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What Is a Governance Token?

8 Minute Read

How can Web3 developers make decisions without sacrificing decentralization? Countless DeFi (decentralized finance) projects have created innovative ways to resolve this dilemma. Web3 developers aim to efficiently scale their operations while considering every network participant's perspective. 

Although every protocol has unique ways of dealing with blockchain governance, many believe governance tokens provide the best solution. Governance tokens may not be perfect, but they’ve influenced how dApps (decentralized apps) reach agreements. Anyone involved in Web3 should understand what a governance token is and how it can affect the future of DeFi.

What is blockchain governance?

Before we move to blockchain governance, let’s first understand governance as a concept. Governance is the process of overseeing or controlling an entity, including the entity’s hierarchy, operations, and systems.

It's impossible to explain governance tokens without a basic understanding of how blockchain governance works. After all, governance tokens were designed to make this decision-making process smoother.

Blockchain governance includes the activities and protocols involved in reaching agreements and implementing changes in a crypto project. 

Although permissioned blockchains can have a hierarchical governance structure, open-source projects try to maintain decentralization. Instead of dictating a project’s future directions, many Web3 developers will submit improvement proposals online and put them up for a community vote. The community's response to these proposals will determine these directions. 

People usually divide blockchain governance into two categories: on-chain and off-chain. On-chain governance occurs directly on a project's blockchain, such as voting on proposals with governance tokens, while off-chain governance includes informal or formal discussions that aren't on the crypto project's chain. Examples of off-chain governance include polls on social media, in-person conventions, or debates on online forums. 

What is a governance token?

Governance tokens are cryptocurrencies that allow holders to participate in on-chain governance for a crypto project. Usually, each governance token a person holds equates to one vote on upcoming proposals, but there are other methodologies. People with governance tokens can use them to accept or reject changes to a dApp or blockchain during scheduled voting periods. Many dApps also allow people to use their governance tokens to create initiatives and put them up for a vote. 

While governance tokens aren't exclusive to DeFi, they’re the most popular in this sector. Most of the top decentralized exchanges (DEXs) and crypto lending sites use governance tokens to give community members a say.

What are governance tokens used for?

The main feature that separates governance tokens from other cryptocurrencies is that they come with voting rights. The list of proposals token holders can vote on is endless, but here are a few of the most common issues people use their governance tokens for:

  1. Deciding on a crypto project's treasury allocation. 
  2. Upgrading a dApp's user interface/user experience (UI/UX).
  3. Increasing or decreasing the interest rates on crypto lending sites. 
  4. Adjusting crypto rewards for liquidity providers (LPs). 

Besides voting on dApp upgrades, governance tokens have other use cases in DeFi. Here are a few non-governance-related ways that people use these:

  1. Native staking on a dApp to earn interest rewards. 
  2. Adding to a liquidity pool on a DEX. 
  3. Trading in the cryptocurrency market. 

How do governance tokens work?

If a DeFi project wants to release governance tokens, it’ll launch them on a smart contract blockchain like Ethereum (ETH). Every dApp will have a unique token issuance policy for their governance tokens that should be listed online and in a whitepaper. 

DeFi protocols often set aside some governance tokens to use as reward incentives for community members. People who lock their crypto in a dApp's liquidity pools receive these governance tokens often for their service. 

When it comes to voting with these tokens, DeFi sites should have a governance portal with active and pending proposals. Then, people will only have to connect their crypto wallet and submit the number of tokens they wish to vote for a proposal. The more tokens a person locks into a proposal's smart contract, the greater their say over the final verdict. 

Most dApps use a blockchain governance structure called a DAO (decentralized autonomous organization) to both submit proposals and tally votes. A blockchain's DAO includes all the stakeholders in a project, including developers, validators, and investors. DAOs also rely on smart contracts to tally votes and execute orders to avoid human manipulation. 

Governance tokens vs. utility tokens

Since utility tokens share many features with governance tokens, some use these terms interchangeably. However, there's one significant distinction between a governance and utility token, i.e., voting power.

To be considered a governance token, holders must be able to vote. While utility tokens can have many use cases on a blockchain, including voting. Thus, every governance token is also a utility token, but every utility token is not a governance token. 

The Brave browser's Basic Attention Token (BAT) is a great example of a utility token that’s not a governance token since it doesn't grant holders special voting privileges. Instead, BAT serves as an incentive for advertisers and users on the Brave browser. 

