Governance Token

The primary function is to grant voting power on governance proposals. This can include:

• On-chain voting: Votes are recorded directly on the blockchain (e.g., Compound, Uniswap).
• Off-chain signaling: Informal polls (e.g., Snapshot) used to gauge sentiment before an on-chain vote.
• Proposal submission: Often requires holding a minimum token threshold to create a formal proposal for the community to vote on.

Governance models define how votes are counted:

• Token-weighted (1 token = 1 vote): Simple but can lead to plutocracy, where large holders dominate.
• Delegated voting: Token holders can delegate their voting power to representatives or delegates who vote on their behalf (e.g., MakerDAO, Curve). This allows for expert participation and reduces voter apathy.

Beyond voting, tokens often have economic utility that underpins their value:

• Fee sharing / Revenue distribution: Protocols may distribute a portion of generated fees to token stakers (e.g., SushiSwap, GMX).
• Collateral & Staking: Tokens can be used as collateral in DeFi or staked to secure the network, often earning rewards.
• Treasury control: Governance votes can direct the use of the protocol's treasury, which may hold significant assets.

Token holders vote on critical protocol parameters that affect security, economics, and growth:

• Fee structures: Adjusting swap fees, interest rates, or mint/burn rates.
• Grant funding & partnerships: Allocating treasury funds to development grants or strategic initiatives.
• Smart contract upgrades: Authorizing changes to core protocol logic or migrating to new contract versions.
• Adding new markets/assets: Deciding which collateral types or trading pairs to support.

Mechanisms to protect against malicious proposals and voter apathy:

• Quorum requirements: A minimum percentage of total token supply must vote for a proposal to be valid.
• Timelocks: A mandatory delay between a vote passing and execution, allowing users to exit if they disagree.
• Vote delegation: As a security feature, it consolidates expertise and vigilance against harmful proposals.

Prominent examples illustrate different governance models:

• Uniswap (UNI): Controls treasury, fee switches, and grants via token-weighted voting.
• Maker (MKR): Governs the DAI stablecoin system, voting on collateral types, stability fees, and emergency shutdowns.
• Compound (COMP): Token-holders propose and vote on asset listings and interest rate models.
• Aave (AAVE): Features a Safety Module where staked tokens act as a backstop for shortfall events.

The primary utility of a governance token is to confer voting rights. Token holders can cast votes on proposals that shape the protocol's future, such as:

• Parameter adjustments (e.g., fee changes, interest rates)
• Treasury management and fund allocation
• Protocol upgrades and smart contract changes
• Adding or removing supported assets or features Voting power is typically proportional to the number of tokens held or staked.

Different protocols implement governance through various models:

• Token-weighted Voting: One token equals one vote; used by Compound (COMP) and Uniswap (UNI).
• Delegated Voting: Token holders can delegate their voting power to representatives or "delegates."
• Quadratic Voting: Voting power increases with the square root of tokens committed, aiming to reduce whale dominance.
• Multisig & Council Models: A hybrid where a council elected by token holders has final execution authority over certain decisions.

Governance tokens often incorporate economic mechanisms to align holder incentives with protocol health:

• Fee Sharing: Protocols like SushiSwap (SUSHI) distribute a portion of transaction fees to token stakers.
• Staking for Rewards: Locking tokens (ve-token models) can boost voting power and generate yield.
• Collateral & Utility: Tokens may be used as collateral in lending protocols or to access premium features, creating intrinsic demand beyond governance.

On-chain governance faces several well-documented challenges:

• Voter Apathy: Low participation rates are common, concentrating power.
• Whale Dominance: Large holders can disproportionately influence outcomes.
• Vote Buying & Manipulation: The potential for collusion or short-term financial attacks on proposals.
• Technical Complexity: The burden on token holders to understand highly technical upgrade proposals.
• Legal Uncertainty: Regulatory treatment of governance rights as potential securities.

Governance tokens interact with several core DeFi and DAO concepts:

• Decentralized Autonomous Organization (DAO): The legal or operational structure often governed by these tokens.
• Liquid Staking: Derivatives (e.g., stETH) that separate staking rewards from governance rights.
• Forking: A contentious governance outcome can lead to a protocol fork, creating a new token and chain.
• Proposal Lifecycle: The end-to-end process from idea discussion to on-chain execution.

A critical vulnerability where a small, potentially malicious minority can control decisions due to widespread token holder inactivity. This undermines decentralization and can lead to proposals that benefit a select few.

• Consequence: Low quorum requirements allow minority takeovers.
• Example: A proposal with a 5% quorum can pass with just 2.6% of tokens voting 'yes', disenfranchising the silent majority.
• Mitigation: Protocols implement vote delegation, incentivized voting, and time-locked governance to encourage participation.

The risk that governance is controlled by a small number of large token holders (whales) or early investors, leading to centralized decision-making that may not align with the broader community's interests.

• Mechanism: Voting power is proportional to token holdings.
• Threat: Whales can single-handedly pass or veto proposals, creating a plutocracy.
• Defense: Some protocols use quadratic voting or conviction voting to reduce large holders' disproportionate influence.

Governance tokens often control access to a protocol's treasury. Poorly structured proposals or malicious actors can siphon funds, leading to catastrophic financial loss.

• Attack Vector: A proposal to send treasury assets to a malicious address.
• Famous Case: The Build Finance DAO was drained when an attacker gained voting control and transferred the treasury.
• Safeguards: Multi-sig timelocks, treasury diversification, and requiring high quorums for large withdrawals.

The practice of accumulating voting power temporarily (vote renting) or forming coalitions to pass proposals for private gain, rather than the protocol's health. This exploits the financialization of governance.

• Method: Using DeFi lending markets to borrow large amounts of governance tokens solely for voting.
• Impact: Decisions are made by mercenary capital, not aligned, long-term stakeholders.
• Countermeasures: Snapshot voting with token locking (e.g., using a time-weighted balance) makes vote buying more costly and difficult.

Direct attacks where an attacker gains voting control to maliciously alter a protocol's core smart contract parameters or upgrade logic, potentially freezing funds or changing fees.

• Targets: Interest rates, collateral factors, fee switches, or admin keys.
• Process: Attacker borrows or buys tokens, passes a malicious proposal, and executes it via the governance executor.
• Protection: Timelocks on execution are essential, giving the community time to fork or exit if a malicious proposal passes.

Governance tokens exist in a regulatory gray area. Regulators may classify them as securities, subjecting holders and DAOs to compliance burdens, liability, and enforcement actions.

• Key Question: Does voting power constitute an expectation of profit from others' efforts (the Howey Test)?
• Risk: SEC enforcement against DAOs or token issuers, leading to fines or operational shutdown.
• Strategy: Some protocols adopt legal wrappers or limit token functionality to reduce regulatory surface area.