What Are Governance Tokens?

Decentralization is the foundational concept of blockchain technology, created to shift power from the hands of the 'high and mighty' central authorities to the people. While this shift is beneficial, developers often face challenges in reaching consensus due to diverse opinions. Considering every individual's viewpoint is impractical, especially when not everyone may prioritize the project's success.

One initiative addressing the challenge of efficient decision-making is the creation of DAOs (Decentralized Autonomous Organizations) and Governance Tokens. So, what exactly are DAOs, and how do governance tokens play a pivotal role in decision-making processes within these organizations?

Understanding a Decentralized Autonomous Organization (DAO)

A DAO is short for Decentralized Autonomous Organization which is a community-run entity built on blockchain technology, operating without a centralized management structure. It's an organization governed by code rather than by leaders.

DAOs are highly participatory. Unlike traditional organizations, they don't require a quorum or a specific number of votes to make decisions. "DAOs operate similarly to the internet, functioning through a form of rough consensus," explains Aaron Wright, co-founder and CEO of OpenLaw.

Their design streamlines the decision-making process, through a form of blockchain governance. This governance involves activities to reach agreements and implement changes within a crypto project. Becoming an active participant in this decision-making process is done through a governance token. Essentially, a DAO is a blockchain-based entity, controlled by its native token, known as a governance token.

What Are Governance Tokens?

Governance Tokens are a type of cryptocurrency that gives their holders the ability to participate in making decisions for a crypto project.

In crypto, there are two main types of governance: on-chain and off-chain. On-chain governance occurs on the project's blockchain, like when token holders vote on proposed changes using their governance tokens.

Off-chain governance, on the other hand, involves discussions outside the blockchain. This can include polls on social media, debates on online forums, and similar platforms. Governance tokens are special utility tokens. They are given to users to show their part in the DAO, essentially representing their stake in the organization.

Aave (AAVE), Decentraland (MANA), Maker (MKR), Uniswap (UNI), Synthetix (SNX), Balancer (BAL), Compound (COMP), Curve (CRV), Ethereum Name Service (ENS), and Yearn.finance (YFI) are examples of governance tokens in the cryptocurrency space.

Uses of Governance Tokens

Governance tokens are primarily used for voting, where token holders can vote on many different proposals. But they have other uses too, such as:

• Deciding how much money to give to a crypto project.
• Making the design and usability of a decentralized app (dApp) better.
• Changing interest rates on websites that lend out cryptocurrency.
• Adjusting rewards for liquidity providers who help with cryptocurrency transactions.

Besides voting on dApp updates, governance tokens have roles in decentralized finance (DeFi) that include:

• Earning interest by staking them on a dApp.
• Getting loans.
• Increasing the amount of money available for trading on a decentralized exchange (DEX).
• Making profit through yield farming.
• Trading in the cryptocurrency market.

How Governance Tokens Works

Decentralized Applications (dApps), Decentralized Autonomous Organizations (DAOs), and DeFi projects all build their decentralized governance on top of governance tokens.

Generally, governance tokens are distributed to participants who have demonstrated commitment or made significant contributions to the community. To advance the project, token holders vote on important issues. Votes are cast using smart contracts, which tabulate and act upon the results automatically, thereby preventing human manipulation. The rules governing these tokens vary by project. They are distributed to stakeholders like the founding team, investors, and users through different methods.

Some governance tokens are restricted to voting on specific issues, while others can vote on a broader range of topics, from smart contract amendments to development updates. One of the beneficial parts is that governance tokens can generate financial returns on investment, whereas others do not.

DeFi sites typically have a governance portal or forum for active and pending proposals, where users can cast their token votes. Users can either vote directly by linking their cryptocurrency wallet and submitting the required number of tokens or delegate their vote to another community member.

Delegating your vote means choosing a trusted community member as your proxy, a useful option for those who want to influence decisions but cannot participate actively in the DAO's governance. The influence of a token holder on the final outcome is proportional to the number of tokens they commit to the vote.

It's important to note that not all token holders participate in every vote. Therefore, most proposals require a minimum number of votes to be considered valid, ensuring that the community reaches a consensus before moving forward with a plan.

Compound is a prime example of a protocol utilizing a Governance token. It's a DeFi system that facilitates cryptocurrency lending and borrowing. The number of COMP tokens users receive is determined by their level of involvement in the Compound network. This means that individuals who lend and borrow more frequently are awarded more COMP tokens.

