Governance Tokens Explained

2 August 2023

9m read

Holders of governance tokens have the option to cast a vote on matters affecting how a blockchain project is developed and run. It is a technique used by projects to delegate decision-making authority to their communities. The project's goals and the interests of token holders are more closely aligned thanks to this decentralized governance approach.


In many traditional businesses, the decision-making process is centralized and controlled by a board of directors or a small group of individuals. The boards of the largest firms typically have ten or fewer members. They have a great deal of influence over how businesses are run. The company's strategy can be determined by the directors, who can also choose which initiatives to invest in and nominate or fire key personnel.
Governance tokens stand for an alternative form of organizational governance. The approach that governance tokens stand for gives a more fair, decentralized, and transparent governance system and is typical for decentralized autonomous organizations (DAOs) and decentralized finance (DeFi). Typically, one token is equivalent to one vote. These coins are intended to unite the communities and ensure that blockchain initiatives may grow successfully.

How do governance tokens function?

The primary tool for achieving decentralized governance in DAO, DeFi, and decentralized application (DApp) initiatives is the use of governance tokens. Active users frequently receive these in appreciation for their dedication and community service. To ensure the projects' strong development, token holders in turn cast votes on important issues. Smart contracts are typically used for voting, and the outcomes are then automatically carried out.
MakerDAO, an Ethereum-based DAO that supports the crypto-collateralized stablecoin DAI, released one of the first governance tokens. Holders of the MKR governance token, which powers the Maker Protocol, make decisions. The proposal with the most votes wins. Each MKR token represents one vote. Holders of tokens can vote on a range of topics, including selecting team members, changing fees, and enacting new regulations. The goal is to make sure that MakerDao's stablecoin is efficient, transparent, and stable.
Compound, a DeFi system that enables users to lend and borrow cryptocurrency, is another illustration. It gives its user base the opportunity to vote on important choices by issuing a governance token called COMP. The distribution of tokens is based on users' on-chain behavior. In other words, you earn more COMP tokens on Compound if you lend and borrow more.
One COMP token represents one vote, just like MakerDAO. Users can also authorize others to cast votes using their tokens on their behalf. Notably, Compound released the admin key for the network in 2020. It means that without the use of any alternative governance mechanisms, the project becomes entirely governed by its token holders.
Aave, the DeFi lending platform, Uniswap and PancakeSwap, the Web3 NFT community ApeCoin DAO, and the virtual world platform Decentraland are among the other significant issuers of governance tokens.
Each project establishes its own rules for how its governance tokens operate. According to various computation models, tokens are distributed among stakeholders, such as the founding team, investors, and users. While some governance tokens only vote on a select group of governance issues, others cast ballots on a wide range of subjects. Different governance tokens have different financial dividend potentials.

The benefits and drawbacks of governance tokens

The advantages of governance tokens are numerous. They can get rid of the conflicting interests that are frequently present in centralized control. The power of administration is distributed to a large group of stakeholders through decentralized governance, which aligns the interests of users and the firm as a whole.
Building engaged, cooperative, and close communities is another benefit of governance tokens. Token owners are all encouraged to vote and advance the project. One token can serve as the basis for fairer and more equitable decision-making because one token often equates to one vote. Each token holder has the ability to submit a proposal for voting. There is less likelihood of fraud because each vote's specifics are visible to everyone.
The 'whales problem' is the largest obstacle to government tokens. Whales are individuals that own a sizable portion of a certain cryptocurrency. The largest holders of a cryptocurrency project's governance token could sway the voting results in their favor if they control a sizeable fraction of the token's overall supply. Projects must ensure that token ownership is equally dispersed and truly decentralized.
However, there is no assurance that the majority judgments are always the best for the projects, even if governance tokens are distributed equitably and widely. Election procedures based on one person, and one vote have a lengthy history and a mixed reputation. In other instances, holders of governance tokens have voted in ways that favor the founding teams and major investors to the detriment of the larger community.

What will happen to governance tokens next?

Governance tokens may become more widely used in additional industries as a result of their invention in the crypto realm. A decentralized internet can be created using governance tokens under the Web3 movement. Other sectors, like gaming, may use this governance model as DeFi and DAOs gain popularity.
Tokens for governance will keep developing in order to address issues as they arise. There might be fresh solutions to the whale issue or different approaches to improving the voting process. Vote delegation techniques could change. While fresh advances are still being made, this area is probably going to get more complicated.
Potential legislative changes are another important aspect that will affect the future of governance tokens. These tokens can be considered securities by some governments. That might make them subject to stringent rules and limit their ability to operate.

Concluding remarks

Governance token development is still in its infancy. Many DeFi and DAO projects have benefited from their help as they have grown rapidly. These tokens are the foundation of decentralization since they have the ability to vote on how the projects are managed.
As long as the tokens are distributed fairly among the community members, the one token, one vote approach puts users and the community at the center. Future growth of governance tokens is possible. Games, Web3 initiatives, and user-owned networks could all use governance tokens to create more dynamic decentralized ecosystems.

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