Technically, a governance token is a type of utility token. However, unless a cryptocurrency gives its holder a say in DAO proposals, it can't qualify as a governance token. 

What are the advantages of governance tokens?

Unlike on Web2 sites like Facebook, Web3 users have a say in the future direction of their favorite dApps. Supporters believe governance tokens offer internet users greater freedom and transparency. Here are a few features in governance tokens' favor: 

  1. Helps preserve decentralization: Governance tokens grant every stakeholder a vote in upgrades to a dApp. These voting privileges help spread the power of decision-making throughout the community, which increases the odds that the majority will reign. 
  2. High efficiency: It's easier to resolve issues by voting with governance tokens versus informal off-chain methods like forum debates or conventions. 
  3. Prevents schisms in the community: Governance tokens give network participants a way to air their grievances, which can help reduce the odds that disgruntled developers will turn away to create a competing "forked" blockchain. 
  4. Enhances transparency: Not only are votes recorded on the blockchain but they’re also entrusted to coded smart contracts. These features prevent manipulation during the voting process. 
  5. Promotes community collaboration: By opening up the voting process to token holders, everyone feels a sense of ownership over the dApp. This increased collaboration can lead to novel proposals and positive community sentiment. 

What are the challenges of governance tokens?

Despite all the pros associated with governance tokens, crypto commentators have a few concerns with this model. Innovations like quadratic coding or soul-bound tokens may address some of these issues, but they are significant apprehensions for today's DAOs:

  1. Selfish or malicious actors: In an ideal world, everyone with governance tokens will always vote for the community's best interest. However, in reality, people are often motivated by self-interest, which can hurt the community and dApp users. 
  2. Whales and validator pools can dominate voting: The more governance tokens a person has, the greater their power over the platform. There's always a risk that crypto whales or massive staking pools can dictate a blockchain’s direction. Mechanisms such as quadratic voting have been created to counteract this effect.
  3. Anonymity removes accountability: Since it's easier to hide when voting in decentralized proposals, it's tougher to accuse any entity of bad actions. If crypto projects want to uphold the value of privacy, it's challenging to hold anyone accountable for poor governance decisions. 
  4. Potential for smart contract code failure: There's always a chance that a smart contract has code vulnerabilities. Voters must rely on Web3 developers' skills when voting in DAOs. 

Governance tokens examples

There are dozens of governance tokens, but the most prominent live on the Ethereum blockchain. Here are a few of the most talked-about DeFi protocols (at the time of writing) that offer DAO tokens:

  1. Uniswap: The Ethereum DEX Uniswap airdropped its UNI tokens to everyone who used its platform in 2020. To this day, the UNI token is one of the top governance tokens available on most centralized crypto exchanges (CEXs). 
  2. Aave: Developed in 2017, Aave is the leading decentralized crypto lender on the Ethereum blockchain. People who hold AAVE governance tokens not only enjoy voting privileges but also can stake their AAVE to secure the dApp.
  3. Maker: The Maker Protocol is best known for issuing the algorithmic stablecoin DAI on the Ethereum blockchain. Maker's governance token is MKR, which token holders use to vote on adjustments to the protocol's DAI issuance, collateral requirements, and interest rates.
  4. Compound: Compound's Compound token (COMP) holds a special place in crypto history. In the summer of 2020, this lending site introduced the concept of a governance token and liquidity mining with the release of COMP. People who hold COMP can propose and vote on proposals to the platform. 

There has been some criticism that the value in voting doesn’t constitute the market cap of these tokens. In reality, their value is derived from a potential to implement a fee switch through governance. 

Wrapping up

Not every crypto project uses governance tokens, but they have become a standard feature on the world's biggest DeFi sites. While it's difficult to say how decentralized governance will evolve in Web3, these cryptocurrencies will likely serve a vital function in many high-profile DAOs. Hopefully, as developers gain more experience with governance protocols, they’ll discover better ways to ensure everyone's voice is heard. 

At Worldcoin, we attempt to address the potential risks of decentralized governance with our Orb technology. Using advanced eye-scanning technology, we hope to create a way to verify unique ownership of a digital wallet without compromising a crypto user's identity. To learn more about how this is possible, please subscribe to Worldcoin's blog.