ZoneBitcoin EditorialYou have certainly heard of governance tokens. Different from "utility tokens", they are mainly used to manage a protocol or more generally an organization. This is what explains why they are used in DAOs, "decentralized autonomous organizations". Holders of governance tokens can then vote for different decisions of a project. This actually makes it possible to facilitate and structure decision-making within the same community, the same protocol for example.
Many decentralized finance tokens are governance tokens. However, they are not just for “voting.” They have other functionalities depending on the project in question. They can also be used to generate yields by staking, Yield farming or anything else specific to decentralized finance.
However, it is very important to understand what governance tokens are if we want to best understand how DAOs work. They are in fact the heart and the main tool of decentralized organizations, which are the spaces where the main decisions of the protocols are made.
What are governance tokens used for?
Holders of governance tokens, as the name suggests, can “govern”. They can vote on features like the user interface, fee amounts, reward distribution, etc. All decisions of the protocol it is issued by can be made in a “relatively” democratic process between the different members. This gives equal rights to all members of a project.
Thus, when a protocol is created, the founders provide governance tokens to their members. The latter can then give their opinions, in the same way, in theory as the founding members.
The purpose of governance tokens is this: to give members the power to express themselves and get involved collectively in a project.
How do governance tokens work?
Each project will define the operation of the governance tokens issued. Voting mechanisms and processes differ from one protocol to another. Each token has its own set of rules. Methods for calculating token ownership also differ from project to project. Typically, when the protocol is created, a certain amount is allocated to the founders, investors and early adopters.
It often happens that early adopters, those who have made a significant contribution, receive governance token rewards.
Some governance tokens are limited on governance issues. Some tokens allow holders to vote on all topics. Others are limited to certain questions.
Regarding usage, certain tokens make it possible to generate financial returns on linked protocols. Others have no other function than allowing voting.
💡 DAOs represent a new form of organization that does not follow a traditional, centralized organizational model. The acronym DAO actually means " Decentralized Autonomous Organization". The vast majority of DAOs are the governance bodies of the protocols and applications of the 3 web. In DAOs, there is no vertical hierarchy; This gives all members the same decision-making power. A user will then have the same power as the founder who launched the project. In the absence of leadership, governance tokens are then used to make decentralized organizations functional.
What is the difference between governance tokens and utility tokens?
Utility tokens (utility token) are, as the name suggests, tokens which have a specific utility. For example, they can be used to pay network costs or to access a given service. For example, AVAX is the utility token of the Avalanche network. It is used to pay fees and also to vote on certain decisions. As for governance tokens, they serve one purpose in theory: to be able to govern.
It is then true that certain utility tokens can have governance functions. It is a fact. However, the reverse is not true. A governance token is only used for votes. It has no other uses, absolutely. However, as there are no fixed borders, many governess tokens are also used in staking protocols, Yield farming etc. This sometimes makes them more versatile than utility tokens.
History of governance tokens
One of the first governance tokens was issued by MakerDAO. This is the protocol that established the stablecoin indexed to the dollar: DAI which is then the utility token of the project. The protocol has also deployed the MKR token which is therefore the governance token. One token equals one vote. Following a democratic process, votes are won with the most votes.
MKR token holders can then vote on issues of fees, rules, partnerships and any other crucial decisions on the development of MakerDAO. It is then, a project which is one of the most transparent in the crypto sphere.
The particular case of Compound
It is especially with the Compound protocol (which allows lending and borrowing) that the governance token has taken on another dimension. The governance token called COMP was instrumental in the appearance of Yield Farming. One COMP token is equivalent to one vote. The governance token is distributed based on user activity within the protocol. So, the more users lend and borrow on the protocol, the more they are rewarded in COMP tokens.
The token was a dazzling success and experienced an exponential rise in 2020. This then attracted new users to the platform who were more interested in obtaining the COMP token than in using the platform. This gave rise to what is called the Yield farming, which consists of generating returns on tokens from protocols.
Since 2020, Compound no longer has sole management of the protocol. This is entirely governed by the token holders. It is one of the most advanced protocols in terms of DAO.
What are the most popular governance tokens?
🔎 MakerDAO : As we said above, MKR is considered to be one of the first governance tokens. It is also an appreciated protocol and leader in DeFi lending and borrowing protocols. Holders have had decision-making power over the entire protocol since 2020. It is one of the most successful examples of a functional DAO.
🦄 Uniswap : The UNI token is the governance token with the largest market capitalization currently. The UNI token is also used by users of the protocol to encourage them to become liquidity providers. Read the article : How to make money with Uniswap?
