What Is a Governance Token & Why Is It Important?

The cryptocurrency landscape is, in many ways, still chaotic and disorganized. Decentralization, while its core aspect, is hard to maintain when the blockchain space simultaneously needs administration and regulation if it is to see wider adoption. That’s where governance tokens come into play.

They represent a compromise between order and chaos, anarchy and democracy. Crypto governance tokens shifted the way we look at decision-making processes, giving more power to individuals while encouraging everyone to work toward common goals.

But how do they work, and what makes them so special? Aren’t governance tokens just another form of digital currency, like Bitcoin? Is it possible to facilitate financial inclusion with some simple lines of code?

In this article, we’ll explore the intricacies of these tokens to answer all these questions and tell you all you need to know about governance in cryptocurrency.

What Is a Governance Token?

A governance token is a type of cryptocurrency that gives its holder decision-making power in a blockchain-based project. In essence, they grant crypto enthusiasts voting rights regarding the future development and operations of dApps and decentralized networks.

By having governance tokens in their wallets, users are able to vote on various aspects, such as the implementation of certain features, network upgrades, project asset management, and more.

The main goal behind governance tokens is to embody the core principle of the cryptosphere, which is decentralization. Many cryptocurrency project developers are moving away from traditional, centralized decision-making models. They are distributing power among the community in efforts to facilitate adoption and improve the chances of long-term success.

It’s often participants with a vested interest who will obtain these tokens and work together toward a common goal. In general, the more interested parties vote on a project, the higher the chances it succeeds.

Many consider Maker (MKR), launched in 2017, to be the first DeFi governance token. Still, the concept is almost as old as cryptocurrencies themselves. Even during the early days of Bitcoin (and later, Ethereum), blockchain advancements were community-managed.

However, these processes were informal and often took more time than required to execute. Governance tokens brought much-needed structure and efficiency while further promoting financial inclusion and digital democracy.

How Do Governance Tokens Work?

Governance tokens work by granting holders the power to vote in a system regulated through smart contracts. Anyone holding these tokens, from retail investors and traders to project developers, becomes a member of a decentralized autonomous organization (DAO).

DAOs can be thought of as boards from the realm of traditional finance (TradFi). They are groups of individuals and entities that participate in a proposal system. However, the difference is that anyone can become a member of a DAO by obtaining governance tokens, and the rules are enforced using transparently pre-programmed smart contracts.

At their core, smart contracts are code written to execute when certain conditions are met. They remove the need for centralized authorities since they can implement decisions autonomously once the consensus among governance token holders has been met. Moreover, these are also used to facilitate voting and count the votes.

Once someone creates a proposal (it’s not uncommon for token holders to be able to create proposals in addition to the developers), users can vote on it by connecting their wallets. In general, an individual’s voting power is proportionate to the number of governance tokens that they hold.

You can think of having governance tokens as having a stake in a TradFi company. You gain the ability to shape the project’s future while simultaneously looking forward to potentially lucrative returns. If a project gains traction and becomes popular, more users might look into joining. That can drive demand up and thus increase the price of governance tokens.

Examples of Governance Tokens

Let’s check out some of the most prominent examples of governance tokens:

• Maker (MKR) is considered a pioneering cryptocurrency when it comes to governance tokens. The token was created by a decentralized organization called MakerDAO for their Ethereum-based platform, Maker Protocol. The project revolves around a community-managed stablecoin pegged to the US dollar called DAI.
• Compound (COMP) is a governance token for the Compound DeFi lending platform. Participants can use Compound to lend their assets and earn interest or borrow secured loans by providing collateral. COMP token holders can vote on various proposals, including incentive optimizations and supply cap increases.
• Uniswap (UNI) grants holders governance over one of the biggest DeFi trading platforms in the cryptosphere. Uniswap decentralized exchange was built on the Ethereum platform to facilitate the trading of DeFi tokens. UNI holders can vote on protocol changes regarding fees, upgrades, liquidity funds, network integrations, and so on.
• Aave (AAVE) is issued by the Aave Liquidity Protocol. This DeFi platform is designed to help users provide liquidity, stake, and borrow crypto to earn passive income. Governance includes the ability to submit an Aave request for comment (ARC), evaluate sentiment through Snapshots, and submit an Aave request for improvement (AIP).
• Curve DAO Token (CRV) is a governance cryptocurrency for the Curve decentralized exchange. This DEX uses an automated market maker (AMM) protocol to facilitate stablecoin trading. Platform governance involves everything from providing site feedback and gauging proposals to voting on submitted ones.

