Summary

Governance tokens give holders voting rights to manage the development and operation of blockchain projects. This is how projects distribute decision-making power to the community. This decentralized governance model helps align the interests of token holders with those of the project.

Introduction

Many traditional companies are managed by a board of directors, or a small group of people, which can be classified as centralized governance. The average size of the board of directors of the largest companies is about 10 people. They have a great deal of power over how the company is run. Directors can nominate or fire key executives, decide which projects to invest in, and set corporate strategy.

Governance tokens are another way to manage an organization. For decentralized autonomous organizations (DAOs) and decentralized finance (DeFi), the model represented by governance tokens provides a fairer, decentralized, and transparent way of governance. In most cases, one token equals one vote. These tokens are designed to connect communities and ensure that blockchain projects can develop healthily.

How do governance tokens work?

In DAO, DeFi and decentralized application (DApp) projects, governance tokens are the core method of achieving decentralized governance. We usually award them to active users to recognize their loyalty and contribution to the community. In turn, token holders vote on major issues to ensure the sound development of the project. Usually, voting is carried out through smart contracts, in which case the results are automatically executed.

One of the earliest governance tokens was issued by MakerDAO, an Ethereum-based DAO that supports the cryptocurrency-collateralized stablecoin DAI. The Maker protocol is governed by holders of a governance token called MKR. One MKR token equals one vote, and the decision with the most votes will be adopted. Token holders vote on various issues, such as appointing team members, adjusting fees, and adopting new rules. The goal is to ensure the stability, transparency, and efficiency of the MakerDao stablecoin.

Another example is Compound, a DeFi protocol that allows users to lend and borrow cryptocurrencies. It issues a governance token called COMP that allows community users to vote on key decisions. Tokens are distributed proportionally based on users' on-chain activity. In other words, the more you lend and borrow on Compound, the more COMP tokens you receive.

Similar to MakerDAO, one COMP token equals one vote. Users can also delegate their tokens to others to vote on their behalf. It is worth noting that Compound handed over control of the network's administrative keys in 2020. This means that the project is entirely managed by its token holders without any alternative governance.

Also worth noting is that governance tokens include those issued by decentralized trading platforms Uniswap and PancakeSwap, DeFi lending platform Aave, Web3 NFT community ApeCoin DAO, and virtual world platform Decentraland.

Each project sets different rules for how its governance tokens work. Based on different calculation models, tokens are distributed to stakeholders, including the founding team, investors, and users. Some governance tokens only vote on a specific set of governance issues, while others vote on most matters. Some governance tokens can receive financial dividends, while others do not.

Pros and Cons of Governance Tokens

Governance tokens have some big advantages. They can eliminate the misalignment of interests common in centralized governance. Decentralized governance enabled by governance tokens transfers management power to a broad community of stakeholders, aligning the interests of users and the organization itself.

Another major advantage of governance tokens is the ability to build an active, collaborative, and tight-knit community. Every token holder is incentivized to vote and improve the project. One token is equivalent to one vote, so it can lay the foundation for fairer and more equitable decision-making. Every token holder can initiate a proposal and vote. The details of each vote will be made public, reducing the possibility of cheating.

The biggest challenge facing government tokens is the so-called whale problem. Whales are users who hold a large percentage of a cryptocurrency. If the largest whales of a cryptocurrency project hold a large portion of the overall supply of governance tokens, they may manipulate the voting process to their own advantage. Projects need to ensure that token ownership is truly decentralized and evenly distributed.

However, even if governance tokens are distributed fairly and widely, there is no guarantee that most decisions will always be perfectly aligned with the project. One-person-one-vote elections are a long-standing tradition with a mixed record. There have been cases where governance token holders have voted in favor of founding teams and large investors at the expense of the broader community.

How will governance tokens develop next?

As an innovation in the cryptocurrency field, governance tokens can be more widely used in more fields. The Web3 movement is where governance tokens come in, and it can help build a decentralized Internet. With the booming development of DeFi and DAO, other industries such as games can adopt this governance model.

Governance tokens will continue to evolve, addressing new issues as they arise. There may be new mechanisms to deal with whales, or other ways to strengthen the voting process. New ways to delegate votes may emerge. This space may become more complex, and new innovations will continue to emerge.

Another big factor affecting the future of governance tokens is potential regulatory changes. Some governments may consider these tokens to be securities. This could subject them to strict regulation and affect how they operate.

Summarize

Governance tokens are still in the early stages of development. They have facilitated the robust development of many DeFi and DAO projects. These tokens carry voting rights in deciding project management and are the cornerstone of decentralization.

As long as tokens are distributed relatively evenly among community members, the principle of one coin, one vote is user- and community-centric. In the future, governance tokens will continue to thrive. User-owned networks, Web3 projects, and games can all adopt governance tokens to build a more vibrant decentralized ecosystem.