(I.e. Corners – It is one of the most reputable protocols and the CRV token also serves as incentives for liquidity providers.
🧮 Bitdao – BIT token holders participate in the decisions of BitDao, a DAO that invests in innovative projects in the website 3.
What are the benefits of governance tokens?
In theory, governance tokens represent a way to decentralize a project and encourage users to get involved in a project. Everyone can give their opinion and get involved in a project. Everyone is in the same boat. This is how a project can then claim true decentralization. There is no higher hierarchy that alone dictates the decisions to be made. No, everyone can participate. Without governance tokens, we are dealing with unilateral companies, like those we know in Web2 for example where only shareholders and management teams participate in project decisions.
The other big advantage of governance tokens is easier communication with users. This is then a real way to hear the real needs of users. THE blockchain developers can then improve their products and deliver something that is really desired by the community.
What are the disadvantages of governance tokens?
⚙️ The complexity : The first big disadvantage is that they are generally difficult to understand. Beginners in decentralized finance can quickly get lost in how tokens work. For example, there are protocols that have several tokens with several different functionalities. We must first understand the concept of decentralized governance and then understand how tokens work. There is such complexity that many platform users are turning away from governance tokens. Likewise, it requires time and a certain knowledge of cryptocurrency in general and the platform in particular.
???? Plutocracy : The other downside – and probably the most dramatic – is the abuse of power. Most tokens represent votes. Now, this means that people who hold more tokens then have more votes. Similarly, when the protocol is created, a large allocation of tokens can be distributed to founders and team members. Even though most protocols now opt for fair distributions, some investors rush to buy these tokens as soon as they have the opportunity. They can then influence a vote in their favor… So, those who hold the most tokens are the ones who have the most power. In political science this is called “plutocracy” where wealth is the basis of power…
⌛️ Lockout period : Sometimes, governance tokens are locked for a fixed period. This can lead to price manipulation. When the tokens are released, in fact, we have observed in certain cases that the tokens were sold massively. The law of supply and demand is then strongly disrupted by this locking system, which nevertheless seeks to limit price manipulation...
🪫 Disempowerment : The other disadvantage that can be mentioned is the lack of accountability. To the extent that decisions are made by the community, this annihilates any personal responsibility. In a sense this can be beneficial but sometimes it can be unfair. If certain people voted for a risky decision, for example, the entire protocol may suffer while only a minority is actually and directly responsible.
Is it possible to make money with governance tokens?
Even if governance tokens were not originally designed with profitability in mind, it turns out that this is the case for many of them. Since most governance tokens can be traded on exchange platforms, they have a “price”. Moreover, many governance tokens are used to generate passive returns, particularly in liquidity mining pools.
💸 We can also cite the Illuvium game where the founders plan to share 100% of the profits which will be distributed among people who stake their governance token, ILV.
Furthermore, certain governance tokens are also used to pay back part of the profits generated by the protocol. They then distribute what we can call crypto dividends. Having governance tokens sometimes means owning shares of the company. Thus, the parallel with shareholders who have speaking rights in companies is then more relevant.
It goes without saying that the governance tokens with the most value are those issued by valued protocols. The more the protocol is known and appreciated, the more its governance token gains value, CQFD.
However, when the project is launched, early adopters usually speculate on the tokens they receive. The tokens only gain value once the project starts attracting users. Another way for the governance token to gain value is by being bought back (in part) by the founders, in a process called Buy-back. The mechanism of the " burn » which consists of destroying tokens can also be used to increase the value of a token.
How effective are governance tokens?
Governance tokens are a new entity in the legal-financial field. There are still a lot of debates, discussions about their purposes and especially about their effectiveness. Moreover, in terms of legislation and regulation, depending on the country, the status of these tokens varies. There is still legal uncertainty on this point.
In theory, governance tokens are great tools for decentralizing organizations. They improve organizational efficiency, for example, and can make protocols more effective.
However, in practice, governance tokens are not the ultimate answer to decentralization. As we mentioned in the disadvantages chapter, there can be many deviations. Whether through the quality of votes, the allocation of tokens, the manipulation of token prices, there are still many issues to be resolved.
What is the future of governance tokens?
For the moment, governance tokens and DAOs are still in the experimental phase, like all of DeFi ultimately. There is still a lot of uncertainty and debate on many topics. We cannot predict the future but most certainly we can assume that there will be new laws. These could regulate governance tokens and consider them as securities, for example. Voting patterns could also evolve, etc.
We can still be certain that governance tokens will continue to exist and be important elements in the protocols. This remains a relevant tool for the decentralization and democratization of protocols. Web3.
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