What are governance tokens?

What are governance tokens? Governance tokens are a type of cryptocurrency that represents a user’s right to vote on a particular blockchain project. Because they delegate users’ powers and rights to other users through the usage of tokens, they serve as the primary utility token for DeFi systems.

One can create governance recommendations using these tokens, and then vote on those suggestions. Tokens can be spent by members of a community to actively impact the characteristics and course of development of a protocol. It is within one’s power to:

• Vote on different fees
• Implement modifications to the user interface
• Alter the distribution of fee rewards
• Revise dev fund

Even while the vast majority of the DeFi tokens now available on the market are governance tokens, this does not mean that voting is the sole characteristic that distinguishes them. Staking, taking out loans, and earning money through yield farming are all options available to holders of it.

Nevertheless, the distribution of electrical power is their only function. Even if voting is the primary function of most decentralized finance (DeFi) tokens, this is not the only characteristic that sets them apart. Those who have these tokens can do several things with them, like taking out loans, staking them, and making money through yield farming. Despite all of this, their primary responsibility continues to be the distribution of power.

There is a great deal of controversy over the usefulness of governance tokens even though they have only been around for a relatively short period. Others are concerned that they will lead to the consolidation of power among a relatively small group of tokenholders, even though other people feel that they are the key to genuine decentralization.

What is the difference between governance and utility tokens?

What is the main distinction between utility tokens and governance tokens? To provide a concise explanation, utility tokens are digital assets that offer some kind of utility to their holders. This utility is typically only available on the blockchain network or crypto platform that it was originally developed for. The BNB token is a fantastic illustration of a utility token.

On Binance, the asset can be utilized for a variety of purposes, such as paying for fees, voting on new token listings, and buying tickets as ‘entry fees’ for services such as the Binance Launchpad.

The primary distinction lies in the fact that utility tokens do not include any form of governance power. Users of Binance do have the ability to vote on which tokens are listed, but other than that, nothing else can be altered. Users are unable to use BNB to decide on other, more important features, cast their vote, or decide how Binance should improve its appearance or function.

Utility tokens have been given a makeover and are now known as governance tokens. Because of this, selecting them can turn out to be the best choice. As was noted before, tokens may also be used for other operations, such as staking and making loans, thus there is no reason why one should choose utility tokens over governance tokens. Staking and creating loans are two examples of this.

How do governance tokens work?

What is the function of governance tokens? Governance tokens are the key component of any decentralized autonomous organization (DAO), decentralized financial institution (DeFi), or decentralized application (DApp) project that implements decentralized governance. They are frequently given out as recognition for the dedication and participation of active users within a community.

To ensure the continued success of the initiatives, token holders are given the right to vote on important matters. In most cases, voting is conducted through the use of smart contracts; in this scenario, the results are automatically put into action.

MakerDAO, a decentralized autonomous organization (DAO) built on Ethereum that serves as the basis for the crypto-collateralized stablecoin DAI, is credited with issuing one of the initial governance tokens. Holders of the Maker Protocol’s governance token, known as MKR, are responsible for its administration.

One vote can be cast with one MKR token, and the winner is the option that received the most support. Token holders are allowed to vote on a variety of matters, including the appointment of team members, the modification of fees, and the adoption of new rules. The MakerDao stablecoin must maintain its stability while also being completely transparent and operating at peak efficiency.

Another illustration of this concept is the DeFi protocol known as Compound, which enables users to lend and borrow cryptocurrency. It does this by distributing a governance token known as COMP, which enables its community of users to vote on important matters.

The tokens are distributed to users in direct proportion to the amount of on-chain activity they perform. To put it another way, the more money you lend and borrow on Compound, the greater number of COMP tokens you will accumulate.

In a manner analogous to that of MakerDAO, one COMP token is equivalent to one vote. Users also have the option of delegating their tokens to other users so that others can vote on their behalf. A noteworthy fact is that Compound gave up ownership of the network’s admin key in the year 2020.

It indicates that the project is now solely managed by the people who have the tokens, and there are no other governance procedures in place.

