What Are Governance Tokens And Why They Matter?
Governance tokens. How do they work?
Key Takeaways
- Governance tokens are crucial to decentralized governance in DAOs.
- They align stakeholders’ interests with the DAO’s success and can increase in value as the DAO grows.
- There are various governance tokens with different attributes linked to the structure of each DAO.
- Some major challenges are related to whale manipulation and security risks.
In the world of crypto, driven by democracy and decentralization as key principles, decision-making structures are created around processes involving all project participants. This is where governance tokens play a significant role in this participatory framework.
They give users a direct say in the project’s direction and development. These tokens embody the spirit of decentralization, ensuring that no single entity has complete control and that the community’s voice is always heard.
Governance tokens are cryptocurrencies that empower holders to vote on key issues affecting a decentralized autonomous organization (DAO) or decentralized finance (DeFi) protocol. These tokens aim to enable a genuinely democratic system with active participation.
The community makes decisions, ensuring projects remain transparent and aligned with the interests of their members. Governance tokens foster a sense of ownership and accountability among all participants.
Governance Tokens, Explained
Governance tokens are a type of cryptocurrency or digital ownership that allows holders to participate in the decision-making processes of a blockchain project. These tokens work in similar ways to having shares in a company.
They provide users with votes on proposals related to the management and development of a project. These proposals range from fundamental changes like new features to transforming a project’s structure. Some examples are included in the following table:
| Protocol upgrades | Fee structures | Resource allocation | Partnerships and integrations | Tokenomics modifications | Community initiatives | Regulatory compliance | Privacy policies |
|---|---|---|---|---|---|---|---|
| New features | Transaction fees | Marketing budget | New partnerships | Inflation rates | Educational programs | Compliance with legal requirements | User data management |
| Protocol changes | Service fees | Community events | Integration with other platforms | Staking rewards | Outreach efforts | International regulatory adaptation | Privacy settings |
| Security improvements | Fee adjustment voting | External project funding | Collaborative technology developments | Burning mechanisms | Community-driven development projects | Adapting to new regulations | Compliance with global privacy laws |
Governance tokens enable users to participate actively in the decision-making process from the proposal conception to the final voting stage. Therefore, these tokens are essential for a project’s strategic direction.
How To Create A DAO Governance Token
DAOs are governed by smart contracts on a blockchain, which allows for their decentralization. For this reason, creating governance tokens is essential.
These tokens empower community members to make decisions and shape the organization in a decentralized manner that aligns with the nature of the blockchain.
- Define the purpose: Outline objectives and goals clearly to define the governance structure later.
- Choose the blockchain platform: Consider scalability, security, and community when choosing a platform. Ethereum, Solana, and Polygon are popular choices.
- Design the token: Define the tokenomics (total supply, distribution mechanism, and token utility), voting rights (e.g., one token, one vote, weighted voting), and token standard (e.g., ERC-20 for Ethereum).
- Create the smart contract: Develop the smart contract that defines the token’s properties, including total supply, transferability, burning and minting mechanisms, and governance functions such as voting and proposal creation.
- Implement governance features: Establish a process for members to submit proposals. Define voting mechanisms. Determine how approved proposals will be implemented (e.g., automatically through smart contracts or manually).
- Distribute the token: Define the distribution model (e.g., airdrops, sales, rewards).
- Launch the DAO: Deploy the smart contract to the chosen blockchain and officially launch the DAO.
- Promote and engage: Engage the community through marketing, social media, and community initiatives.
- Maintain and update: Monitor the DAO’s performance, gather feedback, and update the structure if needed.
Benefits Of Governance Tokens
Governance tokens offer a range of advantages that benefit the token holders and the DAO.
- Decentralization and community involvement: The main advantage related to how decentralized power prevents a single entity from dominating the platform.
- Alignment of interests between stakeholders: aligning the interests of the token holders to the success of the DAO encourages long-term commitment and participation.
- Potential for increased value of tokens: a thriving DAO can increase its interest and the demand for its token, benefiting investors and community members.
How Governance Tokens Work
The general lifecycle of a governance proposal starts with the draft provided by any member of the DAO with governance tokens. Once the proposal is submitted, the DAO members discuss it, debate it, refine it, and decide based on a voting system. This democratic approach ensures that the collective will is part of the ecosystem.
However, each DAO may use different mechanisms, token types, distribution methods, weighting, and voting systems. These variations enable the creation of governance structures tailored to each project’s unique needs and goals.
These aspects are crucial and unique to each DAO, varying based on mission and operational systems.
