What Is a Governance Token? How Do Governance Tokens Work?

Blockchain technology has enabled the creation of many innovative and decentralized applications, platforms and services, especially in the field of decentralized finance (DeFi). One of the key features of these projects is the use of governance tokens, which are a type of cryptocurrency that allow token holders to vote on the direction and development of the project. Governance tokens are designed to decentralize decision-making and to give users a stake and a voice in how the project is run. In this article, we will explore what governance tokens are, how they work, what are the differences between governance and utility tokens, what are the advantages and disadvantages of governance tokens, and what are some examples of popular governance tokens.

What Is a Governance Token?

A governance token is a cryptocurrency that gives its holders a right to vote on proposed changes to a blockchain network or a decentralized application (DApp). This innovation is seen as a necessary step toward keeping certain crypto projects, particularly those within the DeFi ecosystem, decentralized. The idea is that rather than a single person or group controlling the direction of a platform, a community of users can influence decisions in a process known as governance.

Governance tokens are usually issued by decentralized autonomous organizations (DAOs), which are entities that operate according to predefined rules encoded in smart contracts. DAOs can be seen as a form of collective intelligence, where members can propose and vote on various aspects of the project, such as fees, features, upgrades, rewards, etc. Governance tokens are used as a means to access the voting portal and to submit or support proposals. The more tokens one holds, the more voting power one has¹.

How Do Governance Tokens Work?

Governance tokens work by enabling token holders to participate in the governance process of a project. Depending on the project, there may be different ways to acquire governance tokens, such as buying them from an exchange, earning them by providing liquidity or staking them in a pool, or receiving them as rewards or incentives for contributing to the project.

Once a user has governance tokens, they can use them to access the voting portal of the project, where they can see the list of active or pending proposals. A proposal is usually a suggestion or an improvement that aims to benefit the project or its community. Anyone who holds governance tokens can create a proposal or vote on an existing one. Some projects may require a minimum amount of tokens or a deposit fee to create or vote on a proposal.

The voting process may vary depending on the project, but it usually involves some parameters such as quorum (the minimum percentage of votes required for a proposal to pass), majority (the minimum percentage of votes in favor of a proposal for it to pass), and duration (the time period during which voting takes place). Some projects may also use different voting mechanisms, such as quadratic voting (where each vote costs more tokens than the previous one), delegated voting (where users can delegate their votes to someone else), or snapshot voting (where votes are counted based on the token balance at a specific point in time).

Once the voting period ends, the results are calculated and executed automatically by the smart contract. If a proposal passes, it is implemented according to the specifications. If it fails, it is rejected and no changes are made. Sometimes, there may be multiple proposals competing for the same issue, in which case the one with the most votes wins.

What Is The Difference Between Governance And Utility Tokens?

Governance tokens and utility tokens are two common types of tokens that are used in blockchain projects. However, they have different purposes and functions.

A utility token is a token that grants access to certain features or services of a project. For example, utility tokens can be used to pay fees, access premium content, redeem rewards, etc. Utility tokens are usually designed to create an internal economy within a project and to incentivize users to use its platform.

A governance token is a token that grants voting rights on certain aspects of a project. For example, governance tokens can be used to propose or decide on changes to the protocol, such as fees, features, upgrades, rewards, etc. Governance tokens are usually designed to decentralize decision-making within a project and to give users a stake and a voice in its development.

Sometimes, a token can serve both purposes and act as both a utility token and a governance token. For example, Uniswap’s UNI token can be used to pay fees on its decentralized exchange platform (utility) and also to vote on proposals related to its protocol (governance).

What Are The Advantages And Disadvantages Of Governance Tokens?

Governance tokens have some great benefits but also some challenges and risks. Here are some of the pros and cons of governance tokens:

Pros

• Decentralization: Governance tokens enable users to have more control over their own funds and data, without relying on intermediaries or centralized authorities. This can increase transparency, security, and trust in the project.
• Incentivization: Governance tokens reward users for participating in the governance process and for contributing to the project’s growth and success. This can create a positive feedback loop, where users are more engaged, loyal, and satisfied with the project.
• Innovation: Governance tokens allow users to propose and implement new ideas and improvements that can benefit the project and its community. This can foster creativity, experimentation, and collaboration among users.

Cons

• Complexity: Governance tokens can be complex and confusing for some users, especially those who are not familiar with blockchain technology or the specific rules of the project. This can create barriers to entry, participation, and adoption.
• Manipulation: Governance tokens can be subject to manipulation and abuse by malicious actors, such as whales (large token holders), hackers, or competitors. This can undermine the fairness, legitimacy, and security of the governance process and the project.
• Conflict: Governance tokens can create conflict and disagreement among users, especially when there are competing or controversial proposals. This can lead to division, polarization, and fragmentation within the community.

Are Governance Tokens Valuable?

Governance tokens can have value for different reasons. Some of the factors that can affect the value of governance tokens are:

• Demand: The demand for governance tokens depends on the popularity, utility, and potential of the project they govern. The more users want to access the features or services of the project or influence its direction and development, the more they will demand its governance tokens.
• Supply: The supply of governance tokens depends on the issuance model and distribution mechanism of the project. The more scarce or limited the governance tokens are, the more valuable they can become.
• Governance Quality: The quality of governance depends on the effectiveness, efficiency, and fairness of the governance process and the outcomes it produces. The better the governance quality is, the more valuable the governance tokens can be.

Examples Of Popular Governance Tokens

There are many examples of governance tokens in the blockchain space, especially in the DeFi sector. Here are some of the most popular ones:

• Uniswap (UNI): Uniswap is a decentralized exchange protocol that allows users to swap any ERC-20 tokens without intermediaries or fees. UNI is its governance token that allows users to vote on proposals related to its protocol, such as fees, liquidity pools, grants, etc.
• Maker (MKR): Maker is a decentralized lending platform that allows users to borrow stablecoins called DAI by locking up collateral in smart contracts. MKR is its governance token that allows users to vote on proposals related to its protocol, such as interest rates, collateral types, risk parameters, etc.
• Compound (COMP): Compound is a decentralized lending platform that allows users to borrow or lend crypto assets and earn interest. COMP is its governance token that allows users to vote on proposals related to its protocol, such as supported assets, interest rates, oracle sources, etc.
• Aave (AAVE): Aave is a decentralized lending platform that allows users to borrow or lend crypto assets with various features such as flash loans, variable or fixed interest rates, collateral swap, etc. AAVE is its governance token that allows users to vote on proposals related to its protocol, such as asset listings, risk parameters, fee distribution, etc.
• Yearn.finance (YFI): Yearn.finance is a decentralized aggregator platform that allows users to optimize their yield farming strategies across various DeFi protocols. YFI is its governance token that allows users to vote on proposals related to its protocol, such as fee structure, vault strategies, integrations, etc.

Bottom Line

Governance tokens are a type of cryptocurrency that give users a stake and a voice in how a blockchain project is run. They enable users to participate in the governance process of a project by proposing or voting on various aspects of its protocol. Governance tokens are a way to decentralize decision-making and to incentivize users to contribute to the project’s growth and success. However, governance tokens also have some challenges and risks, such as complexity, manipulation, and conflict. Governance tokens are valuable depending on factors such as demand, supply, and governance quality. There are many examples of popular governance tokens in the blockchain space, especially in the DeFi sector.

1. Federal Reserve. Decentralized Finance (DeFi): Transformative Potential & Associated Risks ↩︎