What Is Governance Token - A Detailed Overview

Governance tokens allow users to take on a more active role in managing decentralized projects.

Governance tokens are a type of cryptocurrency that allow tokenholders to vote on the direction of a blockchain project. The primary purpose of governance tokens is to decentralize decision-making and to give holders a say in how the project is run.

Governance tokenholders are usually more invested in the project’s success as they stand to gain or lose more, depending on the outcome. Community members can use tokens to influence the direction and features of a blockchain protocol directly. As such, it is possible to implement changes related to the user interface, vote on fees and reward distribution, or even modify the underlying code of a project.

Although most decentralized finance (DeFi) tokens are governance tokens, voting is not their only defining feature. People possessing these governance tokens can use them to take out loans, stake them and earn money through yield farming. Given all this, their primary function is still to distribute power.

Governance tokens are a relatively new invention, and there is still much debate about their efficacy. Some believe they are the key to true decentralization, while others worry that they will lead to the centralization of power among a small group of tokenholders.

How Do Governance Tokens Work?

Governance tokens act as the foundation to establish decentralized governance in decentralized autonomous organizations (DAOs), DeFi projects and decentralized applications (DApps).

Users who have made significant contributions to the community or have demonstrated loyalty are frequently awarded governance tokens. Tokenholders then vote on key issues to ensure that the projects progress effectively. Generally, people vote by utilizing smart contracts so that the results are tabulated and enacted automatically.

Each project has its own set of governance token rules. They are dispersed to stakeholders, including the founding team, investors and users, using various calculation methods. 

Some governance tokens only vote on a limited number of governance issues, while others vote on everything from development updates to smart contract revisions. Similarly, some governance tokens have the option of generating financial returns; others do not.

Among the types of issues that MKR tokenholders vote on are fees, rules and team member appointments. Ultimately, the goal is to maintain DAI's stability, transparency and efficiency.

Another example of a protocol with a governance token is Compound, a DeFi protocol that allows users to borrow or lend cryptocurrencies. 

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The number of COMP tokens users receive is based on their activity levels within the Compound network. That said, users who lend and borrow more often will be rewarded with more COMP tokens. The COMP token is the equivalent of one vote on the Compound. The tokens can also be delegated to others to vote on your behalf.

In 2020, Compound gave up control of the network's admin key and the project is now entirely governed by its tokenholders without any other governance methods.

Difference Between Governance & Utility Tokens

Utility tokens are digital assets that can be used for a specific purpose, such as fee payment or access to a product or service. In contrast, governance tokens give the holder a say in how the project is run.

Are Governance Tokens Valuable?

Governance tokens are powerful because they give holders a say in how the project develops. Furthermore, governance tokens can improve organizational efficiency. As a result, the entire organization may become more efficient and successful.

In addition, governance tokens have value and may be traded, swapped, exchanged, staked, etc. They are also a great opportunity to earn passive income. Stake governance tokens may also earn users additional benefits, such as increased access to services or a piece of the protocol's profits. If this is the case, possessing a governance token is comparable to having a share in a revenue stream.

So, how do governance tokens gain value? There are a few ways. One is that the tokens will become more valuable as the project becomes more successful. For instance, new blockchain games usually offer early adopters a chance to later stake their governance tokens in exchange for game revenue. In this case, even though a governance token may not seem to have much value initially, it may be worth a lot more in the future.

A decentralized protocol can also increase the value of its governance tokens by buying back tokens. This reduces the number of tokens in circulation, making each more valuable.

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Source: cointelegraph