Governance Tokens: What Are They and How Do They Work?

In the world of DeFi, we can't talk about cryptocurrencies and web3 without mentioning the utility of governance tokens. While most crypto investors focus on non-fungible and blue-chip cryptos, there are a wide range of tokens to consider, including security tokens, utility tokens and platform tokens. 

While Bitcoin perennially remains a hot topic in the crypto scene, governance tokens preserve a critical aspect of decentralization. Not only can governance token holders help shape a protocol's future, but they also bring the community’s members closer. This guide offers a detailed overview of governance tokens and how they work.

Key Takeaways:

• Governance token holders have voting rights to influence a project's direction, proportionate to the number of tokens they hold.

• Token holders can vote to propose changes to a protocol, such as implementing product upgrades, adding new features and modifying the system's parameters.

• Governance tokens play an important role in the DeFi ecosystem, where they’re used to govern the integrity of protocols, yield farming and other decentralized applications.

What Is a Governance Token?

Governance tokens are cryptocurrencies built on blockchain platforms, that grant holders the right to participate in the governance of a protocol.

Token holders have a say in proposing new features to a project and making changes to its governance system, depending upon their voting powers. The voting power of each token holder is proportional to the number of tokens they hold. The more governance tokens they hold, the more influence they have.

Governance tokens are designed to provide holders with ownership in fully decentralized protocols. Anyone who holds a governance token can influence a protocol’s future direction.

Most protocols accommodate a standard proposal submission process that lets developers make various proposals. In the event that a submission is taken to a vote, token holders can use their voting power to influence any potential change to the project. Governance tokens are considered to be a key decision-making mechanism within decentralized autonomous organizations (DAOs).

How Do Governance Tokens Work?

Centralized governance means that the board of directors or shareholders of a corporation has full discretion over decisions about strategic direction. Governance tokens gained popularity within the DeFi system (as opposed to centralized governance) as a way to govern the decentralized ecosystem, and to foster better community involvement, decentralization and decision-making without relying on centralized decision-makers.

Since these tokens exist on blockchains, they’re outfitted with characteristics such as transparent distribution and immutable token ownership, which makes DAOs a perfect laboratory for the decision-making process.

When a governance proposal is taken to a vote, token holders get the opportunity to position their vote on the blockchain. In most cases, the voting power a token holder has is directly proportionate to the total number of tokens that they hold. Therefore, anyone who has 1,000 governance tokens will have double the voting power of a holder with 500 tokens. Nevertheless, each DAO has slightly different governing methods. The types of governance proposals for which token holders can vote typically include:

• Making revisions to developer funds

• Ensuring that best practices are adhered to when developing user interface changes

• Modifying reward distribution

• Voting on fees for network transactions

Governance Structures

The following are the two distinct governance models for decentralized governance.

On-Chain Governance

On-chain governance refers to the decentralized decision-making processes implemented directly on a blockchain. With on-chain governance, rules are essentially hard-coded into the protocol, which means that any decision will immediately be translated into readable codes. Projects such as Tezos plan to use on-chain governance in the future. 

One of the core challenges includes the difficulty for token holders to be participating in decision-making processes, disagreements and conflicts that arise within a community that can result in a governance deadlock. This occurrence may lead to a potential hard fork, or blockchain splits which different governance approaches. 

Off-Chain Governance

Off-chain governance means that decision-making processes occur on a more social level before developers encode them into the protocol. At the moment, Ethereum and Bitcoin primarily use off-chain governance. For instance, Ethereum obtains improvement protocols through GitHub, while developers on Bitcoin display their improvement proposals via the mailing list.

Many users believe that off-chain governance has more checks and balances in place than on-chain governance. Miners are responsible for deciding if proposals will be adopted. However, users can respond by selling their tokens or switching to another protocol.

Governance Tokens vs. Security Tokens vs. Utility Tokens

Governance tokens represent voting rights within DeFi protocols. They distribute the power of decision-making on a blockchain, from a completely centralized structure over to a community — token holders who are also protocol owners. Token holders are typically invested in the project's future because their decisions will influence the outcome of the project. 

Beyond voting rights, governance tokens distinguish themselves from their utility for staking purposes, yield farming and crypto loans. For example, the most popular governance tokens used include Compound Finance (COMP) and Uniswap (UNI).

Security tokens, on the other hand, are designed to comply with securities regulations and offer investors protection and regulatory compliance across different jurisdictions. These tokens are usually backed by real-world assets, such as art, company equity, commodities and more. Security tokens facilitate the entry of investors into high-value assets by allowing them to own a fraction of them through the exchange of compliant security tokens.

