typical votes.

Governance tokens control access to the protocol's treasury, creating a massive attack surface for financial mismanagement or theft.

• Malicious proposals can attempt to drain funds via disguised transactions.
• Economic attacks involve accumulating tokens to pass self-serving spending proposals.
• Risk is amplified by treasury size; larger treasuries are bigger targets.

The risk that governance is controlled by a few large holders ("whales") or early investors, leading to centralized control disguised as decentralization.

• Voting power is proportional to token holdings, not one-person-one-vote.
• Sybil resistance mechanisms can disadvantage smaller, dispersed holders.
• Can result in plutocracy, where the wealthy dictate all protocol changes.

The risk associated with the technical execution of governance-mandated changes, including smart contract bugs, upgrade complexities, and implementation failures.

• Smart contract risk: New code approved by vote may contain critical vulnerabilities.
• Timelocks are a security best practice to allow review before execution.
• Upgrade mechanisms (e.g., proxy patterns) themselves can be attack vectors.

The risk that entities bribe or collude to influence governance outcomes, undermining the integrity of the decentralized process.

• Explicit vote buying: Trading voting power for immediate payment.
• Dark DAOs: Off-chain coordination and bribery via smart contracts.
• Economic incentives for delegates can lead to conflicts of interest.

Specific technical and economic strategies used to attack a governance system.

• 51% Attack: Controlling a majority of voting power to pass any proposal.
• Temporary Governance Attacks: Borrowing or renting voting power (e.g., via flash loans) to pass a malicious proposal within a single block.
• Proposal Spam: Flooding the system with proposals to cause fatigue or hide a malicious one.
• Parameter Manipulation: Changing critical security parameters (like fees or slashing conditions) to weaken the system.

Delegated voting is a mechanism where a token holder assigns their voting power to a representative, or delegate, who votes on proposals on their behalf. This system is designed to improve governance efficiency and expertise.

• Vote delegation allows less active participants to contribute to governance without constant engagement.
• Delegates often publish their voting intentions and rationale, creating a layer of political discourse.
• Implementation: Used by protocols like Compound and Uniswap, where users can delegate their voting power to any Ethereum address.

These are the formal processes for submitting and deciding on changes within a protocol. A governance proposal is a formal suggestion for an action, such as adjusting a fee or upgrading a contract.

• Proposal Threshold: The minimum number of tokens required to submit a proposal for a vote.
• Voting Period: The fixed timeframe during which token holders can cast their votes.
• Quorum: The minimum percentage of the total voting power that must participate for a vote to be valid.
• Voting Strategies: Can include simple for/against votes, weighted voting, or quadratic voting to reduce whale dominance.

Vote-escrow models, popularized by Curve Finance, tie voting power to the length of time a user locks their tokens. This creates a long-term alignment between voters and the protocol's success.

• veTokens: Users lock their base governance tokens (e.g., CRV) to receive non-transferable veTokens (e.g., veCRV).
• Time-weighted voting: Power increases with the duration of the lock, incentivizing long-term commitment.
• Additional Rewards: Lockers often receive a share of protocol fees and boosted rewards for providing liquidity.

While often overlapping, these are distinct token classifications. A utility token provides access to a protocol's core functionality (e.g., paying for gas, accessing services). A governance token specifically confers voting rights.

• Hybrid Models: Many tokens, like UNI or AAVE, serve both utility and governance functions.
• Pure Governance: Some tokens, like early Maker (MKR), were created primarily for governance, though they may accrue value through other means.
• Legal Distinction: The classification can have significant regulatory implications regarding securities laws.

A protocol treasury is a pool of assets (often native tokens and stablecoins) controlled by the DAO and used to fund development, grants, incentives, and other operations. Governance token holders decide on treasury allocations.

• Funding Sources: Treasuries are typically funded by protocol fee revenue, token sales, or a portion of token inflation.
• Governance Control: Major expenditures, like a multi-million dollar grant program, require a governance vote.
• Examples: The Uniswap Grants Program and Compound's Grants Initiative are funded directly from their respective DAO treasuries.