Governance tokens are one of the innovations in crypto meant to enhance democratic decision-making, letting holders of the tokens vote on decisions of a blockchain project.
Governance token holders can decide on many actions including making changes to a user interface of a product, how to distribute fees and rewards in the ecosystem, and changes to the underlying project code.
Other than voting, governance tokens have more use cases including:
- Taking Loans
- Yield Farming
These tokens types are used across different projects including Decentralized Autonomous Organizations (DAOs), DeFi, and Decentralized Applications (Dapps). ‘Decentralized’ is a common keyword among these projects highlighting the key motivation for governance tokens – distributing power and ownership.
There are multiple ways that users can become holders of a governance token, depending on the criteria for ownership set by any given project. Typically, users who have made significant contributions or demonstrated loyalty to the project have the most chances of claiming these tokens.
A project’s criteria can also include how the tokens are distributed among members, usually including how much is available to different sets of stakeholders such as founders, investors, users, etc.
Governance tokens also come with differences in scope, depending on factors including the criteria for ownership and uses, as well as the success of a project. Some of the functionalities that you can expect from different projects include:
- Voting on a limited number of governance issues
- Voting on development updates
- Smart contract revisions
- Generating financial returns
Below is a list of the leading governance tokens by market capitalization (as of March 5 2023):
- Uniswap ($UNI): $4.7 billion
- Internet Computer ($ICP): $1.6 billion
- Aave ($AAVE): $1.1 billion
- Synthetic Network ($SNX): $940 million
- Maker ($MKR): $794 million
- Dash ($DASH): $758 million
- PancakeSwap ($CAKE): $702 million
Case Study: MAKERDAO
Till today, MAKERDAO represents one of the most successful applications of governance tokens, even more so when you consider that it is one of the most successful crypto projects out there.
At the time of writing, MAKERDAO’s DAI stablecoin is one of the most highly-rated stablecoins with a market capitalization of over $5.9 billion and daily volumes exceeding $500 million.
Holders of the governance token $MKR can vote on fees, rules, and team member appointments. One token is equal to a single vote and decisions are adopted based on the number of votes.
Case Study: COMPOUND
Lending and borrowing protocol, Compound, also lets users vote on important decisions using the Compound token ($COMP).
Users receive the tokens based on their activity on the Compound Network such that users who lend and borrow more often have more chances to be awarded the governance token.
The $COMP token also carries one vote like the $MKR token and holders can delegate their token to other voters to vote on their behalf. The Compound protocol is 100% controlled by token holders since 2020 when the project gave up the network’s admin key.
Utility Tokens vs Governance Tokens
Utility tokens and governance tokens are similar and can probably intersect, however, the main difference is understood by their definitions.
Utility tokens are a type of digital asset that can be used for a given purpose, such as paying fees or getting access to a certain product or service. On the other hand, governance tokens give holders a stake in running a project, something that users cannot do with utility tokens.
As we have covered in the introduction, governance tokens also carry some utility functions which can include staking and taking out loans. These are utility benefits that come in addition to a governance token’s hallmark which is giving holders a say in the running of the project.
Below is an outline of the key advantages of governance tokens:
- The best way so far that DeFi projects can implement decentralization
- Incentivize users to remain involved with the project
- It helps the project to only work on features that the community wants
When it comes to drawbacks, governance tokens can sometimes be complex and may be difficult for community members to understand and apply. One of the key issues with governance tokens is that wealthy holders can amass most of the tokens and dominate control of the network.