Governance Token Types
Different types of governance tokens play specific roles. Each facilitates a unique aspect of the DAO’s operation and community interaction.
- Utility tokens: These tokens access specific DAO services or products. Utility tokens can be essential to unlock certain functionalities. For instance, Filecoin (FIL) is used to access decentralized storage services provided by the Filecoin network
- Membership tokens: Granting access to the DAO community. These tokens provide specific privileges for their holders. For instance, Bankless DAO (BANK) tokens are used to signify membership within the Bankless DAO, a community focused on promoting DeFi.
- Treasury governance tokens: These tokens are used to manage the treasury or funds associated with a project. For instance, MakerDAO (MKR) holders can vote on proposals related to the use of the platform’s collateral and how funds are managed.
- Governance as a service (GaaS) tokens: These tokens control a platform that provides other projects with governance services or tools. For instance, Aragon (ANT) lets users create DAOs and allows users to vote on platform upgrades.
- Layer-2 governance tokens: These tokens govern projects or protocols operating on layer-2 solutions or scaling networks. For instance, Arbitrum (ARB) is used to govern the Arbitrum network, a layer-2 scaling solution for Ethereum.
- Staking governance tokens: These tokens are tied to staking mechanisms where users can stake their tokens to participate in governance or to earn rewards. For instance, Polkadot (DOT) holders vote on governance proposals and can stake their tokens to support network security.
- Metaverse and GameFi governance tokens: These tokens govern virtual worlds, games, or metaverse platforms. For instance, Decentraland (MANA) holders can vote on decisions related to land use, content policies, and the overall development of the virtual world.
- Multi-chain governance tokens: These tokens govern protocols that operate across multiple blockchain networks. For instance, Chainlink (LINK) holders participate in governance across Chainlink’s multi-chain ecosystem, which includes oracle networks on different blockchains.
- NFT governance tokens: These tokens are used to govern projects or platforms that focus on non-fungible tokens (NFTs). For instance, Rarible (RARI) holders can vote on platform changes, including the types of NFTs supported and marketplace features.
- Hybrid governance tokens: These tokens incorporate components from many governance models, frequently addressing several project-related issues like protocol choices, treasury management, and ecosystem growth. For instance, Aave (AAVE) holders have a say in protocol upgrades, risk thresholds, and money distribution.
Token Distribution
It is important to note that not all members of a DAO necessarily have the same amount or type of tokens. The membership structure and distribution can vary depending on each DAO’s allocation of tokens. Some methods for the allocation of tokens include the following:
- Airdrops: Free distribution of tokens to a specific group of people. Airdrops often aim to raise awareness, reward loyalty, engage, or create a community from the early stages.
- Crowdsales or public sales: distributions of tokens to raise funds and obtain the capital to make the project happen.
- Rewards for contributions or incentives: Distribution of tokens based on performance and activity within the ecosystem. Some examples include software development, participating in governance, or creating content.
- Liquidity mining: Users get motivated to provide liquidity to a decentralized exchange by depositing their assets in liquidity pools. Liquidity mining ensures that there is enough liquidity on decentralized platforms.
Weighting Of Tokens
DAOs can optimize engagement, ensure fair representation, and balance power among stakeholders effectively by varying the weight of tokens. There are standard methods of token weighting that are directly related to specific voting mechanisms. Therefore, the line between the two can sometimes blur.
- Linear weighting: Each token equals one vote. With this direct approach, power scales directly with the number of tokens.
- Reputation-based weighting: Some DAOs combine token ownership with reputation. As a result, a user’s voting weight might increase with token quantity and their contributions to the community, such as completing tasks or achieving specific milestones.
- Weighted randomness: This method is less common and involves weighted randomness, where decisions are made by randomly selecting token holders to make a decision.
Voting Mechanisms
Each specific token mechanism can impact the token weighting. For example, quadratic voting can significantly alter the influence exerted by token holders within a DAO, especially when there is a highly concentrated token distribution. In a standard one-token-one-vote system, individuals or groups holding large amounts of tokens can dominate decisions due to their sheer volume of votes.
- Simple majority: Each vote counts equally, and the option receiving more than half the votes wins.
- Single transferable vote (STV): Voters rank their choices in order of preference. This method is helpful for elections with multiple winners, ensuring that all votes contribute to the outcome.
- Range voting: Participants score each option on a scale of 1 to 5. The option with the highest total score wins, allowing voters to express varying levels of support for different options.
- Liquid democracy: Combination of direct and delegated voting. Voters can vote directly on issues or delegate their voting rights on specific topics to someone who can better represent their views.
