Governance Token

Governance tokens are developer-created tokens that allow token holders to help shape the protocol. Governance token holders can influence decisions about the project, such as proposing or deciding on new feature proposals, or even changing the governance system itself. In many cases, changes are automatically applied thanks to smart contracts that are proposed, reviewed and then voted on on-chain governance accessed through the use of governance tokens. In other cases, the team that maintains the project is tasked with applying changes or hiring willing people.

Proponents of systems that use governance tokens argue that they allow user control, which is in line with the original cryptocurrency ideals of decentralization and democratization. In most cases, organizations that let users control the development of their systems are called decentralized autonomous organizations (DAOs).

A famous example of a governance token is Maker (MKR). The token allows its holders to vote on decisions related to the decentralized finance (DeFi) protocol that runs the decentralized stablecoin DAI. For example, MKR holders can vote to change the complex economic rules governing decentralized lending, allowing DAI to maintain its price stability. As the text you’re reading is written, MKR holders are voting on whether the protocol’s debt ceiling should be raised.

How Do Governance Tokens Work?

In a traditional corporation, a centralized executive—usually some combination of top management, the board of directors, and shareholders—has sole authority over decisions related to the strategic direction of the organization. DAOs differ from traditional companies in that they do not have a centralized group of decision makers; but they still need to make decisions that impact the future of the organization.

The DAO makes these decisions through a formally defined governance process involving proposals and community voting. While DAOs employ a variety of governance methods, one common feature they all share is the governance token. By existing on the blockchain, governance tokens have certain characteristics, such as immutable ownership and transparent distribution, that make them ideal for distributed decision-making.

When DAO proposals come to a vote, governance token holders have the opportunity to vote on-chain. Typically, a token holder's voting weight is proportional to the number of tokens they hold. For example, if A holds 100 tokens and B holds 50 tokens, A has twice the voting power of B. Some DAOs employ different voting models, such as quadratic voting, to make voting more fair.

Advantages of Governance Tokens

Governance tokens have some great benefits. They can eliminate the misalignment of interests that often occurs in centralized governance. Decentralized governance powered by governance tokens transfers stewardship to a broad community of stakeholders, aligning the interests of users and the organization itself.

Another advantage of governance tokens is the ability to build active, collaborative, and tight-knit communities. Each token holder is incentivized to vote and improve the project. Because one token is mostly equal to one vote, it can lay the foundation for fair and fairer decision-making. Every token holder can initiate proposals for voting. The details of each vote are made public for everyone to see, which reduces the chance of cheating.

Disadvantages of Governance Tokens

The biggest challenge with government tokens is the so-called whale problem. Whales are people who hold large amounts of a particular cryptocurrency. If a crypto project’s largest whales hold a significant portion of its governance token’s total supply, they could swing the voting process in their favor. Projects need to ensure that token ownership is truly decentralized and evenly distributed.

But even if governance tokens are distributed fairly and widely, there is no guarantee that majority decisions will always be best for the project. The electoral system of one person, one vote has been around for a long time, with a mixed track record. In some cases, governance token holders vote to benefit the founding team and large investors at the expense of the broader community.