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What is a governance token and how does it work?

Despite the fact that the main principle of DeFi is decentralization, the first Dapps also used a centralized management structure, which contradicted the basics of blockchain. To solve the problem, a DAO system with decentralized management was created.

The introduction of DAO made it easier to make decisions about changes to the product or ecosystem. In order to vote, a person must have a governance token, which is an element of encouragement and an incentive for further development. The decision is made by a majority of the holders, which ensures the integrity of the vote.

Each token is part of a project. Such an instrument can be compared to a stock. The owner of a security receives dividends and can cast his vote. The difference is that the processes are decentralized and do not depend on a single control center.

In this article, we will explain in detail what a governance token is and how it works.

What are governance tokens?

A governance token is a cryptocurrency that allows you to participate in the life of a decentralized project and influence its future. Essentially, governance tokens represent an ownership or stake in a project or protocol and give holders the right to participate in decision-making processes.

First and foremost, a governance token gives holders the right to propose changes to the protocol. Other powers of governance token holders may include:

Influencing the introduction of new features;
Identifying companies to collaborate with;
Voting for the release of new products;
Revising the development fund;
Voting to burn coins.

While the primary function of governance tokens is voting, it can also be used to make money. For example, holders of such tokens can take credit for digital assets, put them into staking, and make money through yield farming.

In addition, governance tokens are of paramount importance to DAOs because they give token holders the ability to determine the future direction and policies of the organization. By allowing community members to influence decision-making, governance tokens promote decentralization, transparency and inclusiveness.

With DAO tokens, members of the organization can regulate the vector of blockchain project development in the direction they see as promising. In turn, for DeFi projects, it is a way to distribute influence to the entire community, as required by the principle of decentralization.

How do governance tokens work?

Governance tokens act as the basis for establishing decentralized governance in DAOs, DeFi projects, and DApps.

Users who have made significant contributions to the community or demonstrated loyalty are often rewarded with governance tokens. Token holders then vote on key issues to ensure that projects evolve effectively. Users typically vote using smart contracts, so the results are tabulated and automatically go into effect.

The main functionality of governance tokens includes:

Decision-making power. Governance tokens give owners the ability to influence the direction and operation of a project or protocol. Token holders have the ability to express their opinions and vote on proposals.
Voting mechanisms. Governance tokens use voting mechanisms (smart contracts) in their operation, which allow holders to cast their vote when important decisions are made. These voting systems can be structured in different ways, such as one-token-one-vote or token-weighted, where the right to vote is determined by the number of tokens a person owns.
Delegation options. To help holders who may lack the time or expertise to actively participate in decision-making, governance tokens often offer delegation options. Delegation allows token holders to transfer their voting rights to trusted individuals or entities who can vote on their behalf.
Potential rewards. Some projects or protocols incentivize token holders to actively participate in the decision-making process by offering rewards. These rewards can be in the form of additional tokens, protocol fees, or other bonuses.

Examples of governance tokens

One of the first issuers of governance tokens was MakerDAO, a decentralized autonomous organization created as an open-source project on the Ethereum blockchain. MakerDAO's stablecoin is called Dai, and Maker token holders manage the protocol itself. One token corresponds to one vote.

At the moment, governance tokens are used in many projects related to DeFi, GameFi or NFT. Let's list the most famous ones.

Compound (COMP). This is a decentralized lending protocol that allows users to lend and borrow various cryptocurrencies. COMP token holders participate in the management of Compound by voting on proposals related to protocol upgrades, asset listings and parameter adjustments. Voting rights are determined by the number of COMP tokens owned.
Uniswap (UNI). A decentralized exchange protocol that allows the automatic exchange of tokens. UNI token holders can participate in the management of Uniswap by voting on various proposals, from fee adjustments and protocol upgrades to an incentive program.
Aave (AAVE). Lending protocol. Individuals who own AAVE tokens can vote on proposals related to protocol upgrades, risk management parameters, and new asset listings.
Synthetix (SNX). A decentralized platform for issuing synthetic assets on the Ethereum blockchain. SNX token holders play a crucial role in proposing and voting on important system parameters such as collateral types, exchange rates and trading fees. This democratic governance model ensures the continued growth and integrity of the Synthetix ecosystem.
Decentraland (MANA). An Ethereum-based virtual reality platform that allows users to create, test and monetize content and apps. MANA token holders vote on changes to be made to Decentraland, control virtual world policy and moderate content.
Polkadot (DOT). A protocol that connects blockchains to each other and allows users to easily build a blockchain using its Substrate framework. In addition to basic governance, DOT token owners vote on how people within the team need to interact for the long-term effectiveness of the platform.
Curve.fi (CRV). An automated market maker protocol designed to exchange stablecoins with low commissions and slippage. Curve DAO Token (CRV) enables the Curve.fi ecosystem. CRV token holders can anchor their CRVs in Curve DAO as voting CRV escrow tokens (veCRV) to participate in the Curve community management.

Advantages and disadvantages of governance tokens

Pros of governance tokens:

Ability to decentralize the platform;
Provide transparency and trust in making fair decisions on project development;
Productive method for motivating project participants
User influence on project performance.

Along with the advantages, management tokens also have a number of disadvantages:

Attacks on the management system. Attackers can try to manipulate the voting results or disrupt the decision-making process.
Centralization of power. If a significant portion of the tokens is concentrated in the hands of a few commercial entities, decision-making power may be under the control of only one interest group.
Inefficiency of governance. Decision-making with management tokens can sometimes be slow or inefficient.

Governance tokens are one of the key tools for ensuring the full development of a blockchain project. This method of governance enables the creation of a favorable environment for maintaining fairness and transparency in the implementation of a digital product. In the future, more and more digital projects will adopt this management approach. This will create a more dynamic and decentralized ecosystem of the crypto market.