What are governance tokens?

Not every cryptocurrency token is created equally. While it’s true that they are all digital currencies of some kind, there are various uses for different cryptocurrencies, depending on the type of token. For instance, governance tokens, which are used by thousands of projects today, are hugely important in determining how those projects operate now and in the future.

So, how do governance tokens work, why do they exist, and why are they important to the cryptocurrency industry — particularly when it comes to decentralized finance (DeFi) projects and decentralized autonomous organizations (DAO)? Find out in this AAG Academy guide.

One of the best and most appealing things about the cryptocurrency industry is that the majority of it is completely decentralized. In a nutshell, that means that there is no central entity in control. This prevents a single person or company, or a small group of them, from making decisions that are not in the best interests of the wider community.

Decentralized projects don’t have a board of directors or a CEO. However, in most cases, some control and decision-making is required. Without it, a project would not be able to move forward and would eventually go stale. That’s why we have governance tokens, which allow the community itself to decide how a project operates.

How do governance tokens work?

Governance tokens can be bought and sold, just like other cryptocurrency tokens, and they are sometimes issued as a reward to a project’s biggest and most loyal supporters. What makes them different from other tokens is that, rather than being used to pay for goods or services, governance tokens allow their holders to have a say in decision-making.

If you own governance tokens, you get to vote on major issues and determine the direction of the project going forward. In some cases, the more tokens you hold, the more significant your vote is. However, many projects impose limits on this to ensure that a small number of people do not end up with too much power, which would bring a project too close to centralization.

One of the very first governance tokens was issued by MakerDAO, which is behind the DAI stablecoin. It allows MakerDAO to be governed by holders of MKR, and one MKR token equals one vote. Voting is used to decide all kinds of issues, such as who should be appointed to the team, what rules should be implemented, and how much fees should be.

It should be noted that not all projects that use governance tokens are completely controlled by the community. In many cases, there are still teams behind those projects — and they still decide what kinds of things are eligible for change and should be voted on — but they tend to leave key decisions to supporters as much as possible.

What types of governance tokens are there?

All governance tokens are the same in that they are a cryptocurrency that allows a project to distribute power, however, the way they are used can be different depending on how the project chooses to operate. For instance, some projects, such as Compound, relinquish all or most of their control to the community, putting the most power in the hands of supporters.

Other projects, including MakerDAO, may not surrender all control, but they certainly give the community a say on key decisions that will shape the project going forward. Some projects are much more conservative about how much power they are willing to give up, especially in the early stages, so they may only allow voting on smaller, less significant decisions.

Some governance tokens can also earn financial dividends, which means holders receive a small share of a project’s profits.

It is the responsibility of project creators to decide how governance tokens are distributed. They typically reserve a share for founders and investors, and the rest are released to users in various ways. So, in addition to buying them, governance tokens can often be earned, either by using a service in the case of Compound, or by serving a project in other ways.

Who uses governance tokens?

Governance tokens are particularly popular among DeFi and DAO projects, as well as decentralized applications (DApps). In addition to Compound and MakerDAO, other popular projects that use governance tokens are Aave, Decentraland, PancakeSwap, and Uniswap.

Compound, a DeFi protocol that allows its users to borrow and lend cryptocurrencies, is one of the most notable because, as we mentioned above, it relinquished control of the network’s admin key in 2020. In other words, Compound is now completely governed by its token holders with no decentralized elements whatsoever.

Pros and cons of governance tokens

One of the biggest problems with centralized entities is that those at the top make all the decisions, and they don’t always take the best interests of their users into account. Governance tokens go a long way toward eliminating that problem by giving those who actually use and support a project or service a real say in the decisions that are made.

This also helps ensure transparency. Very few people know what happens behind the scenes of private or even public companies because they get to choose, in most cases, what they want to disclose. With a decentralized organization that uses governance tokens, everyone can see what’s eligible for change — and have their say if they want to.

Furthermore, governance tokens help build an active and collaborative community, which can provide the stability a project needs to help ensure its long-term success. Governance tokens aren’t completely perfect, however, and there are some disadvantages you should be aware of before deciding whether or not you should invest in them.

A big problem with governance tokens is what the industry calls “whales.” These are people, typically with vast resources, who can acquire and hold a significant percentage of tokens. This gives them an advantage over other community members — and a significantly bigger say when it comes to voting. This can allow whales to swing decisions in their favor.

Some projects combat this by imposing restrictions on how much power members can have, but it is possible to get around this by using multiple wallets and distributing large numbers of governance tokens between them. There have also been instances of project creators and investors voting to benefit themselves rather than the wider community.

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