Governance Token vs. Utility Token

Governance tokens and utility tokens are both types of cryptocurrencies with distinct purposes and use cases within a broader ecosystem. They share some similarities, which is why many people use these two terms interchangeably.

In essence, governance tokens are a subset of utility tokens. As a result, all governance tokens are utility tokens, but not all utility tokens are governance tokens.

As their name suggests, utility tokens have various use cases. Holders can use them to pay for goods and services on the relevant blockchain. For instance, they are commonly used to pay transaction fees when using decentralized exchanges. Governance is just one of the many uses utility tokens can have.

That makes governance tokens utility tokens with a singular purpose—to grant holders voting rights and influence over a blockchain project. They can’t be used to pay for fees or perform functions outside of on-chain decision-making.

Naturally, both tokens share many similarities that are common to cryptocurrencies in general. Holders can use them in their respective ecosystems to do more beyond a mere value exchange.

Finally, they can be traded between individuals and entities, often on both centralized and decentralized exchanges, and stored in wallets. Some governance tokens can also be staked for passive income.

Advantages of Governance Tokens

Here are some of the key benefits that governance tokens bring to holders and the cryptosphere in general:

• Enhanced decentralization. Governance tokens push the boundaries of cryptocurrency decentralization. They allow everyone to make decisions regarding blockchain projects and protocols. This approach also results in an increased variety of perspectives, which can be beneficial for the project's success.
• Increased transparency. Transparency is one of the main characteristics of blockchain technology, and this attribute extends to governance tokens and proposal voting. Since every vote is done on-chain, everything is immutably stored and transparently displayed. The openness helps build trust among network participants and potential investors.
• Upgraded security. Governance tokens leverage the advantages of blockchain to create a secure system. While there’s always concern regarding fraud and smart contract vulnerabilities, there’s been a lot of advancement in the field. Moreover, personal investment incentivizes holders to support safety-oriented future development.
• Improved efficiency. Before governance tokens, most protocol improvements were done off-chain, through discussions on various platforms like forums and social media. Tokenizing votes helped speed things up and create a much more efficient decision-making system overall.
• Community cooperation. By allowing anyone who holds cryptocurrency to vote and participate in the project’s progress, governance tokens boost user engagement and loyalty. They incentivize participation and cooperation, which can result in organizations of tight-knit individuals who are all working together.

Risks and Challenges of Governance Tokens

Naturally, this governance system isn’t flawless. Here’s a list of governance token risks and challenges:

• Centralization concerns. The cryptocurrency market is relatively small compared to the TradFi market. That makes it easier for large investors (whales) to obtain a large portion of governance tokens, especially in new projects. By having a lot of voting power, they can singlehandedly influence the project’s future.
• Lack of accountability. While votes are transparently recorded on the blockchain, they don’t show who the voters are. While many praise DeFi for its anonymity, in the case of governance tokens, it can help malicious parties get away with bad actions, such as voting manipulation or even fraud.
• Short-term voting. Some token holders might vote against the long-term improvement of the project in favor of short-term profit. Some crypto investors and traders simply want the price of their tokens to increase so they can sell them, which can lead to an unstable environment and questionable development.
• Smart contract vulnerability. Smart contracts used to facilitate the entire process of voting and proposal implementation can be flawed. Even with careful coding practices and auditing, it’s possible for attackers to find ways to exploit the system for personal gains at the cost of other network participants.

The Future of Governance Tokens

In the future, governance tokens are likely to see more adoption and increased efficiency. As the crypto space grows and matures and more people learn about it, chances are there will be more traders and investors willing to actively participate in projects.

Innovations regarding DAOs and Web3 could result in a more user-friendly environment for entry-level participants. A steep learning curve often deters eager investors who might otherwise be useful contributors to upcoming DeFi protocols.

However, chances are that the space will see an increase in regulatory scrutiny, meaning governance tokens are going to be legally defined. On the one hand, that can temporarily impede their progress and adoption. On the other hand, it could draw in more investors from TradFi who aren’t accustomed to cryptocurrency’s regulatory uncertainty.

Ultimately, as blockchain and relevant technology become more robust, governance tokens could become a go-to tool for the majority of cryptocurrency projects going forward.

Key Takeaways

As you can see, governance tokens are much more than just another type of cryptocurrency—they represent the foundation for the democratization of the landscape. These tokens are another crucial step toward decentralization and financial inclusion.

The importance of governance tokens for both issuers and investors cannot be understated. It uses the power of blockchain and underlying technology to promote the diversification of ideas and community bonding.

Governance tokens also aim to change the way we look at high-level decision-making. They aren’t just digital financial assets designed for trading and speculation but also vital to making the cryptosphere a comprehensive fintech ecosystem.