What are Governance Tokens?

Governance tokens are tokens that give holders voting power in a decentralized protocol. Users who hold governance tokens can shape the project’s direction moving forward. The more tokens a user has, the more voting power they possess. 

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Governance tokens holders can suggest changes through a proposal submission process. If the required criteria are met and the submission is put to vote, the governance token holders can then spend their tokens to vote on the proposals.

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By spending these tokens, community members can influence several decisions, such as:

• Choice of new products to develop

• Budget of products

• Allocation of products’ budgets

• Cost of transaction fees

• Distribution of rewards

• New partnerships

• UI (User Interface) changes

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As governance tokens offer their holders the power of ownership and right to ‘govern’ the protocol, they are considered a key feature of Decentralized Autonomous Organizations (DAOs).

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A Decentralized Autonomous Organization (DAO) is a blockchain-governed organization led by the community members rather than a central authority.

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How Do Governance Tokens Work?

In most traditional corporations, the decision-making power is centralized. It is typically just a combination of shareholders, C-suite executives, and a board of directors, who tower over everyone else when it comes to making decisions over the company’s direction. Decentralized Finance (DeFi) and DAOs take a radically different approach, as they don’t have centralized decision-makers. Instead, they distribute the decision-making power to the community’s token holders.

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DAOs use a formal governance process, which includes community proposals and votes, to make decisions. As a by-product of living on the blockchain, governance tokens are equipped with characteristics, such as immutability and transparency, that make them ideal for distributed and decralized decision-making.

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When a proposal goes to a vote, governance token holders get the opportunity to place their vote on-chain. Generally, the voting power of a token holder is directly proportional to the total number of the tokens they hold. For example: If Tom holds 10 tokens and Harry holds 100 tokens, Harry will have ten times the voting power of Tom.

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While different DAOs may have their own unique features and styles, they all share one thing in common: Governance Tokens.

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What Makes Governance Tokens Unique?

Governance tokens fall under the category of ‘Utility tokens’. The utility that governance tokens grants its users is the ability to influence the direction of a protocol. Some examples of governance tokens include:

• Maker (MKR)

• Compound (COMP)

• Uniswap (UNI)

• MANTRA (OM)

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A utility token is a cryptocurrency token that allows users to perform some action on within a specific blockchain ecosystem.

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Governance tokens represent the primary utility token of DeFi protocols and can be termed as the forefather to full-fledged decentralization. By distributing the power of making high-level decisions from a centralized group to the whole community, governance tokens have become the first type of cryptocurrencies to representing voting on the blockchain. Governance token owners also essentially become protocol owners.

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However, governance tokens are not used just for voting purposes. A lot of blockchain projects also allow token holders to use governance tokens for staking, lending and borrowing, and yield farming purposes.

radically shift the power structure of decision-making, involve the community dearly, and allow protocols to evolve faster and swiftly solve urgent issues

What are the Benefits of Governance Tokens?

There are several benefits users can gain from holding and using governance tokens. 

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Alignment of Interests

Centralized governance models can often result in misalignment of interests between the executives and the community members. Governance tokens help to better align the interests of everyone involved.

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Collaboration Opportunities

Voting allows discussion, and discussion allows collaboration. After a proposal is made, token holders are encouraged to collaborate with other community members and can reach a voting decision through discussion.

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Decentralization

Governance tokens are instrumental in accommodating decentralized governance. Without it, the ‘De’ in DeFi would hardly make sense, as DeFi projects would only be smart contracts with nobody to steer the direction.

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Fairness

Governance tokens help to establish a fairer platform for decision-making where every token holder can introduce a proposal for the community to vote on, and the details of each proposal and vote are transparent to the community.

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Involved Communities

Since governance token holders actually have direct power to mold the direction of a project, it leads to them being more active participation.

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What are the Drawbacks of Governance Tokens?

While it's clear that governance tokens have many advantages, it should also be known that they possess several challenges too.

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Lack of Accountability

Since governance tokens involve the whole community, most of whose identities are pseudonymous, they don’t have much accountability. If a decision goes wrong, the users will always blame an invisible majority and it will be difficult to determine who is responsible for the failure.

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Malicious Intent

Community members can also consist of bad actors who may use their voting power to vote for decisions that only benefit themselves, instead of the whole community.

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Uncertainty

Just because the majority makes a decision does not necessarily mean that it is the best possible decision for the project long-term.

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Voting Power of Whales

Whales are investors who own a large portion of a certain token. This means that, in terms of governance, then hold a large amount of voting power too. Since the main purpose of DAOs and DeFi is decentralization, this can easily be problematic.

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One Last Thing…

Governance tokens represent the foundation of decentralization itself. Governance forums are filled with thought, discussion, and ideas to improve the project and increase its value. These tokens radically shift the power structure of decision-making, involve the community dearly, and allow protocols to evolve faster and solve urgent issues swiftly.

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As such, governance tokens have already proven their value. They will likely be a critical part of the industry’s growth, and continue to grow in value and relevance – depending on how DAOs and DeFi are further adopted.