Tokens are one of the integral highlights in the crypto and web3 landscape. As of now, a major share of the discussions around tokens reflects on the classifications of fungible and non-fungible tokens. In addition, you can explore many other types of tokens, such as utility, platform, and security tokens.
Most important of all, governance tokens have become one of the integral highlights of the evolving web3 industry. They have an important function in terms of decentralization of the web, which is one of the basic tenets of web3. This article will help you learn more about governance tokens and their significance, along with some practical uses.
Defining Governance Tokens
Governance tokens represent ownership in a decentralized protocol. They provide token holders with certain rights that influence a protocol’s direction. This could include which new products or features to develop, how to spend a budget, which integrations or partnerships should be pursued, and more.
Generally speaking, exercising this influence can take two forms. First, governance token holders can propose changes through a formal proposal submission process. If certain criteria are met and the proposal goes to a vote, governance token holders can use their tokens to vote on the proposed changes. The specific mechanisms and processes through which these rights are exercised differ across protocols.
In the presence of flat and distributed ownership, as well as the absence of defined leadership like that of traditional hierarchical organizations, governance tokens are an essential decision-making mechanism for decentralized autonomous organizations (DAOs).
How does Governance Tokens work?
Governance tokens act as the foundation to establish decentralized governance in decentralized autonomous organizations (DAOs), DeFi projects and decentralized applications (DApps).
Users who have made significant contributions to the community or have demonstrated loyalty are frequently awarded governance tokens. Tokenholders then vote on key issues to ensure that the projects progress effectively. Generally, people vote by utilizing smart contracts so that the results are tabulated and enacted automatically.
Each project has its own set of governance token rules. They are dispersed to stakeholders, including the founding team, investors and users, using various calculation methods.
Some governance tokens only vote on a limited number of governance issues, while others vote on everything from development updates to smart contract revisions. Similarly, some governance tokens have the option of generating financial returns; others do not.
The Ethereum-based DAO, MakerDAO, was among the first issuers of governance tokens. MakerDAO’s stablecoin is called Dai (DAI), while Maker (MKR) tokenholders govern the protocol itself. One token equates to one vote, and decisions with the most votes are adopted.
Among the types of issues that MKR tokenholders vote on are fees, rules and team member appointments. Ultimately, the goal is to maintain DAI’s stability, transparency and efficiency.
Another example of a protocol with a governance token is Compound, a DeFi protocol that allows users to borrow or lend cryptocurrencies. The protocol has a governance token called Compound (COMP), which tokenholders can use to decide on important protocol-related matters.
The number of COMP tokens users receive is based on their activity levels within the Compound network. That said, users who lend and borrow more often will be rewarded with more COMP tokens. The COMP token is the equivalent of one vote on Compound. The tokens can also be delegated to others to vote on your behalf.
In 2020, Compound gave up control of the network’s admin key and the project is now entirely governed by its tokenholders without any other governance methods.
Governance Tokens vs. Utility Tokens
The fundamental difference between the two tokens is that utility tokens feature no governance power. A great example of a utility token is BNB by Binance. The asset is used for various purposes on Binance, including paying for fees, voting on new token listings, and paying tickets as ‘entrance fees’ for features like the Binance Launchpad.
Binance users can indeed vote on token listings, but beyond that, nothing else can be changed. Binance users cannot use their BNB to decide on other more critical features or to cast their vote and decide to change how Binance looks or works.
Governance tokens are an upgraded version of utility tokens. Because of that, they may as well be the better option. As previously mentioned, governance tokens can also be used for other processes, like smart contract revisions, so there is really no reason why one should prefer utility tokens over governance tokens.
Advantages and Disadvantages of Governance Tokens
While the idea of a governance token may sound almost perfect in theory, in practice, governance tokens have their advantages and disadvantages.
Advantages
- Decentralization. Governance tokens allow developers to keep projects decentralized. Without this type of governance structure in place, DeFi platforms would be only collections of smart contracts that no one could control.
- More effective and inclusive development processes. Developers can arrive at conclusions and implement changes after receiving guidance from the community, instead of needing to figure out everything on their own.
- Community involvement. Governance gives a project’s community a reason to come together to help improve the platform.
Disadvantages
- Potential for a takeover. Individuals or groups with large amounts of capital can sometimes acquire enough governance tokens to make unilateral decisions affecting the network. This can defeat the whole purpose of a governance token, which is to keep decision-making decentralized and democratic.
- Selfish decisions. Just because people have the ability to vote doesn’t mean they will always act in the best interest of their own community. A real-time example: In 2020, Maker experienced a flash crash that caused many of its investors to lose large sums of cash. Initially, the Maker community — represented by current holders of MKR governance tokens — voted to reimburse investors. Six months later, the community rescinded the vote; none of Maker’s investors could reclaim any of the money they lost.
- No real accountability. Ultimately, there’s no legitimate accountability when it comes to democratic crypto governance. If a decision is deemed to be wrong or appears to go against the best interest of many users, there’s no clear person or party to blame or hold accountable.
Final Thoughts
Governance tokens represent the foundation block of all things decentralized. They are the central point of most DeFi projects nowadays, and without them, developers would not have the right to boast how decentralized and better their platform is compared to centralized exchanges.
This powerful tool can dictate the entire blockchain space, which is why more people are investing on it than ever before.
