Key Takeaways

• Holding governance tokens allows you to vote on important decisions in decentralized autonomous organizations (DAOs).
• DAOs distribute power and influence among their members by using governance tokens instead of having them centralized in a hierarchical structure like traditional organizations.
• Each project with a governance token has a distinctive approach to ownership and governance.
• If you want to exercise your right to vote, you should invest some of your money into the governance token as a prerequisite.

What is a Governance Token?

In many traditional companies, a small group of people or a board of directors holds significant control, a practice known as “centralized governance.” The boards of directors in companies typically consist of around ten people, and they get to make decisions on critical aspects of the company’s operations.

They can nominate or dismiss top executives, select which projects to invest in, and set the company’s strategy.

On the contrary, power in a decentralized system is represented by governance tokens. They provide token owners with special rights that impact a protocol’s future, such as deciding which extra updates or services to create, how to distribute resources, and which collaborations or synergies to pursue.

Typically, in DeFI networks, one token equals one vote. These coins are intended to bring together networks and guarantee the successful growth of blockchain enterprises.

Most protocols offer a standard proposal submission process that allows developers to submit various proposals. If a submission goes to a vote, token holders can use their voting power to influence any potential changes to the project. Governance tokens are an essential decision-making mechanism in decentralized autonomous organizations (DAOs).

It’s crucial to note that governance tokens don’t result in unilateral control. They can only affect specific parameters coded into the project from the beginning. Each project has a distinct definition of ownership and governance and decides which parameters are open to change and how changes are approved.

How do Governance Tokens Work?

There are no centralized decision-makers in a DAO, as there are in centralized governance. However, decisions still need to be made about the project’s future, and governance tokens play a crucial role in this process. Typically, users must invest in the project and, in return for their loyalty, receive a say in how it develops. Holding governance tokens is similar to owning shares in a company.

Smart contracts are used to provide on-chain voting for suggested modifications. These adjustments are made immediately when the group or outside parties agree on how the developers will improve the protocol. The number of governance tokens an individual owns often equates to their voting power.

Voting power can, nevertheless, be influenced by other elements, such as the time the token is kept. Time-weighted voting is the term used for this. Governance tokens may be used for staking, lending money, yield farming, and other passive income-generating activities in addition to voting.

Users may also use them to implement UI modifications, vote on different network transaction prices, redistribute transaction fees as rewards, and finance development improvements.

How to Obtain a Governance Token

A vital component of the DeFi ecosystem is the method projects use to distribute their native tokens. In this system, tokens are earned through active involvement in the project. There are a few ways for investors to obtain a platform’s governance token. These include:

• Purchasing the governance token directly on a crypto exchange.
• Earning a governance token through one of the following three methods:
  • Staking another currency on the platform.
  • Adding funds to the liquidity pool.
  • Participating in incentive programs that reward users.

Governance Structure

In the network, there are two known structures of decentralized governance. These structures are known as “on-chain governance” and “off-chain governance” structures.

On-Chain Governance

In the on-chain governance model, decisions are made using programmable interfaces on the blockchain, with voting processed through validator nodes. However, a potential issue with this approach is that developers may need more motivation to participate.

To address this problem, developers can submit their proposals on-chain. If the proposal passes an on-chain vote, it will be quickly implemented on the testnet. Finally, a final vote is held before implementing the proposal on the mainnet. Another challenge with on-chain governance is the possibility of specific stakeholders exploiting the system, as no established norms prevent such abuses.

Off-Chain Governance

Off-chain governance is a system in which existing regulatory and compliance mechanisms are used outside of a blockchain, and their outcomes are incorporated into the blockchain. This could include manual compliance actions or decisions made through traditional governance structures.

While off-chain governance can have more checks and balances in place, it can also create challenges for scaling and coordinating votes. Miners are usually responsible for deciding whether to adopt proposals. Still, users can respond by selling their tokens or moving to a different protocol.

What is the Difference Between Governance and Utility Tokens?

In simple terms, utility tokens are digital assets that serve a specific purpose. Typically, their use is restricted to a particular blockchain network or crypto platform. You can use them to pay transaction fees, vote on new tokens, or access certain features.

However, unlike governance tokens, they don’t hold any decision-making power. On the other hand, governance tokens offer more functionality than utility tokens, including the ability to stake and create loans. Given the additional features, preferring governance tokens over utility tokens makes sense.

Are Governance Tokens Valuable?

