What are governance tokens?

Governance tokens give holders voting rights to manage the development and operation of blockchain projects. In this way, the project distributes decision-making power to the community. This decentralized governance model helps to align the interests of both token holders and the project.

Many traditional companies are run by a board of directors or a small group of people and can be classified as centralized governance. The average board size of the largest companies is about 10 people. They have enormous power over how the company operates. Directors can nominate or fire key executives, decide which projects to invest in, and set company strategy.

Governance tokens are another way to govern an organization. For Decentralized Autonomous Organizations (DAOs) and Decentralized Finance (DeFi), the model represented by governance tokens provides a fairer, decentralized, and transparent approach to governance. In most cases, one coin equals one vote. These tokens are designed to connect the community and ensure the healthy development of blockchain projects.

How do governance tokens work?

In DAO, DeFi, and Decentralized Application (DApp) projects, governance tokens are the core method to achieve decentralized governance. We generally award them to active users in recognition of their loyalty and contributions to the community. Instead, token holders vote on major issues, ensuring the robust development of the project. Usually, voting takes place through smart contracts, in which case the results are executed automatically.

One of the first governance tokens was issued by MakerDAO, an Ethereum-based DAO that backs the cryptocurrency-collateralized stablecoin DAI. The Maker Protocol is governed by holders of a governance token called MKR. One MKR token equals one vote, and the decision with the most votes will be adopted. Token holders vote on various issues such as appointing team members, adjusting fees and adopting new rules. Its goal is to ensure the stability, transparency and efficiency of the MakerDao stablecoin.

Another example is Compound, a DeFi protocol that allows users to lend and borrow cryptocurrencies. It issues governance tokens called COMP, which allow community users to vote on key decisions. Tokens are distributed proportionally based on users’ on-chain activity. In other words, the more you lend and borrow from Compound, the more COMP tokens you receive.

Similar to MakerDAO, one COMP token equals one vote. Users can also vote on their behalf by delegating their tokens to others. Notably, Compound handed over control of network management keys in 2020. This means that the project is entirely governed by its token holders, without any alternative means of governance.

It is also worth noting that governance tokens include tokens issued by decentralized trading platforms Uniswap and PancakeSwap, DeFi lending platform Aave, Web3 NFT community ApeCoin DAO, and virtual world platform Decentraland.

Each project sets different rules for how its governance token works. Tokens are distributed to stakeholders, including the founding team, investors, and users, according to different computing models. Some governance tokens vote only on a specific set of governance issues, while others vote on most matters. Some governance tokens earn financial dividends, while others do not.

Pros and cons of governance tokens

Governance tokens have some big advantages. They can remove the interest bias common in centralized governance. Decentralized governance, enabled by governance tokens, transfers stewardship to a broad stakeholder community, aligning the interests of users and the organization itself.

Another great advantage of governance tokens is the ability to build active, collaborative, and close-knit communities. Every token holder is incentivized to vote and improve the project. One coin is equal to one vote, so it can provide the basis for fairer and more equitable decision-making. Every token holder can initiate a proposal and vote on it. The details of each vote are publicized, reducing the possibility of cheating.

The biggest challenge for government tokens is the so-called whale problem. Whales refer to users with a large proportion of cryptocurrency holdings. If the biggest whales of a cryptocurrency project hold a significant portion of the overall supply of governance tokens, they may manipulate the voting process to their advantage. Projects need to ensure that token ownership is truly decentralized and evenly distributed.

However, even if governance tokens are distributed fairly and widely, there is no guarantee that most decisions will always be a perfect match for the project. The one-person-one-vote electoral system has a long history with a mixed record. There have been instances where governance token holders voted for the founding team and large investors at the expense of the wider community.

How will governance tokens develop next?

As an innovation in the field of cryptocurrencies, governance tokens can be more widely used in more fields. The Web3 movement is where governance tokens come in, which can help build a decentralized internet. As DeFi and DAOs flourish, other industries such as gaming can adopt this governance model.

Governance tokens will continue to evolve, addressing new issues as they arise. There may be new mechanisms to deal with the whale problem, or other ways to strengthen the voting process. New voting authorization methods may emerge. The field may become more complex, and new innovations will continue to emerge.

Another big factor affecting the future of governance tokens is potential regulatory changes. Some governments may consider these tokens to be securities. This could make it heavily regulated and affect how it operates.

Summarize

Governance tokens are still in the early stages of development. They have contributed to the robust development of many DeFi and DAO projects. These tokens have voting rights that determine project management and are the cornerstone of decentralization.

As long as tokens are distributed relatively evenly among community members, the one-coin-one-vote principle is user- and community-centric. Governance tokens will continue to thrive in the future. User-owned networks, Web3 projects and games can adopt governance tokens to build a more vibrant decentralized ecosystem.