Over the past two years, we have experienced the boom of the decentralized finance ecosystem (DeFi) with many suggesting that the cryptocurrency market is expected to hit $32.5 trillion by 2028. Governance tokens are getting much attention in many of the best DeFi projects as the blockchain industry continues to champion decentralization and a new Web 3.0 economy. Every holder of governance tokens gets the possibility to influence decisions or vote on important initiatives in blockchain projects, giving a sense of participation and importance to investors.
Society can cast votes on blockchain-related proposals making these tokens become essential to blockchain projects, distributing control among their user communities, and ensuring participation in future decision-making processes.
Nevertheless, these tokens could run significant risks for users and investors. In this article, we take a look at what governance tokens are, how they operate, and their associated risks. Let’s dive in.
What is Governance Token?
To begin with, one of the most critical parts of decentralized finance (DeFi) is governance. Governance tokens are the first blockchain tokens representing voting power and ownership in a decentralized protocol. Since DeFi protocols give power and rights to users via tokens, the governance token serves as the protocol’s primary utility token. These tokens can be gained through active protocol contributions, such as providing liquidity to asset pools. Public members can spend these tokens as well as use them to directly influence a protocol’s direction and features. By the way, even though the vast majority of the DeFi tokens now available on the market are governance tokens, this does not mean that voting is the only way to distinguish them.
Which functions do Governance Tokens cover?
Voting on a diverse selection of fees
Making changes to the design proposals
Reimbursement of transaction fees
Revisions in developer funds
Governance token holders can also take out loans, put their tokens up for stake, and harvest yields for profit. However, their principal function is to distribute power. Tokens can impact new services development, their roadmaps, and key features. Additionally, you can use it to vote on upgrades and patches for existing programs.
How Do Governance Tokens work?
Following an initial launch, projects issue governance tokens that may be purchased on the open market. These buyers form a part of the decentralized autonomous organization (DAO). Participants in this process can choose from simple changes to significant governance structure reforms.
DAOs are commonly used to describe organizations that allow users to have an input into the operations of their protocol. In contrast, it is common for traditional corporations to have a centralized structure in which a group of individuals or a board of executives decides the company’s trajectory.
To ensure that the DAO succeeds, participants contribute their money in exchange for voting capabilities. Participants who invest more money typically have a significant influence on the election outcome than those who do not. That is how governance tokens are a shared decision-making framework in DAOs.
Tokens engage users in the project and aid engineers in making decisions, and you can determine code updates and treasury management with tokens.
The Main Features of Governance Tokens:
They occur mainly on Proof-Of-Stake consensus-based blockchains and give the holders ‘voting power’ to make changes or perform various functions on the blockchain.
People-centered governance approach: Tokens of governance transfer control from the founders to the users. This means that no one can alter the ledger entries on the blockchain since it is predicated on the premise that no one can edit them. On the other hand, governance tokens can be used to manage it. Communities make new proposals to change or improve certain parts of the project.
When making decisions about the codebase or its management, the views of the community are conveyed via governance tokens in a voting system. These tokens can also be used to set the rules for verifying transactions and blocks on the blockchain.
Examples of Governance Tokens
We’ll look at four crypto industry governance tokens. Maker (MKR), Uniswap (UNI), PancakeSwap, and Aave (AAVE) will be explored.
MKR is a MakerDAO governance token. MakerDAO is the most significant Web3 lending and DeFi platform, and holders can vote on platform economic rules.
Uniswap uses a UNI token and is one of the largest DEXs (decentralized exchanges) on Ethereum. Their owners can offer and vote on platform changes. Uniswap is less decentralized than other protocols on this list since its developers still have a significant influence on its operations.
PancakeSwap is a DEX that serves the BEP-20 tokens exchange and uses an automated market-maker approach (AMM). Its voting system allows CAKE owners to implement changes to the platform.
AAVE token owners take the protocol’s risk and contribute more directly. They care about the protocol’s safety and functionality. Those who own AAVE tokens can vote on the AAVE platform, which is significant in DeFi lending.
What Are The Risks Of Governance Tokens?
Token ownership must be fully decentralized and equitably dispersed among project members. As blockchain operates on the ‘majority wins,’ the majority vote decides what updates/upgrades can or cannot be implemented. They have the power to change the outcome of a vote. This leads to the growing risk of heavy accumulation of governance tokens and a single entity gaining a majority vote through various proxies. In that case, the blockchain will not be decentralized and is subject to the will of a single or few holders. Various mechanisms may exist to avoid such scenarios.
Also, governance token trading can become a big problem and cause a project’s collapse. Project owners have to take a chance selecting the direction of newly issued governance tokens to be moved across wallets before tokens can be traded.
Delegation of votes is another issue to consider. Many people who are eligible to vote may allow someone else to vote for them instead. Most of the time, voters do this when they think that the other person, team, or company knows more than they do and can vote better. But this can also take control away from eligible voters and give it to participants who can use the blockchain to their advantage.
Since cryptocurrencies are becoming increasingly popular, cybercriminals are coming up with new ways to attack blockchain projects. Hence, in situations where governance tokens are not properly distributed and only in possession of a few users, they become targets for these ill-minded attacks and there remains a risk of cyber-criminals taking over the project. It emphasizes the necessity to prevent the ownership of several tokens by a single entity.
The future of Governance Tokens
Governance tokens assist the development of a decentralized internet in Web3. Autonomous initiatives can be achieved through the use of these cryptos. As they decentralize decision-making authority to blockchain project supporters, the decisions can affect the project’s trajectory, including new developments and initiatives.
In the DAO ecosystem, governance tokens have paved the way for token holders to build a true community and have their voices heard by project owners and developers.
The notion of a token that enables the community to administer the project and decide its trajectory has given rise to a diverse spectrum of DAOs, from artistic initiatives to AMM DAOs, investment DAOs, and Metaverses. Increased strength of decentralization allows forming active, collaborative, and mutually beneficial societies. Also, potential legal changes are another key influence on the future of governance tokens.
The rapid progress of governance tokens is showing no signs of slowing down. Instead of trading, people should only be able to use these tokens to vote on things that have to do with blockchain and decide the project’s fate. Governance tokens allow for greater decentralization, making it highly significant. Additionally, they offer a solution to make Web3 protocols, platforms, dApps, and games more accessible to society. With the growth of DAOs and Metaverses, and DeFi continuing to deliver decentralized financing, governance tokens represent the beginnings of something big.