Governance Tokens: What They Are and How They Work | Dex-Trade Academy

Governance Tokens: What They Are and How They Work | Dex-Trade Academy

1. How do governance tokens work?    

2. Pros and cons of governance tokens    

3. What's next for governance tokens?    

4. Closing thoughts    


In traditional companies, a board of directors or a small group of people holds enormous power over how the company is run. However, governance tokens represent a different way of governing organizations, which is more equitable, decentralized, and transparent. In this article, we will explore governance tokens, how they work, their pros and cons, and what the future holds for them.

How do governance tokens work?

Governance tokens are the core method to realize decentralized governance in DAO, DeFi, and DApp projects. They are awarded to active users for their loyalty and contributions to the community. Token holders vote on major issues to ensure the projects' robust development, and voting takes place via smart contracts. In most cases, one token equals one vote.

One of the earliest governance tokens was issued by MakerDAO, an Ethereum-based DAO that underpins the crypto-collateralized stablecoin DAI. Maker Protocol is governed by holders of its governance token called MKR. One MKR token equals one vote, and token holders vote on a variety of issues such as appointing team members, adjusting fees, and adopting new rules.

Pros and cons of governance tokens

Governance tokens have several benefits. One of their advantages is that they can eliminate the misalignment of interests often seen in centralized governance. Decentralized governance enabled by governance tokens transfers that management power to a broad community of stakeholders, aligning the interests of users and the organization itself.

Another benefit is the ability to build active, collaborative, and close communities. Every token holder is incentivized to vote and improve the project. Because one token mostly equals one vote, it can lay the groundwork for fair and more equitable decision-making. Every token holder can initiate a proposal to be voted on, and the details of each vote are open for everyone to see, which lowers the chance of cheating.

However, governance tokens also have some challenges. The biggest challenge is the so-called whale problem. Whales are people who hold a large percentage of a certain crypto. If the biggest whales of a crypto project hold a significant portion of the overall supply of its governance token, they could swing the voting process to their favor. Projects need to make sure token ownership is truly decentralized and evenly distributed.

What's next for governance tokens?

As an innovation born out of the crypto space, governance tokens could find wider usage in more sectors. The Web3 movement is a place where governance tokens can help build a decentralized internet. As DeFi and DAOs gain momentum, other industries such as gaming could adopt this governance model.

Governance tokens will continue to evolve to fix problems as they emerge. There might be new mechanisms to deal with the whale problem or other ways to enhance the voting process. Novel methods of delegating votes could appear. This space is likely to become more complex, while new innovations continue to take place.

Closing thoughts

Governance tokens have facilitated the robust growth of many DeFi and DAO projects. With voting power to determine the projects' management, these tokens are the cornerstone of decentralization. The principle of one token, one vote places users and the community at the center as long as the tokens are distributed relatively equally among the members of the community. Governance tokens may continue to expand in the future, and user-owned networks, Web3 projects, and games could adopt governance tokens. However, regulatory changes could impact how they function.