These tokens play an important role in distributing the control of blockchain projects among their communities of users.
In the decentralized world of blockchain, projects are often looking for ways to distribute a greater amount of power and responsibility to their users. But in order for that to work, they need to employ a method that guarantees only users who are seriously committed to the success of the project participate in it.
One way to achieve that is to create a special type of collectively managed organization known as a decentralized autonomous organization (DAO) and require participants to invest their own money in exchange for voting powers to ensure they all act honestly and the DAO prevails. Usually under this setup, those who invest more money have greater voting power over those who don’t.
A type of utility token known as a "governance token" is then issued to users to represent each person's stake in the DAO.
Distributing control among stakeholders in this way is called “on-chain governance.” The powers denoted by the governance tokens may include traditional management roles and the authority to change the project’s protocol, i.e. its foundation in code. Sometimes users’ votes are weighted proportionally to the size of their holdings of the governance token.
To ensure that the holders of governance tokens have an interest in the good health of the project long term, protocols often channel a share of network transaction fees into the wallets of the token holders. The tokens may also carry non-governance rights, like the right to be exchanged for certain other tokens at predefined rates.
For example, the Terra network uses a governance token called luna. Luna is traded on digital exchanges, just like a regular cryptocurrency, but one of its core functions is to enable its holders to participate in votes on the network policy. A vote by luna holders precipitated a move to "burn" tens of millions of luna tokens in 2021 and mint millions of new TerraUSD stablecoins. The pros and cons of the decision were hotly debated among luna holders in the run-up to the vote. A whole community can act something like an enormous committee in this way, strictly organized by the impersonal mechanism of the protocol’s smart contracts.
Governance tokens, therefore, get some of their value from the fact they confer certain powers to their holders. That may contribute to their sizable valuations: Luna ended 2021 trading at more than $80. In this way, they differ from conventional cryptocurrencies like bitcoin, which functions more like traditional money as a store of value and medium of exchange.
DAOs often structure their decision-making using governance tokens. These entities aim to avoid central management altogether by placing authority wholly into the hands of stakeholders.
Examples of governance tokens in DeFi (Decentralized Finance) include yEarn's YFI and Compound Finance's COMP.
yEarn Finance is a suite of DeFi (Decentralized Finance) tools and products in an interconnected financial ecosystem running on various smart contracts. The yEarn Finance ecosystem is community-controlled and governed by the protcol's governance token YFI. It was created by Andre Cronje.
YFI holders can submit, discuss, and vote upon various YIPs to make operational or governance changes to the ecosystem and its products. YFI was the first fair launch token, meaning that there was no Founder, venture capitalist or early investor pre-mining program to privately claim a portion of a coin's supply. YFI was fair launched on July 20, 2020.
Compound Finance allows users with a MetaMask account to lend or borrow cryptocurrencies and earn interest.
It lets users deposit cryptocurrencies and earn interest, or borrow other cryptoassets against them. Funds are never held by any third party.
The protocol's governance token COMP entitles holders to fees and governance rights over the protocol.
COMP holders can make changes to the protocol through improvement proposals and on-chain voting. Each token represents one vote, and holders can vote on proposals with their token holdings.
Common topics COMP holders vote on include interest rates and required collateralization for each asset.
Maker (MKR)
The Maker (MKR) token was created by MakerDAO. MKR holders are responsible for governing the Maker Protocol, which includes adjusting policy for the Dai stablecoin, choosing new collateral types, and improving governance itself.
MKR holders can vote to change the economic rules that govern the decentralized lending that allows DAI to keep its price stable.
Uniswap is a Decentralized Exchange (DEX) that allows users to swap Ethereum based tokens. Uniswap released their governance token UNI via a surprise airdrop to early users of the protocol in late September 2020. The protocol plans to distribute a capped total of 1 billion UNI over the next four years. 60% percent will go to Uniswap community members, 21.5% will go to Uniswap employees, and the remaining 18.5% will go to investors and advisors.
Frax Finance (FXS)
Frax Finance is a fractional-algorithmic stablecoin protocol to be launched by founding members of the Everipedia team by the end of 2020. Frax Finance is open-source, permissionless, and entirely on-chain, currently implemented on Ethereum with possibe cross-chain implementations on Binance Smart Chain and Polkadot in the future. The Frax protocol aims to provide a highly scalable, decentralized, algorithmic money in place of fixed-supply digital assets like Bitcoin. The Frax Share token (FXS) is the non-stable governance token in the protocol. It is meant to be volatile and hold rights to governance and all excess collateral of the system.