- Approval voting: Voters can vote for all the options they approve of without ranking them. The option with the most votes wins. It’s simpler than STV and often leads to more consensus-based outcomes.
- Capped voting: Some systems cap the maximum number of votes for each member to prevent any single entity from having too much influence.
- Delegated voting: Token holders can delegate their voting power to another party they trust to vote on their behalf.
- Quadratic voting: This aims to prevent excessive influence on decision-making by increasing the cost of each additional token used to vote quadratically. As a result, it becomes disproportionately expensive for large holders to dominate decision-making.
- Time-locked voting: In this system, tokens gain more voting power based on their length of holding. The aim is to incentivize long-term holding and reduce the influence of short-term speculators.
These voting mechanisms are not exhaustive since decentralized government is an evolving field, often with innovative methods.
Comparison Of Governance Tokens in Action
Different DeFi platforms structure their governance and incentive mechanisms in specific ways, resulting in unique tokenomics. This section discusses SUSHI and UNI governance tokens.
SushiSwap (SUSHI) and UniSwap (UNI) serve as governance tokens with additional functionalities. Their features and mechanisms aim to engage their communities in governance and distribute rewards.
- Specific features: SUSHI and UNI users can delegate their votes to others, and a proposal must pass with a minimum number of votes. However, SushiSwap uses a direct governance model. In contrast, Uniswap governance system proposals first need a minimum amount of delegated UNI to move forward for voting.
- SushiSwap example: The platform could propose changing the fee percentage and redistributing the tokens. SUSHI holders would vote on this proposal, potentially increasing their returns if they are staking SUSHI.
- Uniswap example: The platform could propose to create a new liquidity pool for an emerging token. UNI holders vote to approve or deny the creation of this pool, directly influencing the platform’s offerings.
SUSHI offers more financial incentives through profit-sharing and liquidity rewards, aligning stakeholders’ interests with the platform’s economic success. In contrast, UNI focuses more on governance rights, motivating community decision-making, and encouraging token holders to participate actively in the platform.
Challenges Associated With Governance Tokens
While governance tokens have many advantages, they can pose challenges that might affect the DAO’s stability and effectiveness.
- Security risks: Governance tokens, like any digital asset, are susceptible to security threats, including hacking and fraudulent activities, which can threaten the entire ecosystem.
- Potential for manipulation and whale influence: If initial distributions are not carefully managed, they can influence who holds the tokens. It can potentially centralize power instead of decentralizing it, leading to the influence of entities with vast amounts of tokens, known as “whales.”
- Balancing community input with project development: Finding the right balance between community decision-making and the best strategic direction for effective project development can be challenging. Excessive community control can also have consequences like slowing down the progress. At the same time, too little control can lead to the exclusion of community members or centralized power and a lack of community support.
Conclusion
Governance tokens are an integral part of decentralized governance and, therefore, a supporting pillar of DeFi. In the best-case scenarios, their implementation supports a community-driven structure, giving a voice to all DAO members and enabling a democratic system.
However, they also come with risks and drawbacks. DAOs are continually evolving structures that shape the way tokenomics works.
Governance tokens empower stakeholders to make critical decisions, aligning their interests with the platform’s long-term success and potentially increasing the value of the tokens as the DAO thrives.
On the other hand, the challenges associated with governance tokens, such as potential manipulation by whales, security risks, and the problematic balance between community input and project development, highlight the need for robust governance mechanisms.
Effective governance ensures that the community can participate without compromising the strategic direction or security of the project.
In the future, new structures may appear in the ecosystem, providing solutions to significant problems and helping to create decentralization, the common basis of a future society increasingly shaped by blockchain technology.
These innovations could further enhance the effectiveness and appeal of DAOs, driving wider adoption and more profound impacts on both economic and social structures globally.
FAQs
Depending on the DAO’s specifications, there are several ways to acquire a token. For example, users can purchase (sometimes through purchasing native tokens), earn, mine, or stake tokens, and the platforms can allocate them through airdrop Not necessarily. Community members do not need to hold a certain amount of governance tokens to vote. Stakeholders might have more votes if they have more tokens (weighted voting) or have one vote per member, regardless of the number of tokens. It entirely depends on the specific structure of the DAO. It depends on several factors, including market conditions, tokenomics, regulatory environment, project viability, technical risks, and community adoption. Each project is different and might come with different investment opportunities and challenges. How can I acquire governance tokens?
Do I need to hold a certain amount of governance tokens to vote?
Are governance tokens a good investment?