Other significant governance tokens include those issued by the decentralized exchanges Uniswap and PancakeSwap, the decentralized financial lending platform Aave, the Web3 NFT community ApeCoin DAO, and the virtual world platform Decentraland.

Every project has its own unique set of guidelines for how its tokens should be used. Different calculation models are used to determine how tokens should be allocated to various stakeholders, such as the founding team, investors, and users.

While some tokens can only vote on a limited number of governance issues, others can cast their vote on the vast majority of topics. There are two types of governance tokens: those that can earn financial dividends and those that cannot.

What are the advantages and disadvantages of governance tokens?

What exactly are the benefits, as well as the drawbacks, of using governance tokens? The use of governance tokens has been demonstrated beyond a reasonable doubt. But what are the drawbacks of using them, and how do they affect the functioning of cryptographic protocols? Let us quickly summarize the positive, the negative, and the ugly aspects of the situation.

Advantages

Collaboration opportunities

Voting paves the way for conversation, and conversation clears the path for cooperation. When users can cast a vote directly on an issue that affects them, it encourages them to work together with other members of the community to conclude the process of conversation. Because of this, governance forums are the best social platform available, coming in second only to Crypto Twitter.

Greater levels of community participation

Users have a reason and a way to actively guide a project’s path and direction when governance is in place, which leads to a greater level of community involvement.

Efficient development

Governance models make it simpler for developers to arrive at specific solutions and execute the changes that are judged required by their community. This is true even though developers do not completely abdicate their role in the decision-making process.

Decentralization

The use of governance tokens is the only method available to developers for implementing the “De” component of DeFi. Without them, projects would consist solely of smart contracts over which no one would have any influence or authority. If decentralization is the primary objective of digital assets, then why not incorporate it more tangibly?

Disadvantages

Selfishness

A person doesn’t need to vote for the most favorable conclusion simply because they have the right to do so. To put it another way, there will always be those who are motivated solely by their self-interest and vote on measures that will only benefit themselves. Remember when the Maker community debated whether or not they should reimburse their community following the flash crash in March and ultimately decided against it?

Absence of responsibility or obligation

In light of the situation described above, it is quite evident that democratic modes of government will never be capable of producing genuine accountability. If a decision turns out poorly, the community will almost always point the finger of blame at an anonymous or nebulous entity. Users will never admit fault and instead point the finger at “the majority,” but you won’t find anyone who admits to being “the majority.”

Whales

The term “whale” refers to a participant in a governance system who amasses large amounts of a project’s token. Investors frequently have the irrational fear that at some point, the “whale” will, through the sheer power of their financial resources, take control of the majority of the tokens, and then unilaterally create proposals and arrive at a decision that benefits only themselves; this would be a nightmare for blockchain democracy.

What to be aware of when buying governance tokens?

When it comes to purchasing governance tokens, what should be kept in mind? Conduct research into the overall token supply as well as the distribution of tokens before investing in governance tokens.

Some projects have a significant portion of the overall supply locked up in a vesting schedule for the various stakeholders; as a result, this component of the supply is not yet accessible to the stakeholders. When all of the vesting tokens are suddenly issued to the team and investors, the value of the project, which had been artificially inflated by the previous point, may fall.

You may discover information regarding the project’s overall supply on either their website or in their whitepaper.

Final thoughts

Governance tokens are just getting their feet off the ground at this point. They have been instrumental in numerous DeFi and DAO initiatives’ rapid expansion because of the support they have provided. These coins are the foundation of decentralization since they provide holders the opportunity to vote on who will run the projects they support.

As long as the tokens are distributed relatively equitably among the members of the community, the “one user, one vote” approach will put users and the community at the heart of the system. It may continue to gain popularity in the years to come. Governance tokens could be implemented in user-owned networks, Web3 initiatives, and games to facilitate the development of more robust decentralized ecosystems.

The use of cryptocurrency in gaming is at the front of an ongoing economic and digital revolution. At Lunar Sky Games, we are a team of gaming product consultants with over 10 years of expertise in the industry. We work in partnership with web3 companies to help them build and grow their products. We help turn your vision into a reality. Contact us now for a consultation.