There is an entire class of tokens in the cryptocurrency realm called “Governance Tokens”. These are tokens that have two kinds of functions.
The token is a store of value
The token is voting power for making decisions within the network
Along my investing journey, I’ve bought, held, and sold several governance tokens. One of the questions I am always encouraged to ask myself is whether or not blockchain based governance actually works. If it does, then there might be something to these tokens. If it doesn’t then it might just be that the billions of dollars that governance tokens have amassed might be hollow and speculative value. I have a couple of stories to tell about governance tokens, and the conclusions I’ve drawn from owning them.
I was originally drawn in by governance tokens because of the allure that I was participating in something greater. That my participation was essential to the proper functioning of the network. And that the cost of acquiring these governance tokens, would pay for itself through the incentive and reward structures. I’m going to share with you the difference between these tokens, in hopes that you can avoid investing in worthless governance tokens.
Governance is a Tricky Problem
Governance in general is a tricky problem. How do people with potentially misaligned interests come together and make an agreement on something? In other words, how is consensus achieved in a group where people don’t necessarily agree with one other? In a democracy, governance is decentralized as each individual is given one vote. In a dictatorship, governance is centralized as whatever the ruler says, goes.
Governance has always been an important factor when it comes to blockchains. For example, Bitcoin invented its own form of governance called proof of work. Every member of the network gets the chance to make the next decision (block) through a process that is unfalsifiable, and easily verifiable. Therefore proof of work is largely considered to be fair, and secure.
However, a common critique of Bitcoin is that it “wastes” so much energy in the process of attaining this security. Proof of Stake was created at least in part, to address the growing energy expenditure required to run the Bitcoin network. Putting the energy debate aside for now, let’s talk about how blockchain based governance has evolved.
Proof of Stake (PoS)
The idea of proof of stake is that the tokens double as voting power. This allows an entire network to be run on desktop computers, instead of huge mining farms like in the case of Bitcoin. The tokens typically need to be “staked” to the network, which simply means that they’re locked for a predetermined amount of time. Within most proof of stake tokens, you are locking them up in exchange for some predetermined annual return on your investment.
Delegated Proof of Stake (DPoS)
The only difference between PoS and DPoS is that within DPoS, you may retain ownership over your tokens, but give (delegate) the voting power to someone else.
Incentives and Rewards
Within any financial system, you are likely to find incentives, and rewards. A good network has a balance of incentives and rewards where no entity or group of actors can come together to exploit the rewards. As far as I am concerned, the jury is still out as to whether or not Proof of Stake can meaningfully protect against a coordinated attack by a group of wealthy actors. You see, within a system where the tokens double as voting power, the ability to manipulate the governance of that system is one that is able to be gained through monetary means alone. All I need to do is obtain enough of the token to hold a majority share in the network.
My Journey with Governance Tokens
I want to talk more about incentives and rewards because I think the topic is at the heart of whether or not blockchain based governance works. As I said before, it is crucial to strike the right balance between incentives and rewards within a blockchain network.
Peerplays (PPY)
I used to work on a blockchain project called Peerplays. This was my first hand introduction into governance tokens. The core token of the Peerplays network was called PPY, and it doubled as voting power as the network ran on DPoS consensus. It was through this token that I learned that unless there is a potent incentive to vote (or disincentive not to vote), people don’t typically participate in governance.
I, along with every other token holder received nothing for delegating my tokens because there was no reward associated with it. As a result, the token lost 99% of its price, and became worth next to nothing. This is a bad position for a DPoS based chain to be in, because at this point it becomes cheap to attack the network.
Kyber Network (KNC)
I got ahold of KNC tokens during one of the Crypto.com syndicate events. This was in the middle of the DeFi craze and I wanted in! I decided to see what DeFi was all about through Kyber. The tokens doubled as voting power, and by voting, I was entitled to rewards. Kyber is a decentralized exchange that collects fees. These fees are proportionately distributed to the accounts holding KNC that vote on network proposals. Sounds great in theory right? All I had to do to get my rewards was vote by clicking a button every 2 weeks.
The issue with this is in practice. At the time, (and this is still happening), Ethereum gas prices were quite high. The cost of voting was $20, and the cost of claiming the reward was $15. The amount of rewards I would receive from voting was about $.39 worth of Ethereum during that one 2 week period. The balance of incentives and rewards were entirely off. In fact, I had a massive disincentive to vote on the network proposals because it was going to cost me more than what I would profit.
Cardano (ADA)
Modern governance tokens such as ADA are much more sophisticated than the tokens that have come before it. This is largely because we’re all learning how to build better systems as cryptocurrencies evolve. It is crucial that we figure out governance, and I believe ADA to have one of the best working models of PoS out of any other project. Whether or not it will actually work in the future is another issue, but for now, we can learn.
Governance Incentives
Simply by staking my ADA to Cardano, I gain about 15% APR on my ADA. I may earn additional rewards through voting on proposals. About once per month, there is a vote that takes place that determines where ADA will be spent in the future. These votes decide the future of Cardano through deciding where to allocate capital. If this sounds familiar, this is basically what a government does. Rewards vary, but I can definitely pick up a couple more ADA than I would otherwise have simply by giving my input on what I think should be worked on. Unlike Kyber, this vote costs me nothing to cast. This is closer to the right balance of incentives and rewards.
Critical Market Cap
I mentioned earlier with Peerplays that if a governance token becomes worth too little, then this is a vector of attack for anyone wishing to disrupt the network. It is therefore important that governance tokens achieve some reasonably high market capitalization, in order to prevent a wealthy malicious actor from disrupting the governance by buying up lots of tokens. One way to increase the price of the token is to increase rewards for staking the token.
Staking Rewards
Cardano has more than 70% of the total number of tokens staked (locked) on the network. That means that they cannot immediately be sold on the open market. The reward for staking is a sweet 15%, which is high enough to keep people staking for more, and low enough to be sustainable for years to come.
Slashing Bad Actors
In the event that bad actors do try to attack the Cardano network, there are mechanisms in place to detect this malicious activity, and penalize them. So not only is there incentive to follow the rules, there is disincentive for breaking them.
How Does This Impact You?
You will no doubt run into governance tokens at some point throughout your crypto journey. For instance, ETH is in the process of becoming a governance token.
First, it is important to understand how these governance tokens work, and why they work the way they do.
Second, it is important to understand WHERE the supply of the token has been allocated, because the tokens ARE the governance. If the supply is centralized, then so is the governance. This factor can really make or break the protocol, and your investment.
Third, you need to know what incentive/reward structures to look for, and how to evaluate whether or not the cost of the token justifies the incentives and rewards.
Finally, blockchain based governance will leak into our political and corporate governance systems. It is best that you learn the ins and outs of how token governance works NOW, so that you can have a leg up on everyone else when they start adopting blockchain based governance!
Regards,
Keegan
P.S. Charles Hoskinson, the founder of IOHK and Cardano was recently on the Lex Fridman podcast. I haven’t listened to it yet because its 5 hours long … but it’ll be worth listening to in order to gain an in depth understanding of Cardano NOW and where it is going in the future. Expect an update from me on this podcast!
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