Governance Tokens Explained
Decentralized governance is a way for blockchain projects to distribute decision-making power to their communities using governance tokens, which give holders the right to vote on issues related to development and operations. This model aligns the interests of token holders with those of the project and promotes community involvement in project development.
In the traditional corporate world, a small group of people or a board of directors governs most companies, in what is known as centralized governance. The biggest companies' boards are typically around 10 people, and they wield significant influence over the company's direction. They nominate or dismiss key executives, determine investment priorities, and set the corporate strategy.
However, governance tokens offer a different approach to managing organizations. This model, commonly used in Decentralized Autonomous Organizations (DAOs) and Decentralized Finance (DeFi), provides a more decentralized, equitable, and transparent governance method. In most cases, one token equals one vote. Governance tokens are designed to unite communities and ensure blockchain projects develop in a healthy manner.
How Do Governance Tokens Work?
Decentralized governance in DAO, DeFi, and DApp projects relies heavily on governance tokens. These tokens are given to active community members who vote on critical issues to ensure projects’ growth. Voting is typically carried out via smart contracts, and the results are automatically implemented.
MakerDAO is one of the earliest projects to use governance tokens. Its Maker Protocol, which supports the stablecoin DAI, is governed by MKR token holders. The objective is to ensure the stability, transparency, and efficiency of the stablecoin by voting on issues such as team appointments, fee adjustments, and rule adoption.
Another example of a project using governance tokens is Compound, a DeFi protocol that allows users to lend and borrow cryptocurrencies. It allocates COMP tokens to users based on their on-chain activity. One COMP token equals one vote, and users can delegate their tokens to others to vote on their behalf. Compound has relinquished control of the network’s admin key, so the project is now governed solely by its token holders.
Uniswap and PancakeSwap, Aave, ApeCoin DAO, and Decentraland are other projects that use governance tokens. These tokens have different rules and are distributed to stakeholders, including founders, investors, and users, based on various models. Some governance tokens vote on specific issues, while others vote on most issues. Additionally, some governance tokens earn financial dividends, while others do not.
Pros and Cons of Governance Tokens
The use of governance tokens brings various benefits to organizations. The decentralized governance structure that governance tokens enable eliminates the misalignment of interests frequently seen in centralized governance. With decentralized governance, power is shared among a diverse range of stakeholders, ensuring that the interests of the users and the organization remain aligned.
Another advantage of governance tokens is the building of active and collaborative communities. As one token mostly equals one vote, the decision-making process is more equitable and fair. Each token holder can propose an idea to be voted on. The voting process is transparent and open to everyone, which reduces the possibility of cheating.
However, governance tokens also come with challenges, such as the "whales problem." Whales are individuals who hold a significant percentage of a particular cryptocurrency. If the biggest whales of a crypto project hold a considerable portion of its governance token, they could sway the voting process to their benefit. To ensure fairness, projects need to guarantee that token ownership is widely and evenly distributed.
Moreover, even if governance tokens are distributed fairly and broadly, there is no assurance that majority decisions are always in the best interest of the organization. One-person, one-vote systems have had mixed success throughout history, and governance tokens are no exception. Sometimes governance token holders vote to favor the founding teams and large investors at the cost of the broader community.
What's Next for Governance Tokens?
The use of governance tokens, originally developed in the crypto industry, has the potential to expand into other sectors beyond cryptocurrency. One such area is the Web3 movement, where governance tokens can facilitate the creation of a decentralized internet. Additionally, industries such as gaming may adopt the governance model as DeFi and DAOs gain traction.
As governance tokens gain popularity, they will likely undergo further evolution to address new issues that arise, such as the "whale problem," or to improve the voting process through innovative delegation methods. However, the governance token space may also become more complex as new developments emerge.
Regulatory changes may also affect the future of governance tokens, as some governments could classify them as securities, leading to stricter regulations that may impact their functionality.
The role of governance tokens in the DeFi and DAO space has been critical to their growth. They have enabled decentralized decision-making and placed power in the hands of token holders. The principle of one token, one vote has helped to ensure that the community's interests are aligned with those of the organization.
As the concept of user-owned networks gains traction, governance tokens may become more prevalent across a range of industries, including Web3 projects and gaming. However, for governance tokens to be effective, the token distribution must be equitable among all members of the community. If this condition is met, governance tokens can play an important role in building vibrant, decentralized ecosystems.