What Are Governance Tokens & How Do They Work?
You can't talk about cryptocurrencies and Web 3.0 without also mentioning tokens. While most crypto investors focus on non-fungible and fungible tokens, there are also a wide range of additional tokens to consider, which include security, utility and platform tokens.
Among the most notable of these tokens is the governance token, which is a critical aspect of decentralization. Governance token holders can help shape a protocol's future and gain a certain amount of voting power relative to the amount of tokens they hold. This guide offers a detailed overview of governance tokens and how they work.
What Are Governance Tokens?
Governance tokens are given by developers to token holders for the purpose of making decisions that will dictate a protocol's future. Token holders have a say in decisions about new feature proposals and changes to the project's governance system.
Governance tokens are designed to provide holders with ownership in a fully decentralized protocol. Anyone who holds a governance token can influence the protocol’s future direction. Having a larger number of tokens means more voting power when it comes time to vote on proposals. You can influence decisions on everything from how to spend the project's budget, to what features should be developed in the coming months.
Most protocols accommodate a standard proposal submission process that allows for various proposals to be made by developers. In the event that a submission is taken to a vote, token holders are able to use the voting power they have regarding any potential change to the project. Governance tokens are considered to be a key decision-making mechanism when it comes to decentralized autonomous organizations (DAOs).
How Does a Governance Token Work?
In centralized governance, the board of directors or shareholders of a corporation has full discretion over decisions about the strategic direction for the corporation in question. Unlike centralized governance, A DAO doesn't have centralized decision-makers. However, decisions must still be made about the future of the project, which is where governance tokens come in.
DAOs are able to make decisions via a decentralized governance process that's based on community votes and proposals. One common feature that all DAOs share is the inclusion of a governance token. Since these tokens exist on blockchain, they’re outfitted with characteristics such as transparent distribution and immutable ownership, which makes DAOs a perfect laboratory for the decision-making process.
When a governance proposal is taken to a vote, token holders are given 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. Anyone who has 1,000 governance tokens will have double the voting power of someone with 500 tokens. Keep in mind, however, that each DAO can have slightly different governing methods. The types of proposals for which token holders can vote typically include:
Making revisions to developer funds
Making sure that best practices are adhered to when developing UI changes
Modifying reward distribution
Voting on fees for network transactions
There are two distinct governance models for decentralized governance: On-chain governance and off-chain governance.
On-chain governance occurs when rules are essentially hardcoded into the protocol, which means that any decision will be immediately translated into readable code. Projects like Tezos plan to use on-chain governance in the future. The main issue with this option is that developers may not have enough motivation. To mitigate this issue, developers are able to display their proposals on-chain. If the proposal is approved in an on-chain vote, it will quickly be implemented via the testnet.
Eventually, a final vote takes place before the proposal is placed on the mainnet. Currently, there are some issues with on-chain governance to be ironed out. The primary one is that certain stakeholders may be able to take advantage of the system, since there aren't any undefined norms in place to keep such individuals from gaming the system.
Off-chain governance occurs when decision-making processes occur on a more social level before developers encode them to the protocol. At the moment, Ethereum and Bitcoin mainly use off-chain governance. For instance, Ethereum obtains improvement protocols through GitHub, while developers on Bitcoin display their improvement proposals via a mailing list.
Many people 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 over to another protocol.
Governance Tokens vs. Regular Tokens
Governance tokens are considered to be utility tokens. Utility token holders can use their holdings to obtain access to services/products that the protocol offers, or to exercise the rights they have because of their voting power. “Utility” for governance token holders involves the ability to influence the direction a protocol takes in the future. Current examples of governance tokens include Compound and Uniswap.
Governance tokens are used as the primary utility token for decentralized finance (DeFi) protocols. At the moment, governance tokens are designed to be a representation of voting. They distribute the power of making decisions on the blockchain from a completely centralized structure over to a community. Token holders are also protocol owners. A protocol can attach certain attributes to their governance tokens to provide holders with additional benefits.
While there are several different types of tokens that are part of blockchain platforms, the standard type involves transactional tokens used to exchange services and goods. These tokens work like standard currencies, but are able to provide additional benefits because of their decentralized nature. Decentralized currencies like Dai and Bitcoin allow users to perform transactions without the assistance of a bank or similar central authority.
Keep in mind that not every transactional 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.
Benefits of Using Governance Tokens
If you've obtained governance tokens because of your investment in a blockchain project, there are several benefits that you'll gain when using them, which include everything 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 in their Web 3.0 projects are able to do so with the use of governance tokens. 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 will vote, while also obtaining incentives to collaborate with other community members who intend to vote the same way.
Another benefit of governance tokens involves the efficiency that these tokens offer. Having a governance token allows the community members to have a sense of involvement in the project as they now have a say in it. This would then lead to more active participation as most of them would want to see the project succeed. This effectively results in more efficient decisions pertaining to the project being made.
Challenges of Using Governance Tokens
While governance tokens are highly beneficial for Web 3.0 and many blockchain projects, there are a few challenges that crypto companies issuing governance tokens must take into account when issuing them.
Potential for Bad Actors
The most serious challenge involves the potential for malicious actors using their voting 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 decision for the protocol that results could be a poor one.
High Voting Power Among 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 the primary purpose of blockchain projects is to be decentralized.
At the moment, governance tokens don't have much accountability. If a project fails, it's difficult to determine who's responsible for the failure.
When Are Governance Tokens Used?
While there are numerous projects that use governance tokens, the following section details eight of them.
The YFI token is considered to be the native token for Yearn Finance, which focuses on full decentralization. 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 is the governance token for MakerDAO, considered to be among the most popular lending platforms on Web 3.0. Anyone who holds the MKR governance token can use their tokens to vote on changes to the platform's economic rules.
UNI is the primary governance token for the Uniswap protocol. UNI 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 coming months and years, 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.
The veToken Finance platform uses governance tokens to control its future. DeFi users on this platform can enjoy long-term holding, obtain high rewards, and increase their yields without giving up too much liquidity. In the meantime, a user who holds these governance tokens can vote on any proposal that's made in regard to the veToken Finance platform.
Anyone who holds COMP can use this governance token to participate in Compound’s decision-making process, or to delegate their voting rights to someone else, who can vote on behalf of the token holder.
FLX is the non-pegged “ungovernance token” for the RAI protocol. Its purpose is to provide support for the RAI protocol in the event that it performs poorly. Token holders can also govern many components of this protocol.
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 and will likely be critical to future industry growth. By facilitating DAOs, token holders are able to create a lasting community while also making sure to voice their opinions. These communities can take many different shapes, including everything from metaverses to investment DAOs.
Because of the importance of governance tokens to decentralization, they should continue to grow in relevance, largely 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.
By providing token holders with voting power, governance tokens help blockchain projects to maintain decentralized governance. Anyone holding a governance token can vote on proposals, from changing reward distributions to altering the entire governance structure. Because these tokens exist, active collaboration among token holders becomes possible in the ongoing decision-making process. Despite their already-proven relevance, the value of governance tokens should continue to grow as adoption spreads.