What is a Governance Token that Everyone Should Know?

Summary

A governance token provides its holders with voting rights on important issues that affect the development of a blockchain project. This is a way for projects to convey decision-making power from a small group to the entire community. This decentralized governance model helps align the interests of token holders with the interests of the project.

Why Were Governance Tokens Created?

In traditional corporate systems, power is often concentrated in the board of directors. Large corporations typically have a board consisting of about 10 people who hold all decision-making authority. They can appoint directors, decide on strategies, or approve new projects without consulting small shareholders. This management style is called centralized management, but it often leads to a misalignment of interests.

Governance tokens were created to address this issue. They have become popular with decentralized autonomous organizations (DAO) and decentralized finance platforms (DeFi). Instead of top-down decision-making, these tokens allow every member of the community to participate in the voting process. This creates a fairer, more transparent, and truly decentralized governance system.

How Does the Governance Token Work?

The operating method is quite simple: each token represents a vote. Active users are rewarded with tokens for their loyalty and contributions. In return, they have the right to vote on major decisions to ensure the project develops in a positive direction.

The voting process usually occurs through smart contracts, automatically executing results without manual intervention. This eliminates fraud and ensures fairness.

MakerDAO - An Illustrative Example

MakerDAO is one of the earliest DAOs operating on Ethereum, managing the DAI stablecoin backed by cryptocurrency. This protocol is governed by MKR token holders. Each MKR token corresponds to one vote. MKR holders vote on various issues: appointing new members, adjusting fees, or implementing new rules. The ultimate goal is to ensure that DAI is stable, transparent, and operates effectively.

Compound - Activity-Based Distribution Model

Compound is a DeFi protocol that allows for lending and borrowing of cryptocurrencies. It issues the governance token COMP for the community to vote on important decisions. The special point here is that COMP is allocated based on on-chain activity - the more you lend and borrow, the more COMP you receive. Similar to MakerDAO, one COMP token equals one vote. Users can also delegate their tokens to others to vote on their behalf.

It is noteworthy that Compound relinquished all control from the founding team in 2020. This means that the protocol is entirely operated by the token holders, with no other management methods.

Other Prominent Governance Tokens

In addition to MakerDAO and Compound, many other platforms also use governance tokens. Decentralized exchanges like Uniswap and PancakeSwap issue UNI and CAKE. The DeFi lending platform Aave issues AAVE. The Web3 community ApeCoin DAO and the virtual world Decentraland also have their own governance tokens. Each project sets different rules regarding how their governance tokens operate.

Advantages of Governance Token

Governance tokens provide significant benefits. First, they eliminate the issue of unfair benefit distribution often seen in centralized management. Management rights are transferred to a broad community of stakeholders, aligning user interests with those of the project.

Secondly, governance tokens build active, collaborative, and cohesive communities. Each token holder is encouraged to participate in voting and improving the project. Since each token represents one vote, it lays the foundation for fairer and more equal decision-making.

Thirdly, transparency is a significant advantage. Every detail of the ballot is made public for everyone to see, reducing the risk of fraud. Any token holder can submit a proposal to be voted on.

Challenges the Governance Token Must Face

However, governance tokens also have important issues. The whale problem is the biggest challenge. Those who hold a large proportion of the token (, known as “whales”), can manipulate the voting process to their advantage if they hold a significant portion of the total supply. Projects need to ensure that governance tokens are truly distributed and allocated fairly.

But even when tokens are widely distributed, there is no guarantee that the majority's decision is always the best for the project. The one-person-one-vote electoral systems have a long history of becoming chaotic. There are cases where token holders vote in favor of benefiting founding teams and large investors, while the community suffers.

How Will the Governance Token Develop?

As an innovation from the cryptocurrency space, governance tokens have the potential to be widely used in many other fields. The Web3 movement is where governance tokens can help build a truly decentralized internet. After DeFi and DAOs have proven successful, other industries such as gaming and the metaverse can adopt this governance model.

The governance token will continue to evolve to address current issues. New mechanisms may emerge to tackle the whale problem or other ways to improve the voting process. New methods of vote delegation may arise, making this field more complex but also more promising.

A key factor affecting the future is regulatory changes. Some governments may classify governance tokens as securities, forcing them to comply with strict regulations. This could impact how governance tokens are used.

Conclusion

Governance tokens are still in the early stages of development but have facilitated the robust growth of many DeFi and DAO projects. They represent voting rights for management decision-making and are the foundation of true decentralization. The one token - one vote principle places users and the community at the center, as long as these tokens are distributed relatively fairly.

In the future, governance tokens will continue to evolve and become more popular. User-owned networks, Web3 projects, and games can adopt governance tokens to build more vibrant and sustainable decentralized ecosystems.