What is a Governance Token?

As cryptocurrency continues to promote decentralization, Governance tokens have become a staple within the industry. Decentralized projects, such as blockchain games, decentralized exchanges (DEXs), or decentralized autonomous organizations (DAOs), are the primary platforms that adopt governance tokens. The tokens give holders the right to vote on important decisions or proposals that can shape the future of these projects. Unlike centralized corporations, decentralized projects often align their objectives with the will of their users by issuing governance tokens. By owning these tokens, users can decide on existing proposals or forward proposals to be decided upon.

Origin of governance tokens

The first cryptocurrency, Bitcoin, only functions as a utility token in facilitating peer-to-peer transactions. However, the development of Ethereum in 2014 marked the beginning of a decentralized era. By holding Ethereum tokens, users become a part of stakeholders who can submit improvement proposals for Ethereum.

The DAO

The DAO was the first attempt at creating a truly decentralized setup. The Ethereum-based DAO launched through an ICO on April 30, 2016, and was meant to be a community-led VC. Unfortunately, some anonymous hackers exploited bugs in the original code. The DAO's exploit resulted in the first fork of the Ethereum blockchain and had a huge impact. The fork was necessary to reduce the impact of the $150 million loss by splitting the tokens into a parallel chain. Ultimately, the attackers' loot was worth just $8.5 million.

Maker DAO

Maker DAO's MKR launched in 2017 is one of the most successful instances of a governance token. MKR holders across the globe can decide on important issues around the popular crypto-backed stablecoin DAI. Consequently, as DAI succeeds, MKR appreciates as more people become interested and join the community. Therefore, voting rights are the most crucial token utility of MKR.

How governance tokens work

Most projects carefully allocate and set parameters for governance tokens as the key decision-making engine. At a fundamental level, owning governance tokens by purchase or distribution entitles users to an equivalent number of votes. Since the project developers often define and update the parameters for voting on-chain, they cannot manipulate decisions.

Like shareholders in corporations, holders of a governance token have a stake and interest in the protocol's success. They often bear the risk of a bad decision which takes its toll on the project. Hence, most participants in decentralized projects often consider their suggestions carefully before submitting a proposal.

Voting on decentralized platforms is done on the blockchain, with a yes or no button available to participants during voting. Some projects require additional criteria for participants to exercise their voting rights. Setting such criteria prevents dumping and manipulation by whales who buy tokens for a spot in the decision-making. Optimism, for example, requires voters to hold a fixed amount of OP during the preceding snapshot to vote on proposals.

The typical issues decided upon through voting depend on the nature of the project. An on-chain stablecoin protocol like MakerDAO, for instance, may vote on de-risking opportunities and stability. A decentralized exchange like Uniswap, on the flip side, might be interested in adjusting fees to increase liquidity. Another common issue projects often vote on is allocating funds to various aspects of the protocol for growth and sustainability.

Types of governance

Governance can either be done on-chain or off-chain. In off-chain governance, the core team translates the majority outcome into codes and upgrades visible to all participants after the complete timeframe or process. Decentralized blockchains using off-chain proposals are usually run by a decentralized team of developers who communicate through social channels. Ethereum is the best example of off-chain proposals, usually labeled EIP or Ethereum Improvement Proposals. Although the Ethereum Foundation specifies that anyone can submit proposals presenting these proposals, they require a fundamental understanding of the project.

Onchain governance is simple as translating users' decisions into code is automatic. The decision parameters are hardcoded on-chain before voting begins. After voting, the majority vote is automatically implemented on the network. Developers of these projects often test preset parameters on a test network before voting.

Differences between governance tokens and other tokens

Governance tokens bestow voting rights on holders. Token holders are careful about project decisions and are often firm believers in the project. Governance tokens are not strictly utility tokens, although most decentralized protocols offer additional benefits to holders of governance tokens. Curve Protocol, for example, rewards users with its governance token, CRV, for their activities and consistency on the platform. SUSHI, UNI, and others also offer staking rewards using similar consistency and commitment criteria.

Pros of governance tokens

Governance token promotes decentralization by helping developers build inclusive versions of centralized corporations on-chain. They also promote diversity of views, progress, and inclusion in DeFi protocols.

The issuance and distribution of governance have established some of the most formidable communities DeFi has ever seen. For example, the number of UNI, CRV, and MKR token holders has risen significantly due to the governance features each platform provides.

Cons of Governance Tokens

There are also a few problems associated with governance tokens. The biggest of all are institutional whales. Wealthy individuals will try to drive the protocol's decision in their favor by acquiring large amounts of tokens. Allowing such influence is counterproductive to the ideals of decentralization, although it is hard to prevent.

The final problem stems from the nature of governance tokens. Unlike shares of a corporation where the board of directors and CEOs are identifiable, some DAOs are managed by anonymous teams. It is difficult to hold anyone accountable when such projects fail.

The future of governance tokens

As the interest of most people across the globe starts shifting towards making the world a better place, huge corporations will evolve into DAOs. The next thing will be about creating a feasible legal framework for DAOs. At the time of writing this article, only the US State of Wyoming has provisions for DAOs as LLCs.

The expansion of virtual realities into the real world will also speed up the demand for governance tokens. These tokens may be used to administer entire cities and countries as the world embraces the idea of the metaverse and the cities within them. Many believe such cities that seamlessly fuse the physical with the virtual world will be the future. Governance tokens will make the administration of corporations and cities easy, encourage political participation, and allow for fair administration.

These future projects might explore better ways to deal with the problems with governance tokens. For example, some DeFi projects have recently been implementing whale prevention functions as a part of their overall code. Such functions will prevent individual and institutional whales from amassing tokens to the detriment of the decentralized ideal. To ensure accountability, most blockchain projects are also developing ways to prove their commitment on-chain. More accurate algorithmic metrics for proof-of-commitment will be available shortly.

FAQs

What is a ¨good¨ governance token?

When genuine developers set up a project and its tokes are issued according to the tokenomics of their whitepaper, the governance token is ¨good¨.

Do governance tokens have value?

Yes, they do, and this depends on the value such as the service or solution offered by the issuing project.

Is Cardano a governance token?

No, because Cardano's proposals are off-chain and managed by academic researchers, not token holders.