On Compound, one COMP token equals one vote. You can also assign others to vote with your tokens. In 2020, Compound relinquished control of the network's key administrators. Currently, token holders alone are responsible for the project's governance.

Utility Tokens vs. Governance Tokens

You might wonder, what is the difference between utility tokens and governance tokens in the cryptocurrency world? Well, they serve different purposes. Utility tokens are digital assets designed for specific uses within their native blockchain or platform.

They can be used for transactions like paying fees, accessing services, or purchasing goods. A notable example is BNB from Binance, which users can utilize for various purposes including fee payments, participating in token listings, or accessing Binance’s exclusive services like the Launchpad.

Governance tokens, in contrast, extend beyond transactional use. They empower holders with decision-making authority over the project’s direction. Holders of governance tokens can vote on crucial project developments, policy changes, or other significant decisions. This participatory role in project management distinguishes governance tokens from utility tokens.

While utility tokens are restricted to specific applications and lack governance capabilities, governance tokens offer broader functionalities. They can be used for staking, and lending, and are integral in decentralized governance processes.

It's important to note that all governance tokens are a subset of utility tokens, but not all utility tokens are governance tokens. The defining feature of a governance token is its ability to grant voting rights in DAO proposals and influence the project’s trajectory.

Advantages of Governance Tokens

• Maintains Decentralization: Governance tokens distribute voting rights among all stakeholders, fostering decentralization in the DeFi ecosystem. This broadens community involvement in decision-making, enhancing the chances that decisions reflect the majority's interests.
• Increase Productivity: By aligning development with community preferences, governance tokens facilitate more efficient and relevant feature development, unlike traditional approaches where resources might be wasted on unused features.
• Simplifies Decision-Making: Voting with governance tokens streamlines issue resolution compared to off-chain methods like forum discussions or meetings.
• Prevents Community Splits: By giving network users a voice, governance tokens reduce the risk of dissatisfied members creating competing blockchain forks.
• Increases Transparency: Votes are recorded on the blockchain and governed by smart contracts, reducing the risk of manipulation in the voting process.
• Encourages Community Cooperation: Allowing token holders to vote fosters a sense of ownership and involvement, leading to positive community sentiment and innovative initiatives.
• Promotes Continued Engagement: Holding governance tokens, such as COMP, incentivizes users to remain active on platforms to accrue more tokens, creating a positive feedback loop that enhances the platform's value.

Disadvantages of Governance Tokens

• Selfish Actors: Idealistically, token holders should vote for the community's benefit, but personal interests often prevail, potentially harming the community and dApp users.
• Influence of Whales and Validator Pools: Large token holders or staking pools can disproportionately sway decisions, possibly leading to suboptimal outcomes for the platform.
• Anonymity and Accountability Issues: In decentralized settings, anonymity complicates the identification and accountability for poor governance decisions.
• Smart Contract Vulnerabilities: Governance tokens rely on smart contracts, which are susceptible to code flaws, placing reliance on Web3 developers' expertise.
• Complexity and User Apathy: The intricacies of governance tokens and multiple token types can be overwhelming, potentially leading to user disengagement due to a lack of understanding.

How to Earn Passively on Governance Token

You can earn passively on governance tokens through ReHold's Dual Investment feature. This allows investors and traders to earn with an annual percentage rate (APR) of up to 220% on several governance tokens such as MKR, COMP, AAVE, SNX, and MANA, without actively trading. Investing has been made easier, and the best part is that ReHold is completely safe for trade, backed by security audits from blockchain audit companies including CertiK and PeckShield. Plus, it’s completely free to use.

To get started and benefit from this, begin by visiting ReHold.io, launch the app, connect your wallet, determine the governance token (you can rely on the search icon to find that), select the staking period, the amount you plan to invest, approve your token, and start your dual investment.

Interested in trading a governance token but don’t have any? ReHold’s Swap feature provides a cost-free and efficient way to exchange your available token for any governance token on the platform.

Final Thoughts

In the world of blockchain technology, governance tokens stand as a significant innovation, now a default feature in the largest DeFi sites worldwide. These tokens not only allow users to actively participate in project decision-making, making them integral to the DeFi ecosystem but also hold value, offering holders additional benefits such as a potential steady income stream. Looking ahead, the influence of governance tokens on the future of decentralized finance is expected to be profound, particularly in democratizing governance across the DeFi landscape.