Governance tokens are important because they allow for a fair distribution of power. One key benefit is that governance tokens give a voice to all participants in decentralized finance ecosystems. They have value and can be traded, exchanged, staked, and more, providing an excellent opportunity for passive income.

Stakeholders with governance tokens may receive additional perks, such as greater access to services or a share of the protocol’s profits, much like having a stake in a revenue stream. The fate of a project is determined by its community through governance tokens, which come with power and responsibility.

How a project is governed directly affects its success. Even if the tokens initially hold little value, early adopters often anticipate an increase in value as the project grows. Another way tokens can increase in value is if the protocol decides to repurchase them, reducing the token supply and increasing their price on the market.

Examples of Who Uses Governance Tokens

Governance tokens are important in the DeFi ecosystem, which relies on community governance to maintain decentralization. Ethereum is a famous blockchain used by many DeFi protocols. Here are a few examples of well-known governance tokens:

Compound

Compound (COMP) is a digital asset that operates as an ERC-20 utility token on the Ethereum blockchain. It is used on a decentralized finance (DeFi) platform that allows users to lend and borrow cryptocurrencies.

The unique feature of this token is that it enables its holders to participate in the governance of the Compound Protocol through the Compound Governance Dashboard. This means that they have the power to vote on proposals and changes that will impact the network.

UNI

UNI is the primary governance token of Uniswap, a decentralized exchange running on the Ethereum blockchain. UNI token holders have the right to participate in decision-making processes related to the Uniswap platform. However, developers still have some control over the project’s future, making Uniswap less decentralized than other protocols.

veToken Finance

VeToken Finance relies on governance tokens to determine its future course. Users of this DeFi platform can earn high rewards and increase their yields while holding their tokens long-term without sacrificing too much liquidity. Meanwhile, those who possess these governance tokens have the power to vote on any proposal related to the future of the VeToken Finance platform.

Tectonic (TONIC)

Tectonic is a DeFi platform that facilitates lending and borrowing activities for its users. Initially, the decision-making process is centralized, but Tectonic aims to transfer the governance process to the community and stakeholders eventually. Token holders can vote on key parameters, including interest rates, collateralization ratios, and token allocation. This will allow the platform’s users to have a say in the platform’s development and future direction.

Advantages and Disadvantages of Governance Tokens

The comprehensive explanation of governance tokens illustrates their essential role in achieving decentralization. Let’s look at the pros and cons of governance tokens that you should consider.

Advantages of Governance Tokens

Governance tokens offer critical benefits to the decentralized finance (DeFi) ecosystem. One of their most significant advantages is that they allow for power transfer from centralized authorities to users. This ensures that decisions are made with the community’s input, which creates opportunities for new insights and more engagement.

With a governance structure in place, changes are proposed by the community as a whole rather than just developers, leading to faster development. Additionally, governance tokens are essential for maintaining the decentralization of DeFi projects. Without them, DeFi platforms would be nothing more than collections of smart contracts controlled by a central authority.

Disadvantages of Governance Tokens

While governance tokens have their advantages, there are also some disadvantages. For instance, with governance tokens, the human ego can get in the way of making moral decisions, and there is no one to hold responsible for any negative outcomes. Additionally, there is a potential for a takeover by individuals or groups with large amounts of capital, which can defeat the purpose of decentralized decision-making.

Further complicating governance tokens might make it challenging for certain consumers to comprehend how they function. For instance, certain protocols may contain a variety of token types with various functionalities, which may discourage users from taking part in governance.

What’s Next for Governance Tokens?

Governance tokens, originally a product of the crypto world, have the potential to expand into other areas. The Web3 movement is one area where governance tokens can contribute to building a decentralized internet. As decentralized finance (DeFi) and decentralized autonomous organizations (DAOs) continue to gain traction, other sectors like gaming could also adopt this governance model.

Final Thoughts on What is a Governance Token

Governance tokens have played a significant role in the growth of many DeFi and DAO projects, putting power in the hands of users and promoting decentralization. These tokens will get more complicated as the crypto industry develops and their owners become increasingly connected to the community.

Governance protocols will make it possible for groups to jointly operate the brand-new crypto platforms at the center of the future’s decentralized finance and industrial systems. While the future of governance tokens is uncertain and dependent on crucial factors such as regulations, adoption of DAO operating models, and technological innovation, they will undoubtedly remain a mainstay in the proliferation and adoption of decentralized networks.

The potential for governance tokens to be used in other sectors, such as gaming and the Web3, further demonstrates their potential to transform how we interact with the internet and other systems.