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What Are Governance Tokens?

Staff Writer
Staff Writer
February 16th, 2023
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Governance tokens enable holders to vote on issues regarding the development and operations of a blockchain project. They function as an integral part of a voting mechanism allowing community members to achieve a decentralized model of governance.

Introducing Governance Tokens

Governance token ownership is a method employed to help blockchain-based projects, such as decentralized applications or autonomous organizations, self-govern themselves.

This model of governance aims to distribute the decision-making power fairly to every stakeholder, instead of concentrating on a single individual or a group of individuals. Governance tokens represent an individual’s stake in the project.

These tokens allow for the creation of governance ideas and voting on them. Tokens can be purchased by community members to directly affect a protocol's features and direction. It is possible to vote for various fees, implement UI adjustments, distribution of change fee rewards, update the development fund, and a lot more with governance tokens.

Across blockchain networks, decentralized autonomous organizations (DAOs), decentralized applications (dapp), and decentralized finance spheres (DeFi) frequently use governance tokens to maintain decentralization. To explain what governance tokens are, it's important to establish an understanding of what these entities are and how they diverge from their centralized counterparts.

Centralized vs Decentralized Organizations

Blockchain-based projects adopt the decentralization property of the technology; they embrace a bottom-up management model as opposed to being centrally governed. These projects, such as applications, platforms, or organizations, are user-owned and operated. Governance tokens constitute a representation of ownership over such projects.

Traditional organizations may employ a board of directors who steer the future of the organization. While they listen to shareholders and share liability, they ultimately reach decisions exclusively. Decentralized organizations diverge from centralized organizations in two key points:

Regulation — Decentralized communities are regulated by codified terms and conditions, called smart contracts. These contracts run on open-source code that is immutable and self-executed: they trigger a preprogrammed action when certain requirements are met. They function to make the organization publicly auditable and transparent.

Governance — The authority is distributed across a network of participants, and is typically represented by token ownership. This means that any updates or changes in direction are voted on collectively by the token holders, who also keep the right to come up with proposals.

How Does Voting Work?

So, governance tokens enable the decentralization of decision-making for blockchain projects that employ them. More often than not, voting rights are proportionate to the number of tokens a participant hold. Meaning that one token is typically equal to one vote.

But there are more elaborate ways of valuing governance tokens, some tokens become more powerful if they belong to earlier issues, or some organizations may employ other voting mechanisms like quadruple voting for a more fair distribution of power.

In any case, a participant proposes a change in direction, update, or a case of adjusting the transfer fees open up for a vote. In turn, the participants cast votes depending on the degree of decision-making authority they have. The voting polls are usually embedded in smart contracts. When reached a collective decision, smart contracts automatically execute the outcome.

Governance Tokens in Action

Allocation — The way each project allocates tokens varies depending on the utility function, the nature of the organization, desired outcomes, and so on.

MakerDAO, an organization developing stablecoin DAI, issued one of the earliest forms of governance tokens, MKR. Anyone can purchase MKR and have a say in the operations of the organization.

Differently, a borrowing and lending protocol Compound’s governance token COMP is allocated based on the user activity on the chain: the more a participant engages with the protocol, borrows, or lends, the more tokens they receive. Similarly, Curve, a decentralized exchange, rewards its users’ liquidity commitments with a proportioned amount of governance tokens CRV. In these cases, governance tokens are used to incentivize participants to contribute.

Value — Governance tokens don’t necessarily carry the same monetary value as the cryptocurrency belonging to the blockchain ecosystem they are built on. Instead, the value of governance tokens is typically tied to the project’s performance. If the project is doing well, their tokens will likely become more valuable because now, they are responsible for a valuable protocol.

Besides the performance-based value, some governance tokens also pay dividends, or a certain amount may allow holders to gain shares in the project. In those cases, the token holders are directly earning from the profit a project makes.

Votable parameters — Each organization sets its own rules on how governance tokens work, and the nature of decisions made varies greatly depending on the mission of the project. These may include the implementation of a new UI update, making security changes, adjusting transaction fees, appointing new team members, choosing the next project to fund, finding a cause to support, and so on.

What Do Governance Tokens Bring to the Table?

  • Decentralization of power: First and foremost, governance tokens perfectly fulfill their utility function, which is to enable the distribution of decision-making power to a greater number of people in the organization fairly and transparently. They allow stakeholders to actively decide on the future of the protocol, instead of delegating their power to executives, and by extension, be in control of their interests.

  • Economic incentive: In most cases, governance token ownership means being financially invested in the protocol, as the value of the token increases when the protocol performs well and returns a profit. In some cases, tokens are also used to improve the resources of the protocol, like creating the initial liquidity of an asset swap platform.

What Are the Challenges Governance Tokens are Facing?

  • Unfair distribution: Whales, individuals, or groups holding large amounts of cryptocurrencies, constitute an existential problem to governance tokens and reveal a design flaw in the mechanism. The one token = one vote mechanism poses a risk against decentralization, as individuals or groups with resources to purchase large amounts of governance tokens may practically hold too much power over decisions, and go against the majority’s wishes.

  • Lack of productivity: When there are simply too many decision-makers, this slows down operations significantly. This is specifically applicable to public organizations, where there are an awful lot of token holders and voters, who come from varying backgrounds and may need varying degrees of capabilities. MakerDAO, which recently proposed to be divided into subsections of governance, is a prime example.

Are Governance Tokens the Future?

In a brief period, governance tokens have become an essential part of achieving a decentralized management model, and a mostly-functioning way of protecting and rewarding user interests. Today, there are over 2000 forms of governing tokens, with a collective market capitalization of over $16bn.

That being said, there are uncertainties around governance tokens much like any other blockchain-related invention or project. Their future will depend on factors like regulations that would decide which tokens are legally binding or the maturity of decentralized organizations, and the extent to which key decisions will be made on-chain.

FAQs

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