Abstract

Governance tokens address the issues of managing the development and operation of blockchain projects Grant holders the right to vote. In this way, projects allocate decision-making power to communities. This decentralized governance model helps align the interests of both token holders and the project.

Introduction

Many traditional companies are governed by a board of directors or a small group of people and can be classified as centralized governance. The average board size of the largest companies is about 10 people. They have tremendous 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 (DAO) and decentralized finance (DeFi), the model represented by governance tokens provides a fairer, decentralized and transparent way to govern. In most cases, one token equals one vote. These tokens are designed to connect communities and ensure the healthy development of blockchain projects.

How do governance tokens work?

In DAO, DeFi and decentralized application (DApp) projects, governance tokens are used to achieve decentralized governance core methods. We typically award them to active users in recognition of their loyalty and contributions to the community. In turn, token holders vote on major issues, ensuring the project’s robust development. Typically, voting takes place via smart contracts, in which case the results are executed automatically.

One of the earliest governance tokens was issued by MakerDAO, an Ethereum-based DAO that supports cryptocurrency Collateralized stablecoin DAI. The Maker protocol is governed by governance token holders 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. Its 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, allowing 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 is equal to one vote. Users can also vote on their behalf by delegating their tokens to others. Notably, Compound relinquished control of network management keys in 2020. This means that the project is entirely governed by its token holders, without any alternative means of governance.

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

Each project sets different rules for how their 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 receive financial dividends, while others do not.

Advantages and Disadvantages of Governance Tokens

Governance tokens have some big advantages. They can eliminate the interest bias 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 big advantage of governance tokens is their ability to build active, collaborative, and tight-knit communities. Each token holder is incentivized to vote and improve the project. One token is equivalent to one vote, so it can provide the basis for fairer and more equitable decision-making. Every token holder can initiate proposals and vote. 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 proportion of cryptocurrency holdings. If a cryptocurrency project’s largest whales hold a large portion of the overall supply of governance tokens, they may manipulate the voting process to their own benefit. 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 a perfect match for the project. The electoral system of one person, one vote has been around for a long time, with a mixed record. There have been instances where governance token holders voted in favor of the founding team and large investors at the expense of the wider community.

How will governance tokens develop next?

As an innovation in the field of cryptocurrency, governance tokens can be more widely used in more fields. The Web3 movement is where governance tokens come in to help build a decentralized internet. As DeFi and DAOs flourish, other industries such as gaming can adopt this governance model.

Governance tokens will continue to evolve and solve new problems as they arise. There may be new mechanisms to deal with whales, or other ways to enhance the voting process. New ways to authorize voting may emerge. The field is likely to 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 securities. This could subject it to strict regulation and affect how it operates.

Summary

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

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