A utility token is a digital asset mainly used for payment and for access to a product or service. These tokens boast adaptability and functionality for blockchain protocols or decentralized applications (DApps). For example, Binance Coin (BNB) serves its utility by giving holders the right to vote to list tokens, unlock trading rebates and enjoy priority for exclusive events and services, such as Binance Launchpad.

However, not every token is considered to be a currency. It's common for global supply chains to use these tokens in order to benefit from blockchains and smart contract flexibility.

Below is a brief table describing the differences between the three tokens being discussed.

Are Governance Tokens Valuable?

Governance tokens protect a blockchain’s integrity by giving participants the right to make decisions and govern the platform. The value of these tokens comes primarily from governance rights to make changes to the existing protocol, which eventually benefits holders as the platform takes shape. These tokens are usually traded, swapped, exchanged and staked, which means possessing them can be considered a type of passive income stream.

In general, governance tokens become more valuable as projects get adopted en masse, their value mostly gained from the success of the projects. While they may not be valuable initially, the value of governance tokens tends to appreciate proportionally to a project's growth, and increases further as the number of tokens in circulation reduces once a DeFi protocol initiates token burning.

Benefits of Using Governance Tokens

If you've obtained governance tokens due to your investment in a blockchain project, you'll gain several benefits when using them, from better efficiency to more opportunities for collaboration.

Decentralized Governance Functionality

The main benefit of governance tokens is that they accommodate decentralized governance. Developers who implement decentralization within their web3 projects can use governance tokens to do so. If these tokens weren't in place, DeFi solutions would mainly involve copious amounts of smart contracts.

Opportunities for Collaboration

Once a proposal is made, token holders are free to collaborate after holding discussions among themselves. Anyone who holds tokens can state how they’ll vote, while also obtaining incentives to collaborate with other community members who intend to vote the same way.

Greater Efficiency

Another benefit of governance tokens involves the efficiency that they offer. Having a governance token gives community members a sense of involvement in the project, as they now have a say in it. This then leads to more active participation, since members want to see the project succeed, effectively resulting in more efficient decisions pertaining to the project.

Challenges of Using Governance Tokens

While governance tokens are highly beneficial for web3 and blockchain projects in general, there are a few challenges for crypto companies issuing governance tokens to consider.

Potential for Bad Actors

The most serious challenge involves the potential for malicious actors using their governance power to make decisions that only benefit themselves, as opposed to the overall community. If someone with a large amount of voting power is also a bad actor, the resulting decision for the protocol could be a poor one.

Greater Voting Power for Whales

Whales are investors who make exceedingly large investments, which means that they gain access to a considerable amount of governance tokens. This can pose a problem, due to the sheer magnitude of their voting power — since decentralization is one of the primary purposes of blockchain projects.

Low Accountability

At the moment, governance tokens don't come with much accountability. If a project fails, it's difficult to determine who's responsible for the failure.

Where Are Governance Tokens Used?

YFI Token

The YFI token is the native token for Yearn Finance, which focuses on full decentralization. The developers’ main goal for this governance token is to provide the Yearn Finance community with control over the project. This token also emphasizes the potential for developing a truly self-sufficient DAO.

MKR Token

MKR is the governance token for MakerDAO, considered to be among the most popular lending platforms on web3. Anyone who holds MKR governance tokens can use them to vote on changes to the platform's economic rules.

UNI

UNI is the primary governance token for the Uniswap protocol. Token holders can take part in decision-making processes as they relate to the Uniswap platform. However, Uniswap developers still retain control over how the project will continue in the months and years ahead, which means that this protocol is more centralized than some others.

Ethereum Name Service

Initially designed for the purpose of rewarding early adopters, ENS governance tokens were airdropped by their project, Ethereum Name Service, toward the end of 2020. Subsequently, the price of these tokens has increased significantly. Because of the large increase in their value, early adopters have been rewarded for the initial support they gave.

Compound Finance

Anyone who holds a COMP token can use it to participate in Compound’s decision-making process, or to delegate their voting rights to someone else who can then vote on behalf of the token holder.

The Future of Governance Tokens

Even though it's difficult to predict the future of any aspect of the crypto industry, governance tokens have already proven their worth in the crypto space and will likely be critical to future industry growth. By facilitating DAOs, token holders can help create a lasting community, while also being sure to voice their own opinions. These communities can take many different shapes, from metaverses to investment DAOs.

Because of the importance of governance tokens to decentralization, they will likely continue to grow in relevance depending upon how widely DeFi and DAO models are adopted. By providing the broader community with the ability to manage a project, a DAO allows that community’s decisions to directly influence a project’s success.

The Bottom Line

Anyone holding a governance token can vote on proposals, from changing reward distributions to altering the entire governance structure of a DeFi project or organization. Governance tokens foster active collaboration in ongoing decision-making processes among token holders. Despite their already-proven relevance, the value of these tokens is likely to grow further as adoption spreads.

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