Governance Tokens: Investing in the Building Blocks of a New Economy

(Originally in the Defiant Blog)

One of the most important building blocks in DeFi is the governance token. When blockchains have on-chain governance, there is no built-in central entity that controls how any given upgrade is managed. Seeing the opportunity, developers all over the world are creating programmatic systems for on-chain governance, and issuing governance tokens, which give holders the right to vote on protocols, products, new features, goals, upgrades and maintenance of a blockchain. There are as many approaches to governance tokens as there are blockchains, but one principle is true — when a blockchain increases in value, the right to govern it also increases in value. And that is important to crypto investors.

Like Equity

So what makes them valuable? Governance tokens are somewhat analogous to equities in that they are claims or rights. With equities, the holder has the rights to a business’s cash flows after all expenses are paid. With governance tokens, the rights are slightly different. The token holder has the right to vote in the governance and management of the blockchain. Token mechanics, which are incentive systems built within the design of a token, induce people to hold the tokens long-term, and that helps increase their value. Voting rights are enforced by cryptography and software, making the token trustworthy and valuable.

Many new crypto investors focus on a crypto asset’s ability to create value. That’s required but not sufficient. A wise crypto investor will also consider a token’s ability to accrue value. Token mechanics, like the ability to lend an asset at a certain interest rate and exercise governance rights, are attributes that support a token accruing value.

The Ethereum-based Compound governance token ($COMP) allows holders help determine interest rates for this lending platform, for example. It’s possible that down the road token holders will vote to award themselves with even more favorable lending or borrowing rates, or decide to direct a percentage of cashflows to token holders.

Tradable

Second, governance tokens are tradable, and can gain or lose value. Sometimes protocols issue free governance tokens when they are just starting out, in order to create new interest, awareness and add liquidity to the protocol. In late 2020, Uniswap “airdropped” their UNI governance token to the public. Anyone who had interacted with the protocol before the drop was entitled to 400 UNI tokens. UNI is trading at $26 as of this writing — those original token holders are now sitting on about $10K in value.

User Incentives

Third, early adopters will benefit from participating in a token’s ecosystem through incentives provided by the token’s design. Early users may get issued more tokens for doing something within the system that creates activity and raises an ecosystem’s liquidity. Or they could be incentivized to help promote a particular crypto project. Using incentives within the tokenomics allows for tokens to accrue more value.

Crypto assets are nascent and their designs are being experimented with all the time. We are talking about start-up companies that will change, and new players will arrive and disrupt everything. Some platforms and projects will flourish, others won’t make it. Investing in governance tokens is investing in the building blocks of the next big economic wave.

When you think about the next big economic wave, where artificial intelligence, the Internet of Things, and robotics converge to create what I call the Age of Autonomy, governance tokens will be key. Governance tokens make it possible for a group to arrive at a consensus on managing the new crypto-networks that will be at the core of the decentralized finance and production structures of the future. Owners will become more active and participative with their capital. Governance systems will get more complex. Groups of people in decentralized autonomous organizations (DAOs) will participate with the projects they choose to invest in and hold tokens in. Governance tokens and the rights they bring are a critical primitive in how decentralized governance will work in the future and why governance tokens will accrue value now.

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CIO at Tradecraft Capital & Author of Crypto Asset Investing in the Age of Autonomy, published by Wiley